Financial stability as a pre-condition for a hard budget constraint: Principles for a European Monetary Fund

Ever since the financial crisis mutated into a ‘euro’ crisis in 2009-10, the feasibility and desirability of creating a European Monetary Fund (EMF) has been the object of serious debate in both academic and policy circles. In the meantime, the European Stability Mechanism (ESM) has been created to essentially perform the functions of an EMF. It has been t has been critical in containing the cost of the crisis, and four of its five country programmes have been a success. But the case of Greece shows that one needs to be prepared for failure as well. This contribution proposes to keep the ESM’s remit essentially as it is today but would further empower it to impose conditions on countries receiving its financial support. Such support, however, would be limited to prevent situations arising in which the ESM would come to ‘own’ a country. Within such a structure, the ESM/EMF is viewed literally as a financial stability mechanism, whose main function is to ensure that a bailout is no longer “alternativlos”, as Chancellor Angela Merkel used to say. In 2010, the rescue of Greece was presented as TINA (There Is No Alternative) because the stability of the financial system of the entire euro area appeared to be in danger. With financial stability guaranteed by the ESM/EMF in combination with the Banking Union, default becomes an alternative that should be considered dispassionately. Whether the debt of a country is sustainable can rarely be known with any certainty beforehand. Accordingly, it is proper that the Union, in the ‘spirit of solidarity’, initially gives a country the benefit of the doubt and provides financial support for an adjustment programme. But the exposure of the Union should be limited. If the programme does not work as expected a hard budget constraint needs to be imposed, but the ESM/EMF could still be of great help as a source of bridge financing to soften the cost of default.