Box 2.15 Screening and selecting measures of trust

35 Greece had misrepresented its budget deficit and debt for over a decade (Djankov, 2014; Papaconstantinou, 2015). 36 Djankov, 2014. 37 Shambaugh, 2012. 38 The report of the Committee for the Study of EMU (1989)—the Delors Report—had correctly predicted that

Europe’s new free capital markets might not always and consistently rein in profligate debtors (and careless creditors) by requesting substantially higher spreads for less prudent debtors with riskier projects. However, the authors had probably not anticipated that they would be reduced to near zero. 39 This also meant that, when push came to shove, the credibility of the no-bailout clause (Art 125 of the Treaty on the Functioning of the European Union) was rather low. 40 For instance, banks’ exposure to their own sovereigns was rated as having zero risk by the regulators. This could be seen as softening the market’s discipline on the sovereign. 41 In the Italian case, Banca d’Italia had disallowed putting investments in structured products off balance, hence, by insisting on booking on balance and thus requiring backing with equity, these instruments became unattractive. Italian banks were not hit in 2008, only later when the sovereign debt crisis erupted. 42 Other supervisors implemented basically the same European rules differently, of course within the leeway given by the European regulations. They were using “national derogations”. 43 World Bank, 2018. 44 The importance of inter-regional mobility for absorbing shocks was emphasized early on by Blanchard and

Katz, 1992. Since then, however, it has declined. 45 Eurostat, 2018. 46 World Bank, 2016. This calls for the harmonization of qualification standards and certification procedures. The

Bologna process on harmonizing academic curricula was a beginning. 47 European Central Bank: https://www.ecb.europa.eu/mopo/eaec/html/index.en.html 48 World Bank, 2016. 49 Since yearly data at the NUTS-3 level are only available for more recent years, we are unable to conduct population weighted analysis at the NUTS-3 level. 50 Lutz et al., 2019. 51 Even today, the “federal” EU budget is very small (and deemed to stay so): 1 percent of GDP, compared to a US federal budget of about 20 percent. It is mainly spent on agriculture and support for lagging regions and, of course, does not have the automatic stabilizing capacity of the US budget, for instance. MacDougall (1977) had estimated that the EU would need a budget of about 5 to 7 percent of aggregate GDP of member states in order to play this role. 52 In July 2012, ECB president Draghi announced the ECB’s resolve to do “whatever it takes” within its mandate to safeguard the euro. This largely mitigated market fears of an unravelling of the euro. Institutional investors were reassured as the statement was seen to imply that EMU member states would have access to ECB funds when running into liquidity problems, i.e. problems with rolling-over their outstanding debt. The support, called Outright Monetary Transactions (OMT), was conditional on entering an adjustment program with the European Commission, the ECB and the IMF—the “Troika”. The OMT provides a safeguard in case severe distortions in sovereign bond markets occur. Conditions for its activation include that the respective country is subject to an appropriate ESM program with strict conditionality. As any purchases take place only in secondary markets, no direct financing of governments is extended. 53 This assistance is granted only if it is proven necessary to safeguard the financial stability of the euro area as a whole and of the eurozone members. 54 It took the place of the European Financial Stability Facility (EFSF), which was supposed to be a temporary facility that mitigates moral hazard. The EFSF was established to deal with the Greek crisis that started in May 2010.

It went against the “no-bail out” philosophy of the Maastricht Treaty, which had argued that providing member states with insurance against market pressure would lead to unsustainable policies. 55 Berger et al., 2018. 56 Berger et al., 2018. The International Monetary Fund (IMF) was also brought in during the crisis, providing about a third of the funding for the Greek and Irish rescue packages of 2010, with the EFSF providing the other two thirds. Both the ESM and the IMF conducted debt sustainability analyses, with the possibility of issuing bridge loans to reach sustainability. 57 Further development of the ESM (currently with paid-in capital of 80 billion euro) should be one of the elements of the new architecture of the euro area. In parallel, better public debt management and banking supervision is needed to reduce the risks from sovereign bonds infecting bank balance sheets, and, ultimately, the creation of a European “safe asset”. 58 Buti et al., 2017. 59 This should reduce capture and provide for a common, uniform application of regulations.