Thread by @Brad_Setser

. @MESandbu has put out a series of excellent columns on the euro area this week. All three are worth reading closely. I wanted to offer a few reactions, as the events of the last ten years have shown that Europe's internal architecture matters globally.

ft.com/content/c4a502…

I very much agree with Sandbu's framing of the problem, namely that a monetary union "should be a source of stability rather than instability, both for the real economy ... and for itself" and that reforms are needed so the euro area can do a better job of demand management

I also agree that the euro area has pioneered, in Greece, some innovative techniques for sovereign restructuring. It "taught policymakers that sovereign defaults can be restructured within the euro, and illustrated good legal techniques for doing them."

ft.com/content/cdb6c9…

so long as euro area countries continue to issue bonds governed by their own law, the euro area already has the capacity to restructure bonds in an extreme case ...

(the euro area CACs though could be improved, ICMA standard CACs have stronger aggregation provisions)

And with the ESM (the EMF to be) the euro area also has the capacity to provide funding to a country to make sure that debt restructuring isn't always necessary even when a country loses market access (on sustainable terms) for a while.

At least for smaller countries.

so the points of disagreement? I think Sandbu likely overstates the "stabilizing" role of bank bailin: "writing down bank debt is a form of recapitalisation, it should boost banks’ ability to sustain credit flows, lifting growth and with it public finances."

in Italy (a special case, as the banks sold equity, subdebt and bonds to their depositors in the crisis), fear of bailin slowed down recapitalization with public euros, hindering the ability of the system to provide credit.

and using bailin to provide banks with the capacity to keep lending in a crisis is hard - the bailin has to be broad and deep enough that there aren't fears that it will need to be extended. As those fears make it harder for other banks to raise funds in the market.

US got out of its crisis more quickly than Europe by avoiding a bailin of senior bonds and instead forcing banks to take capital, capital that initially was cheap but that got expensive fast. And banks weren't allowed to meet capital requirements by shedding assets.

US approach isn't necessarily better (it did let bank creditors off the hook, and that had a political cost), but it does illustrate that there are lots of different ways of avoiding pro-cyclical behavior in the banks. European rules make some of these approaches hard now.

Biggest question I have though is whether a system that relies on markets to discipline national governments for bad fiscal policy will allow all the member states the freedom to conduct more aggressive counter-cyclical fiscal policy that Sandbu (correctly) wants.

I basically fear that concerns about losing market access (and having to seek european financing and a restrucutring) will force weaker euro area states to act pro-cyclically in future crises ...

I cannot quite get my head around the notion that restructuring would be used to create fiscal space - am stuck on the notion that the markets fear of being caught in a restructuring would reduce fiscal space when it is most needed.

that's all!

ft.com/content/29742e…