- John Paulson Chair in European Political Economy, London School of Economics
- By pooling government debt, the weakest in the union are shielded from the destructive upsurges of fear and panic that regularly arise in the financial markets of a monetary union and that can hit any country.
- Professor of Macroeconomics, University of Duisburg-Essen
- The mutualisation of the euro zone’s debt to bring about the convergence of interest rates will not, in the long run, tackle the roots of the problem. Instead it will sow the seeds of an even larger crisis.
The last European summit that ended on June 29th declared that it was “imperative to break the vicious circle between banks and sovereigns”. Markets revived on the hope that the leaders were finally ready to act to deal with the threat to the euro, and then soon lost heart amid the cacophony of rival interpretations about what had been agreed. Still, the leaders had identified the right issue: weak banks and weak sovereigns are like two bad swimmers that are pulling each other under water.
But which one should be saved with first? Paul De Grauwe says start with the sovereigns, by throwing them the lifejacket of joint-issued debt. In effect, richer countries would guarantee at least part of the debt of weaker ones.
Ansgar Belke reckons instead that it is better to start by saving the banks. This would be done through stronger central supervision and the mutualisation of some liabilities in the banking sector, for instance through a joint fund to wind up failing banks and provide a Europe-wide guarantee of bank deposits. In effect depositors in solid banks would be guaranteeing the savings of those in more fragile ones.
Both debaters agree on many things, such as the threat to the survival of the euro. They both recognise the danger that debt mutualisation could bring moral hazard and higher costs for creditor countries. For Mr Belke there is no getting around these problems. For Mr De Grauwe, though, these risks can be removed, or at least mitigated through careful design of the system. For instance, the euro zone could impose conditions on countries seeking the benefit of jointly issued debt.
The proponent sees the main threat to the euro zone as coming from the fear and panic that can suddenly raise borrowing costs and push countries into insolvency. His opponent reckons the principal menace stems from removing this market pressure too quickly, lest it dampen the need to reform.
Both speak of the political backlash that the crisis creates. For Mr De Grauwe it is excessive austerity in debtor nations that will be resisted; for Mr Belke it is excessive liabilities in creditor states that can cause resentment.
In some ways, through, they are not so far apart. Mr Belke concedes that it is necessary to have some mutualisation of debt, if only to recapitalise banks. Mr De Grauwe accepts that debt mutualisation must be limited to avoid moral hazard.
Reading through the openings, I have two questions that I hope will be answered in the next round. If the banking sector is really to be stabilised, a solution will surely have to deal with the devalued sovereign debt that some are holding. Would they not be better off holding at least some Eurobonds instead of, say, Greek or Spanish bonds? That said, economists who advocate Eurobonds need to find a way of making them politically acceptable. How much political union is feasible, or even desirable, just for the sake of a single currency that many never loved?
I am looking forward to the replies to these and other points, and to the contributions from the audience.
Since the 1970s economists have warned that a budgetary union would be a necessity for a sustainable monetary union. The founders of the euro zone had no ears for this warning. It is now patently clear that they were mistaken and that we face the following hard choice today: either we fix this design failure and move to a budgetary union; or we do not fix it, which means we will have to abandon the euro. Although I was a sceptic about the desirability of a monetary union during the 1990s, I now take the view that we cannot properly manage a deconstruction of the euro zone. A disintegration of the euro zone would produce huge economic, social and political upheavals in Europe. If we want to avoid these, we have to look for strategies that move us closer towards a budgetary union.
A budgetary union, like the one that exists in America, is so far off that there is no reasonable prospect of achieving this in the euro zone during our lifetimes. Does that mean that the idea of establishing a budgetary union is a chimera? Not at all. I will argue that there is a strategy of taking small steps that can lead us in the right direction.
Before outlining this strategy it is important to understand one of the main design failures of the euro zone. This can tell us what exactly has to be fixed.
Euro-zone governments issue debt in euros, a currency they cannot control. As a result, and in contrast to “stand-alone” countries like Britain, they cannot give a guarantee to bondholders that the cash to pay them out at maturity will always be available.
The fact that governments of the euro zone cannot give such a guarantee to bondholders makes them vulnerable to upsurges of distrust and fear in the bond markets. These can trigger liquidity crises that in a self-fulfilling way can drive countries towards default, forcing them to apply austerity programmes that lead to deep recessions and ultimately also to banking crises. This is not to say that countries that have overspent in the past do not have to apply austerity. They will have to. It is rather that financial markets, when they are driven by panic, force austerity on these countries with an intensity that can trigger major social and political backlashes that we may not be able to control. The effects are there for us to see in a number of southern European countries.
The previous diagnosis of a design failure of the euro zone leads us to the idea that some form of pooling of government debt is necessary to overcome this failure. By pooling government debt, the weakest in the union are shielded from the destructive upsurges of fear and panic that regularly arise in the financial markets of a monetary union and that can hit any country. Those that are strong today may become weak tomorrow, and vice versa.
Of course, not any type of pooling of national debts is acceptable. The major concern of the strong countries that are asked to join in such an arrangement is moral hazard—that is, the risk that those that profit from the creditworthiness of the strong countries exploit this and lessen their efforts to reduce debts and deficits. This moral hazard risk is the main obstacle to pooling debt in the euro zone. The second obstacle is that inevitably the strongest countries will pay a higher interest rate on their debts as they become jointly liable for the debts of governments with lower creditworthiness. Thus debt pooling must be designed in such a way as to overcome these obstacles.
There are three principles that should be followed in designing the right type of debt pooling. First, it should be partial—that is, a significant part of the debt must remain the responsibility of the national governments, so as to give them a continuing incentive to reduce debts and deficits. Several proposals have been made to achieve this (for example, Bruegel and the German debt redemption plan). Second, an internal transfer mechanism between the members of the pool must ensure that the less creditworthy countries compensate (at least partially) the more creditworthy ones. Third, a tight control mechanism on the progress of national governments in achieving sustainable debt levels must be an essential part of debt pooling. The Padoa-Schioppa group has recently proposed a gradual loss of control over their national budgetary process for the breakers of budgetary rules.
The euro zone is in the midst of an existential crisis that is slowly but inexorably destroying its foundations. The only way to stop this is to convince the financial markets that the euro zone is here to stay. A debt pooling that satisfies the principles outlined above would give a signal to the markets that the members of the euro zone are serious in their intention to stick together. Without this signal the markets will not calm down and an end of the euro is inevitable.
The mutualisation of the euro zone’s debt to bring about the convergence of interest rates will not, in the long run, tackle the roots of the problem. Instead it will sow the seeds of an even larger crisis in the future.
We have seen what happened in the early years of the euro, when interest rates largely converged. Paradoxically, perhaps, this paved the way for a greater divergence of national fiscal policies. A reckless lack of discipline in countries such as Greece and Portugal—be they more (Greece) or less (Portugal) insolvent—was matched by the build-up of asset bubbles in other member countries, such Spain and Ireland, deemed merely illiquid. Structural reforms were delayed, while wages outstripped productivity growth. The consequence was a huge loss of competitiveness in the periphery, which will not be resolved by the mutualisation of debt.
Debt mutualisation can take different forms. One is to mutualise new sovereign debt through Eurobonds. Another is to merge part of the old debt, as advocated by the German Council of Economic Experts with its proposal for a European Redemption Fund. A third is to activate the euro zone’s “firewall” by using the rescue funds—either the temporary European Financial Stability Facility (EFSF) or the soon-to-be permanent European Stability Mechanism (ESM)—to buy bonds on the secondary market, or to inject capital directly into distressed banks. Indeed, the ECB is already engaged in a hidden form of mutualisation—of risk if not (yet) of actual debt—through its programme of bond purchases and its long-term refinancing operations for banks.
Almost all these are bound to fail for economic or political reasons, or both. The governments of even financially strong countries cannot agree to open-ended commitments that could endanger their own financial stability or, given that they are the main guarantors, that of the bail-out funds. And the danger of moral hazard is ever-present.
Any form of mutualisation involves an element of subsidy, which severely weakens fiscal discipline: the interest-rate premium on bonds of fiscally weaker countries declines and the premium for stronger countries increases. Fiscally solid countries are punished and less solid ones, in turn, are rewarded for their lack of fiscal discipline and excess private and public consumption.
If yields are too low, there is no incentive for private investors to buy sovereign bonds. The countries become decoupled from the capital markets permanently and the debt problems become increasingly structural.
This is true of the ECB’s bond-buying. The credit risk is thus just rolled over from the bonds of the weaker countries to those of the stronger ones, and the ECB is made responsible for its liability. Over time, the ECB’s measures might be inflationary. Allowing the rescue funds to buy bonds is little different, except that they lack the lending capacity to be credible. If they are given a banking licence, as some argue, it would be no different from the ECB buying bonds directly.
What of the European Redemption Fund (ERP)? This could be of particular help to Italy, which could unload half of its debt. But its partners could not force it to tax its citizens to ensure it pays back the dormant debt. And with the assumption of debt, Germany’s credit rating might drop, due to the increase in the German interest burden. The pressure on Italy and Spain to consolidate their budgets sustainably would be reduced. The problems of Greece, Ireland and Portugal would not be resolved, since these countries are unlikely to qualify for the ERP.
On top of moral hazard, there are the political obstacles, which would be most acute in the case of Eurobonds. Germany demands political union before Eurobonds can be considered. But this is to put the cart before the horse: a political union would be created simply to justify Eurobonds. Advocates say treaty changes and high-level political agreements would be sufficient to make sure that euro-zone member countries comply with all decisions taken at the euro-zone level. But the experience of Greece’s adjustment casts severe doubt on such optimism.
A quick glance at the World Bank’s databank of “governance indicators” shows that differences between euro-zone members, on everything from respect for the rule of law to administrative capacity, are so great that political union is unlikely to work, at least in the next couple of years. It follows that the basis for Eurobonds is extremely thin.
The introduction of Eurobonds would have to be backed by tight oversight of national fiscal and economic policies. But there is no true enforcement as long as the euro-zone members remain sovereign. Intervening directly in the fiscal sovereignty of member states would require a functioning pan-European democratic legitimacy, but we are far away from that. Voters in southern countries can at any time reject the strong conditionality demanded by Brussels, while those of northern countries can refuse to keep paying for the south. And either can choose to exit the euro zone.
The emphasis on debt mutualisation means the debate, at least in Germany, has become a question of “all or nothing”: either deeper political union or deep chaos. But there is an alternative to the notion of co-operative fiscal federalism involving bail-outs and debt mutualisation: competition-based fiscal federalism, of the sort successfully operating in America, Canada and Switzerland, among others. These countries have largely avoided serious and sustained public debt in their component states. The sub-federal entities, faced with insolvency, have a great incentive to take early corrective action—without having to be forced into a corset of centralised fiscal policy co-ordination.
To achieve this sort of federalism, it is necessary to separate the fate of the banks from that of the sovereigns. What is needed is not a fiscal union, but a banking union. It should be based on four elements: reformed banking regulation with significantly higher equity capital standards; European banking oversight with far-reaching powers to intervene; a banking resolution fund; and a European deposit insurance scheme.
Banking union—a less comprehensive, more clearly delineated and rather technical task—should be much more acceptable than the Europeanisation of fiscal policy as a whole. Only a small fraction of fiscal policy areas would have to be subordinated to central control in a fiscal union.
Obviously, a central resolution authority has to be given the resources to wind up large cross-border banks. Where does the money for this come from? In the long run, a resolution authority would exist alongside a deposit insurance scheme for cross-border banks. This should be funded partly by the banking industry. But there should also be a backstop provided by the euro-zone governments through the EFSF or ESM to cope with systemic bank failure.
As a temporary transition measure, limited debt mutualisation may be necessary—but only to recapitalise banks that cannot be sustained by their sovereigns. However, the amounts required are much smaller than for, say, Eurobonds.
With the banking system and the debt crisis thus disentangled, banking-sector losses will no longer threaten to destroy the solvency of solid sovereigns such as Ireland and Spain. Eurobonds will not be needed, and neither will the bail-out of sovereigns. The debt of over-indebted states could be restructured, which means that the capital market could exert stronger discipline on borrowers.