The Last Hope for Redemption

For all the fanfare that preceded it, the latest European debt-crisis summit was a major disappointment. Although better supervision and transparency of fiscal behavior is needed, the markets do not have confidence that agreed fiscal rules will be obeyed, given the eurozone’s track record. And by putting the entire emphasis on fiscal restraint, European leaders failed to address the eurozone’s deeper problems.

In a Deep Dive contribution in September, David Marsh, co-chairman of the Official Monetary and Financial Institutions Forum, brilliantly and mercilessly exposed the design faults in eurozone architecture and the history of policy blunders by politicians, Eurocrats, and central bankers. But one architectural flaw in particular is worth highlighting today as policymakers frantically search for ways to save the eurozone: missing Eurobonds — specifically ones with conditions attached. Because Eurobonds are a kind of government debt security guaranteed by eurozone governments collectively, they do not carry the risk associated with any single country’s inability to service its debt.

Even before Europe’s Economic and Monetary Union was established in the early 1990s, Wim Boonstra, the chief economist at the Netherlands-based Rabobank, realized that reducing sovereign borrowing costs for countries with a history of higher inflation that adopted the euro would encourage fiscal laxity and, ultimately, moral hazard. He therefore proposed "jointly and severally" underwritten conditional Eurobonds with risk premiums conditioned on ratios of government debt and deficits to GDP. For the outside investor, in other words, German and Italian Eurobonds would be identically priced. But the riskier eurozone counties would pay a premium, or "spread," to safer eurozone countries for underwriting their common debt issuance and tolerating the extra risk that doing so would entail. Italy, for example, would pay a substantial risk premium to protect German taxpayers and give Italian governments the incentive for good fiscal behavior.

Although excessive government debt may be today’s main obsession, there are two more eurozone fault lines: excessive rises in private credit in Ireland, Portugal, and Spain; and widening gaps in competitiveness, together reflected in large current account deficits. (In 1998, I warned of the tensions a common monetary policy would cause in liberal-credit economies such as Spain and Ireland and argued the case for Britain’s staying out of the eurozone.) Conditional Eurobonds with risk spreads linked to competitiveness, current account imbalances, and government debt-to-GDP ratios would have greatly reduced tensions within the eurozone by giving governments strong incentives for prudent fiscal and financial policies and for structural reforms aimed at boosting competitiveness. Tough rules on supervision and transparency would have been required, but substantial fiscal decentralization, or "subsidiarity," would have been possible. (Subsidiarity delegates detail tax-and-spend decisions to individual parliaments, which are better equipped to respond to local democratic pressures than a Brussels-based fiscal authority would be.)

Lessons from history and the looming abyss of a new Great Depression may just be the necessary preludes for reform that Europe needs. Aided by market panic and confusion, German toughness has arguably transformed reform prospects for Europe. Greece, Italy, and Spain now have credible, reform-committed governments. Ireland, bailed out under tough conditions, has cut its unit labor costs — the average cost of labor per unit of output — by 17 percent over two years and is showing growth. Portugal is strenuously reforming its public sector and labor markets. Market panic, however, has been costly for the European banking system and for short-run economic prospects. This might have been a price worth paying if German Chancellor Angela Merkel can now complete the final stage of restructuring the eurozone. It would be seen as a remarkable moral, political, and economic triumph.

Many observers, including senior figures at the European Commission and the European Central Bank (ECB), agree that some form of Eurobond is essential to save the eurozone. Without "joint and several" underwriting of new issues of sovereign debt, the current costs of borrowing for Italy and Spain will make their debt levels unsustainable and heighten fear in the markets of a vicious circle of bank insolvencies, credit crunches, and economic slumps. Without the support of the fiscal authorities, the ECB cannot undertake in eurozone sovereign debt markets the types of interventions carried out by the U.S. Federal Reserve and the Bank of England. These interventions have driven the U.S. and British governments’ borrowing costs to record lows, despite, in some respects, their inferior fiscal positions relative to the eurozone. Yet the eurozone’s "no bailout" clause (under which no eurozone country can be held liable for the debts of another) and the German fear of a "transfer union," in which it’s on the hook for its peripheral and less prudent partners, have conspired to make the very word "Eurobond" almost unmentionable in German political discourse. And Germany, after all, is spearheading Europe’s response to the debt crisis.

Germany and Finland, in fact, appear to be the only countries officially opposed to Eurobonds, at least in their conventional form. The French position is fundamentally in favor, though President Nicolas Sarkozy has sometimes wavered under German pressure. While Berlin is generally perceived to have the upper hand in negotiations over the future of the eurozone, it would be useful for other countries to demonstrate that they do not necessarily have to bow to German opposition to fiscal decentralization and any form of Eurobonds. It’s worth noting that Germany’s private-sector unit labor costs since 1998 have diverged more from those of other eurozone countries than those of the non-German eurozone countries have diverged from each other (except Greece). This divergence could be used as an argument for suggesting that Germany leave the eurozone and return to the deutsche mark. The ECB could then move to Paris and a collectively underwritten Eurobonds structure could be adopted by the remaining eurozone countries. The gain in competitiveness for France and the others would strengthen their economies greatly and make a non-German eurozone quite credible. This may be a far-fetched scenario, of course, but if the Germans push too hard they could face this very reality, which would prove economically and politically disastrous for them.

Still, some German officials have expressed support for a carefully constrained Eurobond tuned to the German psyche. In its annual report this year, the German Council of Economic Experts proposed a "redemption fund" in which sovereign debt amounts that exceeded 60 percent of GDP "would be transferred to a common redemption fund subject to joint liability" and countries "would be obligated to autonomously redeem the transferred debt over a period of 20 to 25 years." German Finance Minister Wolfgang Schäuble is reportedly against this proposal, though Die Zeit has suggested that with new treaties on eurozone fiscal governance, Merkel might persuade her coalition partners to take this path after all. The council’s analysis of the eurozone’s deep problems and its case for a Eurobond are well argued. Under the plan, redemption fund debt would build up gradually as countries refinanced their existing debt. The council proposes strict fiscal discipline, with national debt "brakes" written into each country’s constitution, a penalty of exclusion from new borrowing if a country does not meet its commitments, and a requirement that some tax revenue be paid straight into the fund. A most interesting suggestion is that participating countries pledge part of their gold and foreign reserves as collateral for 20 percent of their borrowing.

This worthy proposal, however, could be substantially strengthened on the "belt and suspenders" principle by incorporating risk spreads. Riskier countries could pay risk spreads into an insurance fund that helped protect the guarantor governments against a potential future write-down of sovereign debt. A formula could define the risk spreads as a function of relative competitiveness, relative debt to GDP, and relative current account deficits to GDP (for reasons I explained in a recent Centre for Economic Policy Research paper). In a worst-case scenario in which even the foreign exchange collateral and the insurance fund measures were insufficient to cover a debt write-down, guarantor governments would share in the remaining loss, most obviously in proportion to GDP. But using risk spreads means that some element of risk is required — otherwise, it becomes hard to justify the requirement that Italy and Spain should pay substantially more for their borrowing than Germany does. But this would by no means constitute the much-feared "transfer union."

Policymakers could strengthen the eurozone further by accepting the European League for Economic Cooperation proposal that countries, such as Greece, Ireland, and Portugal, that are on a conditional program from the IMF or so-called "troika" (the IMF, European Commission, and European Central Bank) not be allowed to borrow in the form of Eurobonds until they are cleared from such programs.

In the short term, quick agreement should be possible on one-year euro bills with the above principles of risk spreads and foreign exchange collateral. During 2012, agreement could be reached on the reinforced form of the redemption fund proposed above. This would remove from the market the fear of early disintegration of the eurozone and prevent an incipient banking crisis. It is the last hope for redemption.