The Eurozone suffers a serious sovereign-debt crisis exacerbated by a serious debt-management problem. The markets are telling us this loud and clear. There is also no shortage of economists saying the same thing (see for instance Tabellini 2011 this week on VoxEU).
This week’s meeting of the leaders of the Eurozone (21 July) will tell us a lot more about how bad the management problem is. The meeting is supposed to provide a solution to the Eurozone’s debt crisis or, at least, to reach an agreement on the second international bailout for Greece. The latter was already announced on 2 July but failed to satisfy one of its basic condition – the “voluntary” involvement of the European banking sector. Hopefully leaders understand that their game of chicken against the periphery has failed – pressure on periphery countries did not and cannot result in “miraculous austerity plans” and better repayment prospects.
It would be extremely dangerous to leave this crisis like unresolved over the summer, so Eurozone leaders need to come up with a non-fictitious agreement. But even a short-term agreement will not solve the underlying sovereign debt management problem.
The Eurozone needs a credible institutional commitment – the fiscal parallel of the euro.
The Eurozone’s architects understood that many of the potential members needed to impose greater monetary discipline and lower their inflation rates in order to prove their fitness for the enterprise. They believed that the discipline needed to join the euro club would allow these countries to benefit from lower interest rates, wider access to capital markets, and improved growth. The hope was that this would lead to convergence in their economies. The concerns about monetary discipline and inflation were the greatest for some of the periphery economies – Portugal, Italy, Greece, and Spain.
Eurozone architecture designed monetary discipline into the system by handing the decisions to ECB and setting it a very clear mandate for monetary discipline. Discipline on the fiscal side were less concrete even though it was well known that fiscal policies would have to be sustainable to support a monetary union. The solution was the Maastricht conditions constraining fiscal deficits to 3% of GDP and debts to 60% of GDP.
The architects also understood that labour markets would have to become more efficient and competitive if these economies were to succeed with a strong currency. The monetary conditions were met, the fiscal conditions approximately so, and the euro was launched.
Why are things now threatening to fall apart?
The answer is simple really. The ECB part of the design worked because nations surrendered monetary discretion and this insured monetary discipline going forward. Unfortunately, there was no such institution to constrain fiscal policy. There was only a “reference guide” (the Growth and Stability Pact) and too much discretion left to sovereign governments.
Early on some of the strong economies were close on target, while others struggled to meet the fiscal criteria. The experience was different regarding structural reforms, such as labour-markets reforms. In the 1980’s unemployment rates were high throughout Europe and there was much talk of eurosclerosis. Some strong economies implemented reforms and they made other decisions that were consistent with their long-term strength; better labour-market institutions, investment in the human capital needed to succeed in a strong-currency country, and more efficient tax systems. Others did not reform enough, in spite of all “the commitments” to implement the Lisbon agenda. In any case, unfulfilled commitments and deviations from the “reference guide” have at most resulted in “critical warnings” (in other words, “cheap talk”).
Now it is clear that if the Eurozone is to continue and prosper, it needs to accomplish two things:
- Address the short-term problem of the excessive indebtedness of the periphery countries in a way that does not cause excessive contagion and paralysis for the banking sector;
- Solve the mechanism-design problem to insure a degree of fiscal discipline in the long run.
Many proposals are circulating for addressing the first problem – not all of them workable. Any viable plan will probably involve two elements:
- A debt exchange of maturing issues for longer-term bonds possibly with lower interest rates that make debt servicing feasible;
- Some kind of guarantee of new debt.
This exchange will likely be treated as a default event by rating agencies because it would be a “distressed exchange” even if it were voluntary. In any case, on July 21st the Eurozone leaders will be walking a very thin line when it comes to default ratings.
However, the thornier problem is the second one. Eurozone members agreed to give up a degree of sovereignty when they abandoned national currencies for the euro. But that was easier than giving up fiscal sovereignty. To give it up would be impossible within the framework of the euro. How then do we insure fiscal credibility?
Look to the US solutions
For an idea about how to solve this dilemma it might be useful to look at the US. The US states have many sovereign powers that give them a great deal of financial discretion. They have the power to establish their own tax systems and spending powers. Many states are legally required to balance their budgets, although this is often meaningless in a dynamic sense if they don’t have to fund future obligations. In addition states cannot file for bankruptcy under the US Bankruptcy Code.
So how do the states guard against default and preserve their access to capital markets? In spite of their well-advertised budgetary problems the US states do have access to capital markets and at generally favourable rates. The reason is institutional. Most states give debt service a constitutional priority over other expenditures.
This means that the “sovereign” debt has to be paid out of revenues before other obligations. There are some minor exceptions. In California and some other states for example education funding has a prior claim on revenues – probably a good thing if it prevents them from undermining their long-term growth prospects. This mechanism does not prevent fiscal problems from arising. The problems of states like California are well known and they are severe. But fiscal problems become sovereign political problems, not threats to the stability of the US. It should be noted that their debt levels are quite small relative to sovereign nations.
Applying the rules to the Eurozone
If Greece and other periphery countries were required to give general obligation debt priority, their internal problems would be no less severe. But their fiscal problems would not be a threat to the banking system and to other sovereign states.
In addition, they would have stronger incentives to not let fiscal problems get out of hand to begin with. There are other elements that could strengthen this institutional framework like ex-ante funded insurance against unforeseen shocks. The institutional change of giving sovereign debt priority would solve the fiscal time consistency problem without Eurozone members having to surrender their authority over taxing and spending. It would make unsustainable fiscal policies a sovereign political problem since it would be the responsibility of the “national leaders” to come up with a proper “austerity and growth programme”, instead of one being imposed on them, which can easily be criticised as a loss of sovereignty.
The “Euro Plus Pact”, adopted in the European Council of 24-25 March 2011 is supposed to be the Eurozone answer to the “fiscal discipline – sovereignty” dilemma. It contains two main elements: a “peer pressure economic policy coordinating mechanism” and the European Stabilisation Mechanism (ESM). The former is not very different from the mechanism that was supposed to implement the Lisbon agenda: countries making programmes of fiscal discipline and of growth enhancing reforms, EU-EC meetings to review plans and benchmarks (e.g. the revised Growth and Stability Pact) with threats of public shame or even penalties, etc.
The ESM, in contrast, can be an institutional creature of the current crisis. Given that the Eurozone does not have a federal budget as the US has, the ESM can play a key role as an insurance mechanism, not just for catastrophic debt crises where debt extension is a form of insurance. In fact, as we argued, the latter can be better avoided with an institutional change as the one that we propose, rather than with a long list of commitments, difficult to monitor and sanction, easy to revise and adapt. In fact, a credible threat can be the temporary exclusion from the ESM if a country does not fulfil the institutional commitment to prioritise debt payments.
Is such a solution feasible within the European framework? If it isn’t, it needs to be.
What is abundantly clear is that some kind of commitment mechanism is needed to prevent these moral-hazard problems from continuously repeating themselves. Larry Summers once wrote that policymakers should beware of moral-hazard fundamentalists, arguing that moral-hazard problems are not that severe. In a way he is right. Most of us do not take huge risks, whether in personal decisions or investing, simply because we are insured against them. But if there is a powerful lesson of the last few years it is that they are not that severe until they are – until the accumulation of many smaller risks becomes a systemic event.
Tabellini, Guido (2011), “The Eurozone crisis: What needs to be done”, VoxEU.org, 15 July.