The way forward: Coping with the insolvency risk of member states and giving teeth to the European Semester

Peter Bofinger 12 February 2016



The experience of the last 16 years shows that EZ is a more crisis-prone regime than other major currency areas like the US, Japan, or the UK. This is mainly due to its hybrid institutional architecture which relies on intergovernmental and supranational elements. While monetary policy is fully integrated under the aegis of the ECB, 19 national governments are responsible for the EZ’s fiscal policy. In addition, labour markets remain segmented as wage bargaining processes and labour market regulations are still organised at the national level.

‘Design failures’ or ‘unfinished building’?

These are not necessarily ‘design failures’ (de Grauwe 2015). Instead, the EZ can be regarded as an unfinished building that needs to be completed with more coordination and more political integration. In fact, the banking union shows more stability can be achieved by increasing the supranational elements.  

Solutions to the specific insolvency risk of EZ member states

The hybrid nature of the EZ is a major source for its dismal economic performance. It exposes its members to an insolvency risk which is absent for comparable countries. EZ membership implies that government debt is denominated in euro, while the national central bank is not able to print this currency (‘original sin’).1 With the EZ crisis financial markets became aware of this risk, so that some member states lost market access and others (Italy and Spain) were confronted with very high risk premia.

This intensified the recession in the EZ. Long-term interest rates increased in 2011 (Figure 1), while they declined in Japan, the UK, and the US (G3). Growing market pressure also limited the room for manoeuvre in fiscal policy. Compared to the G3, the EZ’s initial budgetary response to the Great Recession was very limited and the crisis required premature consolidation attempts in 2011/12 (Figure 2).

Figure 1. Long-term interest rates

Source: European Economy, Statistical Annex Autumn 2015.

Figure 2. General government underlying fiscal balances

Source: OECD, Economic Outlook 98 database. The underlying balances are adjusted for the cycle and for one-offs.

As a result, from 2007 until 2013 GDP growth in the EZ was much weaker than in the G3 (Figure 3). The improvement that has taken place since is mainly due to the implicit regime change by  Mario Draghi’s convincing statement from 26 July 2012 to do “whatever it takes to preserve the Euro” and the ECB’s announcement of Outright Monetary Transactions (OMT). This has fundamentally changed investors’ perception of the insolvency risk. Under this monetary umbrella member states were no longer forced to reduce deficits at any price. Since 2013 consolidation in the EZ has come to a halt.

Figure 3. GDP developments since 2007


Source: OECD, Economic Outlook 98 Database.

  • The main lesson that can be drawn from the aggravation of the Crisis until July 2012 and the significant improvement after the implicit regime change is that a monetary union where each country is exposed to financial markets without a supranational backstop is not viable.

In such a ‘gold standard without gold’ (Blyth 2013, p. 184) financial markets “can force countries into a bad equilibrium characterised by increasing interest rates that trigger excessive austerity measures, which in turn lead to a deflationary spiral that aggravates the fiscal crisis.” (De Grauwe 2015).

This diagnosis can lead to two different solutions. Some economists believe that the insolvency risk is unavoidable. Therefore, institutional procedures should be developed for dealing with future insolvencies. The alternative approach is to reduce or even eliminate the insolvency risk of member states by strengthening the supranational features of the EZ.

Preparing for insolvency by an insolvency regime for sovereigns

The majority of the German Council of Economic Experts proposes a formal insolvency mechanism for sovereigns. The authors argue that this would help to stabilise the architecture of the EZ.

“At times of great uncertainty, there is a risk of severe, even excessive financial market reactions that create multiple equilibria in a self-fulfilling prophecy. An insolvency mechanism for countries stabilises the expectations of market participants, which contains such effects”. (GCEE 2015a, para. 47).

However, in a special report on the EZ crisis the authors explicitly acknowledge the destabilising effects of such a regime change: “The mere announcement of an insolvency regime could cause considerable turbulence on the financial markets, which makes its introduction impractical at this time.” (GCEE 2015b, para. 87).

A comparison with the US indicates that a formal insolvency mechanism for EZ sovereigns goes into the wrong direction. Even for the US states no bankruptcy mechanism exists because they are considered sovereign. In addition, the main task of macroeconomic stabilisation is executed at the federal level. So far, nobody has seriously considered introducing a formal insolvency regime for the US Federal Government.

The Great Recession shows that high government deficits can be required to deal with serious demand shocks (Figure 2). After the introduction of a formal insolvency regime EZ member states with high debt levels might no longer be able to stabilise their economies effectively. With a passive fiscal policy or even a bankruptcy of the government a Great Recession could turn into a Great Depression.

Coping with the insolvency risk by debt mutualisation

The only way to deal with the insolvency risk is therefore not to prepare for a hard landing, but to find solutions that reduce or even eliminate it. The ECB’s pragmatic OMT approach has been a very effective emergency solution. And for the time being it will remain the only way for coping with this risk. However, it is dangerous to rely on this informal stabilisation device as a permanent solution. For instance, it is not certain that the mandate of the ECB would make it possible to support Italy in a severe crisis of confidence.

Therefore, a stable architecture of the EZ requires some form of debt mutualisation, which would protect member states against bad equilibria. Prominent proposals are the ‘Debt Redemption Fund’ (DRF) by the German Council of Economic Experts (2011) and the ‘Blue Bond Proposal’ (BBP) by von Weizsäcker and Delpla (2010). The two models are complements. While the Bond Proposal entails a pooling of sovereign debt up to a level of 60% of GDP, the Debt Redemption envisages a pooling of debt exceeding the 60% threshold.

Both schemes imply a very high amount of joint debt. The Blue Bond would lead to a pool of 6.4 trillion euro, the Redemption Fund to a pool of 3.6 trillion euro (Table 1). For the time being such a high amount of debt mutualisation seems politically very difficult to achieve. At least it would require major steps towards political integration. A specific problem of the Redemption Fund is the disproportionate share of member states in southern Europe that would by far exceed their share in the EZ’s GDP.

Table 1. Schemes for debt mutualisation in the EZ 

Given these constraints a scheme with relatively limited amount of mutualisation, e.g. in the order of magnitude of 10% of the EZ’s GDP might be considered.2 This would correspond with the asset purchase programme (APP) of the ECB for which a volume of about 1.1 trillion euro is envisaged. As in the Blue Bond Proposal, the share of each member should be determined by its GDP share. Such ‘monetary policy bonds’ would create a pool of absolutely safe assets which would facilitate open market operations. Due to the limited size, the moral hazard problems seem to be less pronounced so that no additional political integration might be required.  

If the scheme is set up in the form of an international treaty, a change of the EU Treaty might not be necessary. In addition, if its size is clearly determined, it would be also compatible with the requirements laid down by the German Constitutional Court in its decision on the European Stability Mechanism (BVerfG, Urteil des Zweiten Senats vom 18 März 2014 - 2 BvE 6/12 - Rn. 1-245).

Giving teeth to the European semester

A second major flaw of the EZ is the lack of coordination of fiscal policies and wage developments. These problems were already identified in the Delors Report (1989, p.19):

“(...) the fact that the centrally managed Community budget is likely to remain a very small part of total public sector spending and that much of this budget will not be available for cyclical adjustments will mean that the task of setting a Community-wide fiscal policy stance will have to be performed through the coordination of national budgetary policies. Without such coordination it would be impossible for the Community as a whole to establish a fiscal/monetary policy mix appropriate for the preservation of internal balance (...).”

“As regards wage formation (…), the autonomous negotiating process would need to be preserved, but efforts would have to be made to convince European management and labour of the advantages of gearing wage policies largely to improvements in productivity.” (p. 20).

Making fiscal policy coordination more effective

The absence of fiscal policy coordination is indicated by the very weak fiscal policy response of the EZ in the years 2009/2010 and the premature consolidation in 2012/2013 (Figure 2).

The European semester which was introduced in 2011 could be an ideal framework for fiscal policy coordination. But so far it has been a complete failure. The country-specific recommendations (CSR) are extremely vague. In 2014 they called for “a coherent and growth‐friendly fiscal stance across the euro area”, in 2015 for an “aggregate euro area fiscal stance (…) in line with sustainability risks and cyclical conditions.” 3,4 No attempt was made to translate the aggregate picture into specific recommendations for the member states.5

The coordination process could be considerably improved if the recommendations define a concrete value for the aggregate fiscal policy stance. Based on this aggregate fiscal policy stance, specific target values for the structural budget balance of each member state should be derived taking into account the differences in fiscal space. In the case of a severe crisis like the Great Recession additional fiscal space could be created by increasing the ceiling for debt mutualisation if such a scheme was be already in place.

Avoiding asymmetric wage adjustments    

National wage developments are another area where coordination is virtually absent. The German wage moderation of the years 2000-2007 created serious imbalances (Bofinger 2015). Today, the member states with high unemployment also try to improve their competitiveness by wage moderation. However, in Germany wage setting processes do not take into account the need for a symmetric adjustment. As a general principle, the average increase of unit labour costs in the EZ should be in line with the ECB’s inflation target. However, the average increase in unit labours costs was only 0.7 % in 2015, which can be regarded as a main cause for the low EZ core inflation rate (Figure 4).

Figure 4. Unit labour costs 

Source: European Economy, Statistical Annex.

In a zero interest rate environment it is difficult for the ECB to combat deflationary trends. Therefore a symmetric wage adjustment would provide a more effective solution. It implies higher wage increases in Germany leading to unit labour cost increases above the 2 % threshold, at least for some years.

Again, the European semester and the country-specific recommendations could deal with such an asymmetry. However, the asymmetry problem is not addressed at all. The country-specific recommendations for Germany even call for “measures to reduce high labour taxes and social security contributions.” Such internal devaluation would make it even more difficult for the other member states to improve their price competitiveness. Thus, in the area of wages the country-specific recommendations are not only ineffective but even counterproductive.


Due to its hybrid structure the EZ will remain more crisis-prone than other major currency areas. A main challenge is the specific insolvency risk to which the member states are exposed. A formal insolvency regime would intensify this risk instead of mitigating it. With the OMT programme the ECB has provided a pragmatic and so far effective protection against this risk. But in the longer-term it can only be eliminated by some form of debt mutualisation. Schemes with large pools of joint debt would be met with strong political resistance and they would require more political integration. Therefore, as a first step, a mutualisation of debt amounting to 10% of the EZ GDP should be envisaged. This would create safe assets of about 1.1 trillion euro that correspond with the volume of the EZ’s asset purchase programme and facilitate open market operations.  

In addition, the EZ suffers from an insufficient coordination of fiscal policies and wage trends. So far the European semester has been a complete failure. Its recommendations for fiscal policy are too vague at the aggregate level and no attempts are made to translate them into specific recommendations for national fiscal policies. Wage developments in the EZ suffer from an asymmetric adjustment. As a consequence, the aggregate increase in unit labour costs is incompatible with the ECB’s inflation target. In the country-specific recommendations this asymmetry is not addressed at all. Thus, the European semester needs a much stronger focus on the task of coordinating national fiscal policies and wage trends. A better coordination in these areas would lead to more symmetric and more balanced developments in the EZ. This would reduce the need for monetary policy stimulation and avoid the negative side-effects that are associated with such an overburdening of the ECB.


Bénassy-Quéré, A (2015), “Economic policy coordination in the euro area under the European Semester, provided in advance of the Economic Dialogue with the President of the Eurogroup”, in ECON on 10 November 2015.

Blyth, M (2013), Austerity: The History of a Dangerous Idea, Oxford 2013.

Bofinger, P (2014), “Fiscal and macro-structural challenges and policy recommendations for the Euro Area and its Member States under the 2014 Semester Cycle, provided in advance of the Economic Dialogue with the President of the Eurogroup”, in ECON on 4 September 2014.

Bofinger, P (2015), “German wage moderation and the EZ Crisis”, VoxEU, 30 November.

De Grauwe, P (2015), “Design failures of the Eurozone”,, 7 September.

Delors-Report (1989), “Report on economic and monetary union in the European Community”,

Expert Group on Debt Redemption Fund and Eurobills (2014), Chaired by Gertrude Tumpel-Gugerell, Final Report, 31 March 2014.

German Council of Economic Experts (2011), “Assume Responsibility for Europe”, Annual Report 2011/2012.

German Council of Economic Experts (2015a), “Economic Policy: Focus on Future Viability”, Annual Report 2015/16.

German Council of Economic Experts (2015b), “Consequences of the Greek Crisis for a More Stable Euro Area”, Special Report, 28 July 2015.

Weizsäcker, J and J Delpla (2010), “The Blue Bond Proposal”, Bruegel Policy Brief.

Zsolt, D and L Alvaro (2015), “The limitations of policy coordination in the Euro Area under the European Semester”, Bruegel Policy Contribution 2015/19.


1 German Council of Economic Experts (2011, para. 144).

2 A similar proposal was made by the Expert Group on Debt Redemption Fund and Eurobills (2014), which proposed a size of 20% of EZ GDP. 

3 Council Recommendation (2014/C 247/27)

4 Council Recommendation (2015/C 272/26)

5 The short-comings of the Semester were criticised by several economist (Darvas and Leandro 2015, Bénassy-Quéré 2015, Bofinger 2014). 



Topics:  EU policies Monetary policy

Tags:  insolvency risk, insolvency mechanism, European semester, debt mutualisation, fiscal policy coordination, country-specific recommendations

Professor for Monetary Policy and International Economics at the University of Wuerzburg, member of the German Council of Economic Experts and CEPR Research Fellow

Vox Talks