Any solution to the Eurozone crisis must meet two objectives. One is short run and the other is long run. Unfortunately they tend to conflict.
The first necessary objective is to put Greece, Portugal, and other troubled countries back on a sustainable debt path, defined as a long-term trajectory where the ratio of debt-to-GDP is declining rather than rising. Austerity won’t restore debt sustainability. It has raised debt-to-GDP ratios, not lowered them. A write-down would do it. New bigger bail-outs might too, or might not. But write-downs or bailouts would then create moral hazard and thus make even it even harder to satisfy the second necessary objective.
That second objective is to reform the system so as to make it less likely that similar debt crises will recur anew in the future. Fiscal rectitude in the long run is indeed the way to accomplish this. But it is hard to commit today to fiscal rectitude in the future. Rules to cap debt such as the Maastricht fiscal criteria, “no bailout” clause and Stability and Growth Pact (SGP) didn’t work because they were not enforceable.
Eurobonds could be part of the solution, if designed properly to take into account fiscal fundamentals, both short term and long term (see Favero and Missale 2012). These are defined as government bonds that would be the liability of the Eurozone in the aggregate.
The creation of a standardised Eurobond market would bring a boost to help a reform plan come together, badly needed in light of the damage that years of failed European summits have done to official credibility. That boost is the latent global portfolio demand for a good Eurobond.
Even when the euro was at the height of its success five years ago, its international currency status suffered from lack of a counterpart to the US Treasury bill market, a deep, liquid, standardised market in low-risk bonds. Instead, Europe’s bonds are issued by the 17 member governments. This fragmentation has hindered European financial integration and impeded any bid by the euro to rival the US dollar as international reserve currency. Central banks in China and other big developing countries are still desperate for an alternative form in which to hold their foreign exchange reserves – an alternative to holding US government securities, that is. US Treasury bills pay extremely low interest rates, and the value of the dollar has been on a negative downward trend for 40 years (ever since President Richard Nixon took the dollar off gold and devalued in 1971). Despite all of Europe’s problems, a Eurobond would be attractive to central bankers and other portfolio investors around the world, both to achieve higher expected returns than on US treasury bills and to diversify risk.
But that latent global demand for Eurobonds will not come to the table unless they are by design backed up with solid economic and political fundamentals.
Germany opposes Eurobonds on the sensible grounds that if individual national governments were allowed to issue them freely, the knowledge that somebody else was paying the bill would make the incentive for member countries to spend beyond their means worse than ever. This version of Eurobonds would be bound to fail, both economically and politically. This seems to be the version that some opponents of austerity have in mind, such as the new French president, François Hollande, though it is hard to tell.
A different version of the Eurobond proposal has recently begun to gain traction in Germany. The German Council of Economic Experts – usually called “wisemen”, although the council includes a woman – proposed last year a European Redemption Fund (hence yet another new acronym, ERF) (Bofinger et al. 2011). The plan would convert into defacto Eurobonds the existing debt of (approved) member nations in excess of 60% of GDP, the supposed threshold specified in the Maastricht and SGP criteria. The ERF bonds would then be paid off over 25 years. Steps toward this proposed solution to the short-term debt problem would be paired – politically and logically – with approval of the Fiscal Compact, Angela Merkel’s proposed solution to the long-term problem.
But this seems upside down. Yes, any solution to save the euro will have to ask German taxpayers to put still more money on the line. But to use Eurobonds as the mechanism for eliminating the big debt overhang looks like the nail in the coffin of the longer-term moral hazard objective. It offers absolution precisely on the margin where countries in the future will in any case have the most trouble resisting the temptation to sin again, the margin where they cross the 60% threshold.
If the Fiscal Compact or proposed “debt brakes” could be relied on as a firm constraint on future behaviour, then fine. But there is little reason to believe that they could, especially after confirmation of the precedent that individual spendthrifts are relieved of their excess debt burdens.
The new Fiscal Compact is unlikely to succeed where the Maastricht criteria failed, the “no bailout” clause failed, and the SGP failed. It is less credible that excessive deficits will be punished than it was three years ago – and it wasn’t credible even then. Rules don’t work without some enforcement mechanism. The problem with the SGP wasn’t that it wasn’t written strictly enough or even that it wasn’t incorporated into the constitutions of the member countries as the Fiscal Compact would have it. The problem with the SGP was that no matter how many times a member government’s deficit or debt exceeded the specified limit, the country’s officials could say (often sincerely) that the gap was the fault of unexpected circumstances such as slow growth and low tax receipts and that they expected to do better next time (Frankel 2011c, 2012). Even if some court in Brussels or Frankfurt were given life-and-death power to enforce the rules, exactly which officials would it punish for violations, and how? No version of the SGP or Fiscal Compact or debt brake proposals has ever provided a satisfactory answer to that question.
Hope by some Europeans that the Fiscal Compact would finally make enforcement credible by writing the constraints into the constitutions of member states might be based on misunderstanding of the US system (Henning and Kessler 2012). One can see the logic: The US federal government has never bailed out one of the 50 states and nobody expects it to do so in the future. How has the US solved the problem of moral hazard that so plagues the Eurozone? The states have rules to limit deficit spending (well, 49 of them do; these laws are voluntary on the part of the states, and Vermont does not have one) (Poterba and Rueben 2001). That must be the answer!
State laws are not in themselves the explanation for the absence of US moral hazard. The primary explanation is that the right precedent was set in 1841 when the federal government declined the opportunity to bail out eight troubled states and let them default (Dove 2012). Euro leaders should have done the same with Greece a year or two ago. A second (related) explanation for absence of moral hazard in the US federal system is that, ever since 1841, when American states start to run up questionable levels of debt the private market demands an interest rate premium to compensate for the default risk (Bayoumi et al. 1995). The premium acts as an automatic disincentive to further profligacy (Alessina et al. 1992). This mechanism should have operated after the euro was created in 1999, but it never did: Greece and the other high-borrowers were able to borrow at interest rates that – disturbingly – had fallen virtually to the same levels as German bunds.
The final explanation is that when citizens started to ask more from their public sectors in the 20th century (defence, entitlement spending, etc.), the expansion in the case of the United States took place at the federal level, not the state level. For this reason even the fiscally most dysfunctional of the American states, which is probably California, does not operate on a scale remotely like European national governments. US federal spending is 24% of GDP versus an EU budget of 1.2% of GDP. Europeans are not ready to transfer most spending and taxation from the national to the federal level. And even if they decide some day that they are ready, if the bailout precedent still stands then this federalisation will not solve the moral hazard problem regarding the spending that remains at the national level.
The version of Eurobonds that might work is almost the reverse of the Germans’ Redemption Fund proposal. It goes under the more colourful name of ‘blue bonds’, originally proposed two years ago by Jacques Delpla and Jakob von Weizäcker at the think tank Bruegel (Delpa and von Weizäcker 2010). Under this plan, only debt issued by national authorities below the 60% criteria could receive Eurozone backing, be declared senior, and effectively become Eurobonds. These are the ‘blue bonds’ that would be viewed as safe by investors. When a country issued debt above the 60% threshold, the resulting junior ‘red bonds’ would lose Eurozone backing. The individual member state would be liable for them. This proposal structures the incentives ‘right side up’.
The blue bonds proposal has been extensively debated in Europe. As usual in such controversies, many participants in the euro debate fixate on one evil or the other – moral hazard or austerity – and fail to grapple with practical proposals to balance the two.
As I see the plan, the private markets could make the judgement as to whether a country was in the process of crossing the threshold, even before the final statistics were available, and therefore assess whether default risk on the new red bonds required an interest rate premium. If private investors judged that the new debt had genuinely been incurred in temporary circumstances beyond the government’s control (say a weather disaster), then they would not impose a large interest rate penalty. Otherwise, the sovereign risk premium mechanism would operate on the red bonds, much as it does among American states, and much as it did in Italy, Greece and the others before they joined the euro. Similarly, if the ECB after 2000 had operated under a rule prohibiting it from accepting as collateral the debt of SGP-noncompliant countries, the resulting default risk premium might possibly have headed off the entire euro sovereign debt problem early in the decade (Frankel 2011a, 2011b).
The point is that the red bond mechanism would be truly automatic, as desired. Perhaps in ambiguous borderline cases the judgement whether a country had truly exceeded the limit, or whether it was still in good standing so that its debt qualified for Eurobond status, would ultimately have to be made by a Eurozone agency or court, with an inevitable lag. But, in the meantime, private investors could apply informed views about the merits from moment to moment. The resulting market interest rates would provide the missing discipline. Compliance would not rely on discretionary letters from Brussels bureaucrats, which have proven toothless no matter how many exclamation points are put at the end of their penalty threats. Nor would it require unenforceable debt ceilings legislated at the national level. The US has one of those too. It has never had any effect, except on a very few occasions, when Congress has actively used the debt ceiling law to make everything worse (Frankel 2011d, 2011e).
Of course the euro countries cannot jump to a blue-bond / red-bond regime without first solving the problems of debt overhang and troubled banks that are front and centre. Otherwise, in today’s world, the plan by itself would be destabilising since it would put almost all countries immediately into the red. The debt paths that are currently unsustainable in many countries result from the combination of debt/GDP ratios that are already far in excess of 60%, combined with very high sovereign spreads and recessions in the most troubled countries. Relieving them of responsibility for debt up to 60% would be substantial assistance, but would not in itself restore sustainability to all members.
Thus Eurobonds are emphatically not the complete solution to these vexing problems. It is hard to say, at this late date, what the right short-term solutions are. In Greece’s case, it may be forced to default and to drop out of the euro. The banks and sovereigns in other countries will then have to be insulated from the conflagration through a combination of acronymic ‘bailout’ money (EFSF, ESM, ECB, ...) and serious policy conditionality, as always. Creating this fire break between Greece and the heart of Europe would have been far easier two years ago, before debt-to-GDP levels and sovereign spreads climbed so high and before the credibility of the euro leaders sank so low, or even one year ago (Frankel 2010, 2011b).
But one thing seems clear. German taxpayers, whose longstanding fears that they would be asked to bail out profligate Mediterranean euro members have been proven correct, will not be happy when asked to put up still more money in the cause of European integration by the same elites whose assurances of the last 20 years have proven false. They will at a minimum need some credible reason to believe that future repetitions have been rendered unlikely, that the bailout is ‘just this once’. Official assurances do not constitute that credible reason. Nor does the Fiscal Compact, in itself. The red bonds / blue bonds scheme just might.
A much condensed version of this posting appears in Project Syndicate, June 14, 2012.
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