On the way to implementing a European Redemption Fund: Creating the right incentives for Eurozone countries’ structural reforms

Stefano Scalera, Riccardo Pacini, 7 December 2012

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On 23 November 2011 the European Commission adopted a proposal for a ‘Regulation of the European Parliament and of the Council’. It consisted of common provisions for monitoring and assessing draft budgetary plans in an attempt to correct the excessive deficit of Eurozone member states (European Commission 2011).

Recent EU changes, beyond regulation

On 13 June 2012, the European Parliament voted to adopt 80 amendments (Amendments 1-18 and 20-81) from the European Commission’s proposal (European Parliament 2012). Most of these amendments go beyond ‘regulation’, and are instead aimed at:

  • Deeper coordination of economic policy and incentives for policy compliance (Amendment 4).
  • Higher attention to growth and jobs (Amendment 7) via. new specific facilities and programmes (Amendment 67 and 68).
  • More democratic processes, involving the European and member states‘ parliaments at the assessment and correction phase (Amendment 76).
  • The possibility for delegation of power to the Commission (Amendment 59).
  • The establishment of a roadmap and a framework for enhanced debt issuance (Amendment 27 and 67).

Sound public finances and balanced budgets are clearly a prerequisite for economic and financial stability, but the European Parliament recognises that today’s deficit, associated with stagnated economies, requires even stronger incentives for economic reforms. Current deficits also require specific financial resources dedicated to public investment (such as "a sustainable growth instrument aiming at mobilising approximately 1% of GDP, including an increase in the capital of the European Investment Bank and project bonds" (Amendment 67); or "frontloading and mobilising financial resources, including European Investment Bank credit lines and relevant EU financial instruments" (Amendment 68), whose output and macroeconomic multiplier effects are to be certified through accurate forecasts, cost-benefit analysis and ex post measurements (Amendments 50, 51, 53, 55 and 56).

A roadmap for coordination

More importantly, according to Amendment 27, the European Parliament states that:

“It is necessary to adopt a roadmap towards Eurozone common sovereign debt instruments including the establishment of an enhanced economic policy coordination framework. As a first step for the coordinated and common issuance of Eurozone sovereign debt instruments, it is essential that a redemption fund be established over a period of approximately 25 years together with the coordination of euro area Member State debt issuance. This first step is without prejudice to the implementation of further steps in the roadmap before the end of that period.”

Through Amendments 66, 67, 78 and 80, the European Parliament outlines what steps of the roadmap will be followed in order to establish a European debt authority. That said, it is only the first step that is ready to be implemented upon approval of the regulation.

Each of the following steps of the roadmap are to be implemented by new regulations on:

  • The methodology to be followed to improve the debt issuance coordination among Member States (Article 6c(3) introduced by Amendment 67).
  • The establishment of a European Redemption Fund (European Redemption Fund) based on joint liability and strict fiscal discipline aiming at reducing excessive debt over a period of 25 years (Article 6d introduced by Amendment 67).
  • The eventual creation of a European debt authority (Amendment 80).

Indeed, Amendment 78 mandates the Commission “to present a report to the European Parliament and the Council examining the feasibility of options and making proposals for possible roadmap towards common issuance of public debt instruments,” paying “particular attention to the feasibility of introducing a redemption fund which combines temporary common issuance of debt and strict rules on fiscal adjustment.”

Regulation implementation needs to be quick

Given the actual economic and financial crisis, the earlier the necessary regulations are drafted the smaller the uncertainty of implementing the measures provided for. This will facilitate greater debate between all stakeholders on both the steps to be taken and on the final goal of the roadmap.

Following the German Council of Economic Experts’ proposal

For the regulation required to set up the European Redemption Fund, there is already a complete and valid proposal made by the German Council of Economic Experts. It provides for a mechanism to ensure that all Eurozone countries whose debt exceeds 60% of GDP follow a non-modifiable path of reduction of public debt, for which there is joint and several liability among Eurozone countries (GCEE 2012). Drafting the regulation from the GCEE proposal will shorten the time required and convince even the most sceptical that the decision to reduce the debt to 60% of GDP is definitive (Bofinger et al. 2012).

Questions about the European Redemption Fund remain

However, there are still three main questions that should be properly addressed for the European Redemption Fund to be successful:

  • How can the right incentives be provided in order for member states to put in place the structural reforms needed to spur economic growth (i.e. generating growth needs time and financial resources)?
  • How can a burden-sharing mechanism of the cost of the crisis be provided for that matches the benefits derived from the introduction of the euro (Asdrubali et al. 1996)?
  • How should the European Redemption Fund loans status be defined with respect to the debt directly issued by Eurozone countries?

Indeed, Europe asks all countries for a balanced budget, which for the more indebted countries means large primary surplus attainable with austerity programs today, while the implementation of the needed structural reforms will generate economic growth tomorrow. However, this approach may be liable to halting the structural reforms by being too focused on a balanced budget, or worse, on criteria that are not based on any economic model (Abeille 2012).

The risk of following this overall economic strategy should be shared within the Eurozone countries until the reforms are effective. Ironically, as the Greek bailout shows, it has already happened: a highly indebted country has helped some less indebted countries to reduce the Greek bond holdings of their banking system (Alcidi et al. 2012)

GDP-linked bonds

To this regard, the first two questions may be addressed borrowing from the practice of issuing GDP-linked bonds that pay low or even negative coupons until the country is in recession, and high coupons when the national economy finally starts to grow again. These securities, which have been issued in South America but also, recently, by Greece, have the advantage of being countercyclical, ‘hedging’ the reduction of tax revenues due to a deep recession with lower interest payments.

If applied to the interest payments on national debt that exceeds the 60% threshold outsourced to the European Redemption Fund, this would implement a genuine risk sharing mechanism among all Eurozone countries, making each of them bear the risk of failure of the structural reforms of the others.

This mechanism would improve the European Redemption Fund design and create the right incentives to reform the economic system to increase growth potential.

Considering the last question, the European Redemption Fund should be granted seniority status with respect to Eurozone national debt, in order to gain high liquidity and the benchmark status in the Eurozone bond markets. Combined with progress towards a more integrated Eurozone over time, anybody will be able to use the European Redemption Fund to have access to the market, accelerating the path toward a single risk-free issuer in the Eurozone.

Conclusion

As an element of the first step of the roadmap for enhanced debt issuance, the European Redemption Fund must be designed to reduce the likelihood of a breakup of the Eurozone and pave the way to a Eurozone single issuer. This will complete the integration of the Eurozone capital market. In particular, linking the interest payments on the national debt outsourced to the European Redemption Fund to GDP growth, may be a powerful incentive for more troubled Eurozone countries to undertake necessary structural reforms and to keep on implementing austerity measures. Since such a provision would bring about a binding risk sharing mechanism among all Eurozone countries, it would signal that the stronger Eurozone countries are committed to the wider EU project and that they believe that the austerity/structural reforms package is the right approach.

Disclaimer: The views herein expressed are those of the authors and do not necessarily represent those of the institutions with which they are affiliated.

References

Abeille, G (2012), “Pourquoi le déficit à 3% du PIB est une invention 100%... francaise”, Temoignage, La Tribune, 1 October.

Alcidi C, A Giovannini, and D Gros (2012), “‘Grexit’: Who would pay for it?”, CEPS Policy Brief, 272, 23 May.

Asdrubali, P, B E Sorensen, and O Yosha (1996), "Channels of Interstate Risk Sharing: United States 1963-1990", The Quarterly Journal of Economics,111(4), 1081-1110, November.

Bofinger P, C M Buch, L P Feld, W Franz, and C M Schmidt (2012), “A Redemption Pact for Europe: Time to act now”, VoxEU.org, 25 July 2012.

European Commission (2011), “Proposal for a REGULATION OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL on common provisions for monitoring and assessing draft budgetary plans and ensuring the correction of excessive deficit of the Member States in the euro area”, COM (2011) 821 final, Brussels, 23 November.

European Parliament (2012), “DRAFT EUROPEAN PARLIAMENT LEGISLATIVE RESOLUTION on the proposal for a regulation of the European Parliament and of the Council on common provisions for monitoring and assessing draft budgetary plans and ensuring the correction of excessive deficit of the Member States in the euro area”, (COM (2011) 0821 – C7-0448/2011 – 2011/0386(COD)), 29 May.

German Council of Economic Experts (2012), “After the Euro Area Summit: Time to Implement Long-term Solutions”, Special Report, 30 July.

Topics: EU institutions, Europe's nations and regions
Tags: Eurozone crisis, Greece

Head of economic research, Agenzia del Demanio

Director General, Agenzia del Demanio

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