The annual gathering of finance ministers and central bank governors at the IMF/World Bank meetings in Washington seems to have been an epiphany for Eurozone leaders. Finally, there seems to be agreement that their July 2011 agreement was insufficient (Reuters 2011).
In a previous Vox column, I sketched a way of stopping the public debt crisis that is engulfing the Eurozone (Wyplosz 2011). Here I develop this idea into a coherent proposal that, if adopted, would immediately stop the rot.
The proposed solution would:
- Get Eurozone governments out in front of the markets by setting a floor on the price of public debt;
- Allow distressed governments to both reduce their debt burdens and recover access to market funding; and
- Deal with the moral hazard issue that mesmerises German taxpayers.
It involves three steps and no cost, because it works like bank deposit guarantees – as long as they are credible, they don’t get used because they eliminate bank runs. In the current situation, however, what we need to stop is a run on public debt.
Three steps to a solution
The first step deals with the existing stock of public debts.
- The ECB should set a floor on public debt values by offering a guarantee.
The guarantee should be partial to allow defaults for countries unlikely to serve their debts. A guarantee could cover each country’s debt up to, say, 60% of GDP.
- Markets would promptly re-price debts. Greece’s debt would likely trade at 60% of its GDP, about 50 cents to the euro;
- Others would trade higher all the way to Germany’s, which would stay at par.
The market price would offer a clear guide for governments to negotiate a restructuring. The ECB – and German taxpayers – would suffer no loss. The crisis would be over, moving to the resolution phase.
The second step is designed to shift from fiscal austerity to growth-enhancing action.
- To allow governments to borrow again, the ECB should guarantee all future public debts – excluding the rollover of non-guaranteed debts.
Without complementary policies, this would obviously create endless moral hazard (ie temptation for Eurozone governments to issue cheap debt irresponsibly on the back of the guarantee).
To eliminate the moral hazard created by both guarantees, two conditions are needed.
- First, each country would have to adopt domestic institutional arrangements (fiscal rules, independent fiscal councils, etc.) that lock in lasting fiscal discipline as a matter of national law. (Just as US states avoid the problem with state constitutions that require balanced budgets.)
To be credible to the domestic body politic, each nation’s arrangements must fit local political institutions – but the proposed change would be subject to approval by the European Commission and the ECB.
- The second condition for the ECB’s guarantee would be that each country strictly enforces its own arrangement.
Access to the ECB guarantee on new issues will start only once an arrangement has been validated. It would be suspended if and when particular nations failed to respect their approved arrangement. Such suspensions would immediately raise the cost of further borrowing by the delinquent country, but it would not affect the guarantee already given to debt issued previously– that guarantee would be meaningless if the ECB could renege.
Step three addresses banks' vulnerabilities arising from the fact that sovereign defaults are likely to result in bank failures.
- Given that some countries will default, the EFSF will have to recapitalise failed banks.
Here the ECB would act as lender of last resort with the EFSF guaranteeing its interventions. Well-crafted recapitalisations do no need to be costly. For example, the Swiss National Bank is now making profits on its creative recapitalisation of UBS during the global crisis.
Importantly, these schemes would be voluntary. No country would be forced to accept the ECB guarantees but any country could ask for it at any time.
Could the ECB suffer losses? A crucial element of this solution is that the ECB would spend almost no money if the guarantees are well-specified enough to be credible.
Why it would be pro-growth
- The combination of low interest rates on guaranteed newly issued debts and the conditions imposed means that the risk of further defaults is very significantly reduced.
- By opening up space for fiscal policies that support a recovery, fiscal stabilisation would become much easier once growth takes hold, further shielding the ECB.
Member governments will have put in place institutions that permanently deliver fiscal discipline – a quest that has eluded the European Central Bank since the start and that so worries – and rightly so – German taxpayers.
The alternative is more of the same
Because the ECB’s mission is to preserve the euro, it will continue indefinitely with sporadic and limited actions in response to the latest market turmoil. But this leads to a never ending sequence of Pyrrhic victories. Because the ECB will never stay idle when the Eurozone is on the brink and the markets know this, the ECB is taking major risks but achieving nothing that lasts.
Wyplosz, Charles (2011). “They still don’t get it,” VoxEU.org, 22 August.
Reuters (2011). “Under fire, Europe works to bolster crisis fund,” Reuters news story by Dina Kyriakidou and Dan Flynn, 26 September.