Editor’s Note: This column is a declaration that was subject to an open voting scheme for German economists; 189 economists voted for it, seven voted against it, and eleven abstained. You can add your vote and see the full list of votes at http://www.wiso.uni-hamburg.de/pdoek.
In May 2010 the EU established a rescue fund, limited to three years, for over-indebted euro countries. Some now favour enlarging the volume of this fund and maintaining it as a permanent facility to support countries facing liquidity crises. But, alas, both proposals are seriously lacking a convincing justification. It is also not evident that the alarming risks already present have been realistically appraised and that adequate provisions have been made for the case that the rescue fund fails.
The current AAA-rated volume of the rescue fund exceeds the entire refinancing requirements of Ireland, Portugal, and Spain up to 2013 by nearly 80%. For this reason, it is incomprehensible why the fund must be expanded. To support states with liquidity crises that are not yet insolvent, a rescue fund is not necessary since these states are able to arrange with their creditors a restructuring of their national debt at an unchanged present value. States that need the rescue fund because their creditors are not convinced that they merely face a liquidity bottleneck must then be considered insolvent. The case we make here is aimed at the German government, but its implications span across all Europe.
Guaranteeing the wrong incentives
A lasting assurance of the EU that would guarantee the solvency of apparently only illiquid but in fact insolvent states via community credits would have extremely negative consequences. Favourable credit conditions and the liability of the European community of states would give over-indebted countries a powerful incentive to repeat the mistakes of the past and to continue a policy of indebtedness at the expense of their EU partners.
Moreover, because it lacks the necessary means of enforcement, the EU is also not in a position to correct these false incentives with stricter budget controls or with the recently proposed “Competitiveness Pact”. These measures are limited and cannot lastingly counteract the fundamental false incentives that emanate from a permanent guarantee of the financial solvency of over-indebted countries. The result will only be to further intensify the debt crisis in Europe, placing enormous strains on the solidarity of the solvent countries, both economically and politically, and ultimately undermining the foundations of the EU.
Taking a haircut without cutting up the euro
A long-term strategy to counter the debt crisis in the Eurozone requires the possibility of a state becoming insolvent and subsequently restructuring its debt. An important aspect of this is that also private creditors must forego at least a portion of their claims against the debtor states. Only after this has been done are loans from the EU in order.
The participation of private creditors in the costs of debt rescheduling means that the bonds of over-indebted states will be traded with appropriate risk premiums that will counter a further increase in the national debt much more effectively than political controls or the threat of sanctions are able to achieve. If, however, over-indebtedness is already present because the servicing of interest and amortisation payments exceed a sustainable level, a debt rescheduling enables the affected states to reduce their outstanding debt and to undertake a fresh start in their fiscal policy. A debt rescheduling does not require that the insolvent country leaves the euro, and it also does not endanger the stability of the euro system.
Without debt rescheduling, the necessary economic reforms in the affected countries could trigger frustration and protest if despite ambitious consolidation measures the debt- servicing cannot be sustainably reduced. Debt rescheduling also ensures that the credit-loss risk is borne at least in part by private creditors, who have already benefited from the risk premiums. A permanent rescue mechanism, however, that excludes state insolvency and debt rescheduling leads to an unjustified redistribution from the taxpayers of the solvent euro countries to the creditors of the debtor states.
A strategy to counter the debt crisis that credibly includes the possibility of a state insolvency must ensure that its consequences are not incalculable. Here the necessity may arise of systemically limiting the maximum default risks of systemically important private creditors (“haircut”), in order to prevent panic-like reactions on the financial markets during the introduction of the debt rescheduling clauses in the new credit agreements after June 2013. Under no circumstances should the EU completely assume the default risks.
It is also necessary, after the final completion of a debt rescheduling agreement, that the EU provide credits to the affected countries, since experience shows that private loans immediately after a state insolvency are virtually impossible to obtain. These credits should have preference over those of private creditors and should only be granted under strict structural adjustment conditions.
Finally, a key question is how after a concluded debt rescheduling procedure an over- indebted state can regain its competitiveness. Since the Eurozone does not allow nominal devaluations, international competitiveness can only be restored by means of structural reforms in the affected states. The IMF has extensive experience in this area and can also provide technical and administrative assistance, for example in the area of tax administration. Nevertheless, recessionary reactions to structural adjustments will not be completely avoidable.
Establishing the new rules
A set of rules that includes the possibility of a state insolvency is only credible when political decision-makers have the incentive to make use of them in cases of crisis. These incentives must be available in particular for the representatives of those countries that have to bear the consequences of insolvency. Every such decision-maker will carefully weigh up the costs and benefits of a possible insolvency. Whereas the costs of the credit losses are relatively concrete and irreversible for domestic banks and the ECB, the benefits may seem to be less tangible.
In addition, a decision on this issue is complicated by political risks, since insolvency and its results cannot be discussed in advance publicly and provided with parliamentary backing. It might therefore be tempting for politicians to play for time by providing new guarantees for an over-indebted country rather than agree to insolvency with subsequent assistance without parliamentary approval. For this reason it might be desirable to shift the determination of insolvency to an independent institution, for example the IMF. Only after a determination of insolvency by an independent institution should assistance be provided by solvent partner countries.
No time to delay
Insolvency declarations of over-indebted states must not be circumvented or delayed by the ECB using its monetary policies in support of these states. The selective purchase of high- risk government bonds favours individual member states and can arouse the envy of other states with high debt burdens. This would endanger the reputation and the independence of the ECB. In addition the interventions of the ECB are by no means merely short-term and only aimed at calming the markets since it is not able to sell off the purchased bonds without causing market irritation. For this reason the ECB must again concentrate on its contractual obligation of monetary stability and leave the solution of excess debt problems to the governments of the Eurozone countries in accordance with the responsible agent principle.
The debt crisis of the EU can lead to three conceivable results.
- First, it can be overcome by means of real growth in the over-indebted countries.
- Second, it can be defused via insolvency procedures for the affected states with subsequent remedial measures. And,
- Third, it can lead to a “communitarisation” of the debts of individual member states, be this through higher taxes or through higher inflation throughout the EU.
The risks of a policy that exclusively concentrates on the first and most favourable of these possibilities are considerable. No one can foresee today whether the affected states will muster the strength to pay off their debts, which have been increased even further by the European Rescue Mechanism.
For this reason we call on the German government to take precautions for the case that the European Rescue Fund fails and – together with its European partner countries – to develop immediately a detailed insolvency plan for over- indebted euro member states that corresponds to the above-stated requirements. This alone can prevent the EU from heading towards the third alternative, with fatal long-term effects for the entire project of European integration.