Since the beginning of this year, the Eurozone crisis has worsened. Despite notable efforts, the June European summit has not succeeded in restoring confidence in the euro. Fearing the restructuring of public debt in EZ countries, investors have turned their back on sovereigns in the Eurozone, and even on the Eurozone as a whole.
This distinctly systemic nature of the crisis originates from the implicit sovereign default risk. In contrast to the central banks of the US, the UK and Japan, the ECB is not allowed to finance treasuries in the member states. It cannot therefore act as a lender of last resort for governments. This dividing line between monetary and fiscal policy was drawn by the Maastricht Treaty to ensure price stability and, given the experience with monetisation of fiscal deficits in Europe’s history, should remain in place. But it induces an implicit insolvency risk for investors financing sovereign debt of EZ countries which, in the current situation, induces investors to either avoid the countries in trouble or even the Eurozone as a whole. The Eurozone thus faces the threat of breakup.
This situation requires a new governance structure for the Eurozone in order to regain investors’ confidence. The crisis has become so gridlocked, however, that the new governance cannot be established easily. The European Redemption Pact (ERP) proposed by the German Council of Economic Experts (GCEE) in November 2011 allows for breaking this deadlock. The GCEE therefore proposes a revised and extended ERP which addresses both the exacerbation of the crisis during the last months and a number of concerns induced by the original proposal.
We view this as a device for solving the current crisis whose time has come.
Structural reforms and the systemic nature of the current crisis
Default risk for investors financing sovereign debt would not have arisen if all members had maintained low public indebtedness (as required by the Stability and Growth Pact), low private-sector indebtedness, and sustainable external balance of payments. Because this is not the case, the countries in trouble need to address problems in three different areas:
- an overhang of sovereign debt;
- ailing banks with insufficient equity capital to buffer severe shocks;
- deficient competitiveness leading to low potential growth.
These problems not only reinforce each other, but also create policy trade-offs; actions taken to alleviate problems with the situation in one area can worsen the situation in others.
The most visible and highly discussed problem is the overhang of sovereign debt. In addition, several highly indebted European countries are characterised by low international competitiveness and, thus, low growth prospects. Structural reforms would be needed to enhance competitiveness, with the aim of allowing these indebted economies to grow out of their problems. But not only would these reforms take considerable time to take hold, they are also politically difficult to enact because their typical budgetary consequences lead to reduced economic activity in the short term. The only short-term option to achieve budgetary stability is austerity, but if this route is followed decisively, it will be difficult for these economies to avoid recession.
At the same time, banks and sovereigns in many European countries are heavily entangled, with banks holding a large amount of their respective governments' debt and with highly indebted governments being responsible for the rescue of ailing, systemically important banks. During the crisis, the mutual interdependence between banks and sovereigns and the “home bias” in banks’ asset portfolio increased.
In this situation, banks will find it difficult to build up capital buffers against shocks via retained earnings or additional external equity. And as banks turn to deleveraging instead, economic growth is restricted by the financial sector when the investments for future growth need to be financed by credit. Adding to this situation of fragility, the ECB has become entangled. To prevent imminent disaster, the ECB has become heavily involved in stabilising financial markets, thereby blurring the previously sacrosanct dividing line between fiscal and monetary policy.
In this situation, European policymakers need to formulate and communicate a credible and coherent strategy that will successfully take the Eurozone out of this crisis. This strategy would have to specify concretely:
- how sovereign EZ debt will be curbed in in order to once again reach sustainable public finances; and
- which structural reforms will be undertaken to reduce macroeconomic divergence among member states.
Since this strategy has to convince financial markets, it needs to be backed by appropriate contractual arrangements and institutions. And since it has to receive the backing of European citizens, European leaders need to convince voters that following this strategy will reward short-term pain with long-term gain. Finally, this strategy needs to address the systemic nature of the problem.
Structural reforms, fiscal consolidation or improved fiscal institutions will not be sufficient to reduce investors’ fear of sovereign default. The provision of liquidity, either by the ECB further blurring the dividing line between monetary and fiscal policy, or by the fiscal action of EZ member countries will be necessary to cope with the instability of the Eurozone. EZ member states must credibly commit to the continued existence of the euro.
Current crisis management
So far, the frantic rescue operations by European policymakers have given the impression that they are ignoring the systemic nature of the crisis. Instead of devising a coherent strategy, they have relied heavily on a sort of piecemeal engineering, with stepwise widening of rescue schemes and stepwise augmentation of coordination mechanisms, only inching towards a more integrated Europe with each decision.
Most disconcertingly, this piecemeal strategy is testing at every step along the way the devotion of all participants in this endeavour to avoid a breakup of the common currency. Given the diverging interests and views held by the EZ members, it is difficult to forge an agreement that addresses the systemic nature of the crisis while consciously balancing the short-term effects of stabilisation measures with long-term consequences. Failing to solve the crisis is now seriously endangering the process of European integration.
The principle of strict conditionality and adherence to the adjustment measures promised by countries receiving support are keys to regaining the desperately needed competitiveness. Thus, it is easy to understand why, in this process, especially Germany as the major fiscal backstop in the Eurozone has insisted on a quid pro quo -- tying financial support to commitments.
If these commitments have to be wrenched from the partners at every step, it is unthinkable to agree to a more persistent type of support as, for example, the idea of Eurobonds. As long as member countries in need of structural reforms do not find a way of tying themselves convincingly to a binding reform path, the German government will not be able to convince the German public or the German Constitutional Court that providing more than short-term support will be a sensible option.
But it is also easy to understand why other countries have become frustrated with this insistence on ruling out joint and several liability. Some, albeit not all countries, have already started serious consolidation of their public budgets, cutting public employment and wages, and have also enacted drastic structural reforms in their pension systems, their labour and product markets. While these measures promise to bear fruit in the future, in the short term the people in these member states mainly feel the burden of adjustment. Those countries’ desire to receive some alleviation in their high refinancing cost on the financial markets derives from two motives. First, and most directly, without sufficient breathing space, it will be more than difficult to establish the long-term fiscal strategy which is needed to overcome the systemic crisis. Second, more subtley, governments of the member states in need of reform have to convince their voters that there is some light at the end of the tunnel, and this will only be possible if success appears to be achievable and if there is evidence of support by stronger European economies.
The European Redemption Pact
Hence, there is an impasse between the measures aiming at short-term stabilisation and the provision of the structural basis for long-term prosperity. There is also a lack of any device enabling European policymakers to appropriately balance short-term solidarity and long-term solidity. These deficiencies of the current situation were already addressed by the GCEE in the fall of 2011. In its annual report to the German government published in November 2011, the GCEE suggested a bridge between short-term stabilisation and long-term governance: The European Redemption Pact, one element of which is the European Redemption Fund. In fact, the European Redemption Pact (henceforth “the Pact”) rests on three pillars, (i) a European Redemption Fund (henceforth “the Fund”), relying on mutualizing part of Eurozone debt; (ii) the Fiscal Compact, in particular a commitment to national debt brakes preferably at the constitutional level; and (iii) the installation of a crisis resolution mechanism, with provisions for the possible involvement of the private sector in future crises.
It is the Pact's aim to provide a credible device for restoring national responsibility for fiscal solidity. Its principal idea is to reduce financing cost for the Fund by accepting joint and several liability and to pass the low interest rates on to participant countries when buying their debt in the primary market, in exchange for the commitment that they will be using this advantage exclusively to facilitate the reduction of their sovereign debt overhang. Specifically, all participant countries would have to accept the obligation to individually redeem their own transferred debt; it is not to be rolled over perpetually. Given the ultimate aim of leading each participant economy back to a sustainable debt-to-GDP ratio, this device would be specified to be temporary and limited in magnitude. Nevertheless, it would have to operate over the course of as long as about 25 years. And at its maximum, the magnitude of this unprecedented operation would be enormous – the Pact would allow member countries not yet supported by the European rescue funds to refinance via a joint refinancing scheme all of their current debt which exceeds 60% relative to GDP. If the Fund were to be initiated now, slightly under 2.6 trillion euros would qualify (see chart below).
The actual operation of the Pact will proceed in two different regimes. In a “roll-in phase” of roughly five to six years, participant countries will transfer their eligible debt to the Fund, whereby the concrete path will be determined differently from country to country according to the structure of outstanding debt. While short-term debt of up to two years would still be financed directly through the market, countries would not directly raise longer term debt on the markets but instead refinance it at the rates offered to them by the Fund. They will have to start redeeming their transferred debt immediately, using this interest advantage. (It will presumably be a disadvantage in the case of Germany, though.)
This roll-in phase will be decisive in three respects. First, these initial years will be a practical test of the commitment of all participant economies to the conditionality imposed and thus the more painful aspects of the Pact. Specifically, the roll-in years must be used, secondly, to reduce the structural deficits, and to initiate, thirdly, the structural reforms which are necessary to restore the currently lacking competitiveness. The interest advantage is destined to provide the breathing space to follow the respective consolidation and reform paths which have to be agreed upon as part of the Pact.
In the subsequent “redemption phase”, the Fund will shrink continuously due to debt redemption. Consequently, individual governments will be refinancing a declining amount of transferred debt via the Fund, while the share of their payments to the Fund which is used for redemption is continuously increasing. The remaining debt which is not transferred to the Fund needs to be financed via financial markets. That is, at the end of the roll-in phase participant economies will be confronted with the full force of market discipline, over and above the short-term debt which remains the object of market scrutiny throughout the process. Because the remaining debt henceforth has to be retained within the 60% limit, at the beginning of the redemption phase effective debt brakes must take over full responsibility from the consolidation agreements which are operative during the roll-in phase. In addition, the reform plans for ascertaining competitiveness will have to extend well into the redemption phase.
Compliance and governance
It is obvious that those countries in the Eurozone which are currently under intense scrutiny by financial markets will tend to find participation in the Pact highly attractive. But in order to forge such an agreement, it will be necessary to convince sceptics, not least in Germany, that all participants will indeed adhere to their promises of redeeming their debt overhang and reforming their economies, especially since the period of redemption will span more than two decades.
Recognising the sensitivity of this issue and given the intense discussion which the original proposal of the Pact had experienced since November 2011, in its recent special report the GCEE (2012) not only proposed a number of "safety valves" to be installed in the Pact, but also suggested concrete regulations regarding the governance of the Fund. According to these considerations, the overall balance between solidarity and incentives should rest on the concrete arrangements in three areas: (i) taxes and interest advantages; (ii) sanctions and market discipline; and (iii) governance and parliamentary rights.
First, as an important part of their consolidation efforts, participant economies should pledge to raise earmarked redemption taxes whose proceeds directly flow into the payments to the Fund. Together with the interest advantage conveyed by the fund, the Pact thus makes the persistent realisation of the primary surpluses possible which are the major ingredient of any effort to reduce debt overhang. Clearly, participant countries have an incentive to convince the Fund to provide them with the maximum interest advantage made possible by the low refinancing cost of the Fund, both during the roll-in and during the redemption phase. The Fund could reduce the typical difference between its own and the interest rate charged to participating countries, generating an additional advantage to reward particularly compliant behaviour.
Second, one could install a number of possible sanctions into the operation. They would be triggered by failures of compliance with the provisions of the Pact, and they would increase in the severity of this failure. As a mirror-image of possible interest rate reductions vis-à-vis the typical rate, the Fund could sanction insufficient compliance by applying interest rate surcharges. Selling government bonds on the open market could serve as a variant of this idea because this would increase the refinancing cost for debt not being transferred to the Fund. The Fund could also enact direct sanctions by seizing part of the gold or currency reserves or covered bonds which participant countries have to pledge at the outset when entering the Pact. The GCEE suggests that for each participant country, this collateral should reach the order of magnitude of 20% of transferred debt, respectively. The most drastic form of a sanction would be the exclusion of a participant country during the roll-in phase, a sanction which would certainly be reserved for highly severe compliance failures.
Third, the governance of the Fund will be decisive for its ability to effectively impose sanctions in due time and of sufficient severity. In principle, devising this governance structure is a problem similar to devising the governance of the rescue operations under the auspices of the ESM. Consequently, it will be important to ascertain substantial influence of the stronger economies on decisions of the Fund, up to reserving an effective right to veto decisions. Moreover, if open market operations should ever be used as an instrument to invoke market discipline, the governing body of the Fund needs to be independent of political influence, similar to the ECB.
With all these specifications, the Pact would address the systemic crisis by creating a safe asset and, at the same time, providing for a credible and coherent strategy to reduce sovereign debt and to conduct structural reforms in the Eurozone. The Pact would fail, though, if only parts of these specifications were entered into the agreement to be forged by participant economies. The balance of solidarity and incentives is too tender to pick out only a subset of its elements. To overcome this systemic crisis, it would not be sufficient if only Germany were to become "more European" and provide more solidarity, nor would it be sufficient if only the rest of Europe were to become "more German" and adhere to ironclad budgetary discipline. In fact, we need both. If European policymakers want to make the Eurozone work, they need to embrace the whole package. European leaders should forge such a Pact now to at last provide the desperately needed bridge into the Eurozone’s future.
Editor's note: An English translation of The German Council of Economic Experts Special Report "After the Euro Area Summit: Time to Implement Long-term Solutions" is available here.