European Economies
How to Save the Euro
Daniel Gros
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BRUSSELS – The European Union is facing a constitutional moment. The founders of Economic and Monetary Union (EMU) warned even before the euro’s birth that fiscal profligacy would constitute a danger to the common currency’s stability. Nevertheless, the euro-zone’s member countries insisted on maintaining their full sovereignty in this area.
The solution to this conundrum was supposed to have been the Stability and Growth Pact, working in tandem with the so-called “no bailout” clause in the Maastricht Treaty. The latter was intended to impose market discipline, and the former, to preserve the stability of public finances by fixing a strict limit on the size of national budget deficits.
Both proved futile. The Stability and Growth Pact clearly did not prevent “excessive” deficits, and the no-bailout clause failed its first test when European leaders, facing the Greek crisis, solemnly declared on February 11 that euro-zone members would “take determined and coordinated action, if needed, to safeguard financial stability in the euro area as a whole.”
The failure to impose market discipline via the no-bailout clause was predictable: in a systemic crisis, the immediate concern to preserve the stability of markets almost always trumps the desire to prevent the moral hazard that arises when imprudent debtors are saved. But in September 2008, the United States government thought otherwise, and allowed Lehman Brothers to fail in order to impose market discipline. The disaster that followed illustrated the damage that an uncontrolled failure can produce.
Yet the lesson should not be that failure has to be avoided at all costs: applied to the case of Greece, this would mean that the pressure on the Greek government to adjust would evaporate. The alternative, instead, is to think ahead and prepare for failure!
A debtor’s strongest negotiating asset is always that creditors cannot contemplate default, because default would bring down the entire financial system. But market discipline can be established only if default is a true possibility. This is why it is crucial to create a mechanism to contain the cost – and thus minimize the unavoidable disruptions – resulting from a default.
This is the key aim of the Euro(pean) Monetary Fund (EMF), which Thomas Mayer and I have proposed, and which has been put on the Union table for discussion by German Finance Minister Wolfgang Schauble, among others. The EMF (or rather ESF, as some have dubbed it, for European Stability Fund) could manage an orderly default of an EMU member country that fails to comply with the conditions attached to an adjustment program.
We imagine a simple mechanism, modeled on the successful experience with Brady bonds. These were bonds issued by distressed Latin American countries in the early 1990’s as part of an arrangement to reschedule their international debts. US government securities provided collateral for them.
To safeguard against the systemic effects of a default, the EMF could offer holders of the defaulting country’s debt an exchange of this debt against claims on the EMF. Of course, debt-holders would be obliged to accept a uniform discount (or “haircut”) on what they are owed.
This would be a key measure to limit the disruption from a default. A default creates ripple effects throughout the financial system, because all debt instruments of a defaulting country become, at least upon impact, worthless and illiquid. But, with an exchange à la Brady bonds, the losses to financial institutions would be limited (and could be controlled by the choice of the haircut given to creditors).
In return for offering the exchange against a haircut, the EMF would acquire the claims against the defaulting country, which would then receive any additional funds from the EMF only for specific purposes that the EMF approves.
Other EU transfer payments would also be disbursed by the EMF under strict scrutiny, or they could be used to pay down the defaulting country’s debt to the EMF. Thus, the EMF would provide a framework for sovereign bankruptcy comparable to the procedures that exist in the US for bankrupt companies that qualify for restructuring.
How would the EMF finance its interventions? We propose to establish a common insurance fund with contributions proportional to the risk that each member country represents. Ideally, one should base the contributions on market indicators of default risk. But the very existence of the EMF would distort credit-default swap spreads and yield differentials among EMF members.
We therefore propose that contributions to the EMF should be based on member countries’ fiscal deficits and public debt levels, because both represent warning signs of impending liquidity or insolvency risk. The EMF could receive a levy that would be proportional to any fiscal deficit in excess of 3% of GDP and public debt in excess of 60% of GDP – the caps imposed by the Stability and Growth Pact. This levy would represent a sort of automatic fine, thus making the elaborate structure of the Pact redundant.
These two simple elements – orderly default and a financing mechanism – could resolve the current crisis within the euro zone: by creating a European Monetary Fund along these lines, the euro area would acquire an institution that could support member countries in difficulties, but that would also ensure that market discipline really worked.
Daniel Gros is Director of the Centre for European Policy Studies.
Copyright: Project Syndicate, 2010.
www.project-syndicate.org
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rienhuizer 03:49 16 Nov 10
Maybe this should be shown again! Some pretty silly things have been said on this site recently!
BerndKlehn 01:57 24 Nov 10
Your Eurobond design is based no the wrong elements. The problems of the Euro zone coursed only by the Balance of Payments and the NetInternationalInvesmentPositions (NIIP). Both should be for the whole Euro zone in a very small plus area. This should be also the aim for every nation in the Euro zone. The Balance of Payment should be in the range of plus 0,5% and the NIIP plus 5% for every country. I therefore propose that contributions to the EMF should be based on member countries’ Balance of Payments and NIIP levels, because both represent warning signs of impending liquidity or insolvency risk and arose currency stresses between the Euro zone members. Therefore payments towards the EMF should be starting by differences from more than +-1,5% in the Balance of Payment and/or +-25% NIIP from the above level.
Cheers
Bernd Klehn
rienhuizer 02:35 24 Nov 10
Apart from this sovereignty nonsense (a state is sovereign if it declares itself to be and no alternative claimants obtain its territory for a sufficiently long time) the EU does not need sovereignty in order to act as agent of its members in accordance with its "constitution" (in the EU's case, the foundation documents of the Union.
What is being proposed here would be OK as ong as there is no better solution. One of the better solution is to create simply two classes of EU (and especially EUR) sovereign debt. (1) debt to a EU central borrowing agency that would borrow under the joint and several liability of all EUR members and from a date in the future would issue all EUR debt to the market, passing on the proceeds to member states on the basis of EUR approved budgets. And (2) local debt (also denominated in EUR) representing a claim on a member state's revenues, subordinated to debt owned by the EUR issuing agency. The second type of debt (which could be the debt of German Federal States or Greek municipalities) would be subordinated to obligations to the Issuing Agency. These claims should have returns reflecting the market perception of their default risk relative to the EUR Issuing Agency's risk. Due to the stricty conditions attached to Issuing Agency debt, the ECB should be justified in acting as a buyer of last resort of those bonds, regardless of monetary targets existing at the time, as long as the system would return to complete discipline (ie a borrowing requirement that would either lead to balance through the cyle or regardless of the cycle). My own preference would of course be in favor of no cyclical fiscal policy whatsoever and stable and slow growth of the money supply, assuming an updated definition in order to achieve at something ressembling budget constraint irrespective of financial innovation and other institutional factors. Governments wishing to cater for protecting their citizens against the cycle could do so of course but by using funds saved in good years or by using asset sales.
Countries not prepared to submit to reasonable discipline of this type should be given leave to separate from the union and no country shoul;d be accepted that could not provide reasonable assurances to the existing members that their accession would not pose undue risk to the fiscal and monetary arrangements of the existing members.
Why else would one let others into a closed group? Democratic countries cannot afford to be altruistic in their foreign policy.
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Charlesvillette 12:43 16 Mar 10
Dear Sir,
Monetary unions are inherently instable. Sooner or later their members are faced with two possible outcomes: political integration or disintegration.This is because monetary and fiscal policies are essential elements of sovereignty which may not be eternally separated from one another. Especially in crises, the frontier between both becomes blurred, as we can see from today’s quantitative easing or the previous centuries’ use of the printing press.
The problem today is that sovereignty can no longer be bestowed to the European Union: this is because, for most constitutional courts, Europe is not a democracy. Indeed, it is illegal for any democratic government to transfer significant parts of its sovereignty, in particular in the economic and social realm, to a government or empire that is not democratic.
The solution is as simple as the problem: Europe must become a democracy. A European economic government, a European government with its own fiscal policy, a European government that can intervene to help a large member country overcome a crisis, can only be established if it draws its democratic legitimacy from the European people.
It is rather easy to establish such a democracy: all that is needed is to give the European Parliament the right to initiate its own laws.
Right now, the European Commission has the monopoly of legislative initiative, for two complementary reasons: first, only the Nation-States, and not the European people, confer parts of their sovereignty to the European Commission, under strict conditions of efficiency and reversibility; second, the Commission is the most appropriate organ for transmuting individual sovereignties into a European spirit, through carefully crafted, highly technical directives.
So far, the Parliament only has the right to turn down directives proposed by the Commission. All would be changed if, by a stroke of a pen, the States would agree to give the Parliament the right to initiate its own directives. Then, the Parliament would enact laws in the name of the European people. These laws would face the powerful test of the European council, which represents the interests of Nation-States and especially the interests of their peoples, some of which, including my own, are over two thousand years old.
But, in the end, those laws that truly represent the European spirit would prevail, because they would be based on reason and the will of the European people, rather than feudal arrangements or institutional alchemy.
All would be changed, because the Parliament would then have the right to raise taxes and to vote a budget. The Commission, aptly renamed European Government, would finally have the legitimacy and the means to decide whether or not some of its members need financial assistance, and under what conditions.
This evolution of European institutions would not be very different from that of a multi-lingual confederation like Switzerland, albeit at a much greater scale.
Best regards
Charles Villette