Thursday, October 30, 2014

Debt Without Drowning

LONDON – Since the 1970’s, economists have warned that a monetary union could not be sustained without a fiscal union. But the eurozone’s leaders have not heeded their advice – and the consequences are becoming increasingly apparent. Europe now faces a difficult choice: either fix this fundamental design flaw and move toward fiscal union, or abandon the common currency.

Choosing the latter option would have devastating consequences. Indeed, while the desirability of establishing a monetary union may have been open to question in the 1990’s, dismantling the eurozone now would trigger profound economic, social, and political upheaval throughout Europe. To avoid this outcome, Europe’s leaders must begin designing and implementing strategies aimed at bringing the eurozone closer to a fiscal union.

To be sure, a fiscal union such as that in the United States is a distant prospect that eurozone leaders should not expect to achieve any time soon – or even in their lifetimes. But that does not mean that establishing a fiscal union is a chimera. Small steps in the right direction now can make a significant difference.

A successful strategy would have to address one of the eurozone’s main design flaws: member governments issue debt in euros, a currency that they cannot control. As a result, they cannot provide a guarantee to bondholders that the cash will be available to pay them at maturity.

The mistrust and fear that this elicits in the bond markets can lead to liquidity crises that, creating a self-fulfilling prophecy, drive countries closer to default. They are then forced to implement austerity programs that lead to deep recessions and, ultimately, to banking crises.

While austerity measures are appropriate in countries that have overspent in the past, the austerity that panic-stricken financial markets force upon a country can trigger a major social and political backlash. In fact, several southern European countries – such as Greece, Italy, Portugal, and Spain – are currently experiencing exactly that.

To overcome this fundamental design flaw, government debts must be pooled. This would protect the weakest economies from destructive, panic-fueled movements in financial markets, which, in theory, can hit any member country – even those that are strongest today.

In developing a strategy for pooling government debt, Europe’s leaders must address the possibility of moral hazard (the temptation for weaker countries to relax their debt- and deficit-reduction efforts in response to the increased credibility conferred by stronger countries). Indeed, given stronger economies’ unwillingness to be exploited in this way, the risk of moral hazard is the most significant obstacle to pooling debts in the eurozone.

But it is not the only obstacle. A debt-pooling scheme must also address the fact that the strongest countries will inevitably face higher interest rates on their own debts when they become jointly liable for the debts of less credit-worthy governments.

To overcome these obstacles, a eurozone debt-mutualization scheme must satisfy three crucial requirements. First, the share of government debt that can be pooled must be strictly limited, leaving each country responsible for a significant portion of its national debt, and therefore motivated to maintain sound public finances. (Several initiatives have aimed to achieve this, notably Jakob von Weizsäcker and Jacques Delpla’s 2010 Blue Bond proposal.)

Second, an internal transfer mechanism between eurozone member states is needed in order to ensure that less credit-worthy countries compensate, at least partly, their more economically sound counterparts.

Finally, a supervisory authority must be established to monitor governments’ progress toward achieving sustainable debt levels – and to create clear consequences for those that break the eurozone’s budgetary rules. The Padoa-Schioppa group recently proposed that rule-breaking governments should gradually lose control over their own national budgetary processes.

Opponents of debt mutualization, especially in northern Europe, often argue that, in the absence of political unification, it amounts to putting the cart before the horse. But what other measures could be taken to bring the eurozone closer to a political union? Military force – so often used in the past to unite diverse nations under a single political umbrella – is out of the question. And simply waiting will have no effect. The only practical approach is to take small, sequential steps, starting with debt pooling.

In fact, Alexander Hamilton adopted this approach more than 200 years ago, when he decided to mutualize the debts that individual US states had incurred during the Revolutionary War – a decisive move toward further political integration. Rather than wait for political union to happen, Hamilton took action that eventually helped the US to become a full-fledged monetary, fiscal, and political union.

The eurozone is gripped by an existential crisis that is slowly, but inexorably, destroying the monetary union’s very foundations. The only way to stem the erosion is to take determined action that convinces financial markets that the eurozone is here to stay. A debt-pooling scheme that satisfies the requirements outlined here would signal that the eurozone member countries are serious about sticking together. Without this gesture, further market turmoil is inevitable – and the eurozone’s collapse will become only a matter of time.

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  1. CommentedJose araujo

    In what sense would the dismantle of the Eurozone, even the EU have devastating consequences?

    Is this a Dogma, written in stone that we cannot question? Was the dismantle of USSR catastrophic? The Czechoslovakia, Yugoslavia, etc etc

    EU is a tyranny, we currently live under an Eurocrat dictatorship, ruled by unelected officials, breaking up would be the best thing for Europe, e are a continent not a country, face it and move on. Small is beautiful.

  2. CommentedManuel Gomes Samuel

    Paul De Grauwe is right. The million dollar question is whether the EU is going to integrate further to correct the shortcomings of the EMU (e.g. by mutualizing debt and establishing a fully fledged banking union) or disintegrate (starting with a euro implosion). Without a fully functioning EMU and in the absence of a banking union and mutualized debt, the business community in the Southern periphery of Europe will suffer more and more from expensive and difficult access to credit. This is so evident. The EU core says that the periphery needs to be more competitive but in order to regain competitiveness business in the periphery need vibrant internal markets, state subsidies/incentives and quick and fairly priced credit. At the moment these conditions are almost an utopia. Therefore little wonders the ever growing divide between the core and the periphery.
    As Harry Dexter White once said " trade will bring Nations closer", but this is exactly the contrary of today's trend in Europe where every other government/business is looking for overseas markets and EU intra-trade is dwindling.

  3. CommentedJose araujo

    OK, this is a good first step, but still fails to address the main problem, the competitive difference between Euro countries. More protectionism is needed for this countries and to some extent more control on capital movements. Differential VAT on national and Euro goods is needed to protect this economies. The lifting of Euro regulation on some areas to reduce the cost of doing business, etc etc.. But we should start somewhere and the Euro-bonds would be a good start.

  4. CommentedMark Pitts

    Fiscal union without political union would inflame the crisis, because so much more would be at stake. Without political institutions that can resolve the inevitable conflicts, it cannot work.

      CommentedCarol Maczinsky

      That implies that principles and agreements are kept. the Schäuble proposal tested that. They are unwilling to give competences to Brussels to control their fiscal spending. In other words they are not willing to keep their agreements. Means, they are not trustworthy. We see all the immature blame games againt restoration of trust that demonstrate what corrupt, unprincipled cowards they elected to govern them.

      CommentedZsolt Hermann

      I fully agree with you.
      We exist in an integral system, meaning humanity evolved into such a network where each and every individual, nation is connected to everybody else and we fully depend on each other even for our basic necessities.
      In an integral system there exists no partial union.
      Either all elements are fully interconnected in a mutually complementing way and then the system works optimally, or all elements break apart causing the destruction of the whole system.
      What Europe is doing is proving this point, as they try to force a partial union, partial connection within the integral system.
      As a result, regardless of how stubbornly they are trying the experiment is falling apart threatening with very unpredictable, probably very violent consequences.
      The alternative of a united Europe is extremists policies, isolation and war.
      The truth is we have no free choice in the matter.
      Our choice is if we go through the inevitable changes in full awareness, in a proactive way changing our attitude, the relationships in between us, building the necessary mutually responsible and complementing system foregoing the problems, or we will be beaten to it by unprecedented suffering.
      The most important thing history shows us, as long as we continue evolving in an instinctive, "natural" manner, humanity is never tired of trying the same costly mistakes, causing increasing level of destruction and loss each time.
      It is time we rise above our inherent nature, our egoistic, selfish instincts and try a new path by understanding ourselves and the system we exist in.

  5. CommentedMassimo GIANNINI

    Germany will be compelled sooner or later to accept a) Eurobonds b) some forms of mutualisation of debt. Eurobonds will have to be used for a) EU budget b) EU projects (that is public investments) c) refinance the sovereign debts (below the 60%). You will have noted that “synthetic” or proxy EU bonds already exist in the ECB budget via its operations. Launching Eurobonds will be just a matter to go beyond the European Stability Mechanism. Appropriate compensation facilities could be set up among countries to take account also of interest rate spreads.

  6. CommentedEric West

    On what basis do you support the claim that a break up of the euro would have "devastating consequences". It seems likely that a German exit, which would be followed by an Austrian and Benelux exit, would result in a perfectly manageable dissolution and, indeed, this clearly remains the best option for the people of Europe. Mutualisation of debt will simply sustain the North/South divide which, as we are already seeing, is leading to a steady migration from the latter to the former.

  7. CommentedMarco Cattaneo

    Debt mutualization wouldn't solve competitivity differences. It would perpetuate the intra-eurozone split to create a situation similar to the Italian North / South divide (and to England vs Scotland, Flanders vs Walloon, West vs East Germany etc.) Even more important, Germany is ABSOLUTELY NOT available to consider it. The eurocrisis solution requires reforming the euro monetary system to reintroduce flexibility on a country basis. It can be done without breaking up the euro:

  8. CommentedJoão Miguel Ejarque

    Currently the fraction of debt that can be mutualized is 0 and yet that still does not motivate governments to maintain sound public finances...

  9. CommentedCraig Hardt

    It would seem that this proposal, while beneficial for Europe as single, monolithic entity, would be highly undesirable for nations with strong economies like Germany.While the resulting turmoil if the Euro were to collapse would cause some pain in strong Eurozone countries, pooling their debt with the debt of other countries would also cause pain. Further, it would diminish the sovereignty of these countries and inextricably link their economic and political future to countries with different histories, priorities, and economic situations. While it might save the Euro, if this is the only solution to European economic woes it seems more likely the Euro will soon be gone.