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Two Models for Europe

MUNICH – Interest rates for public debt within the eurozone have spread once again, just as they did before the introduction of the euro. Balance-of-payment disparities are steadily increasing. The sovereign-debt crisis is eating its way from the periphery to the core, and the exodus of capital is accelerating. Since the summer, €300 billion, in net terms, may well have fled from Italy and France.

The printing presses at the Banque de France and the Banca d’Italia are working overtime to make up for the outflow of money. But this only furthers the exodus, because creating more money prevents interest rates from rising to a point at which capital would find it attractive to stay.

If Europe had the same rules as the United States, where the Federal Reserve’s regional banks have to pay the Fed for any special money creation with securities collateralized in gold, they would not create this much supplementary money, and capital flight would be limited. Instead, local printing of money is essentially aiding and abetting the exodus.

If the eurozone does not want to embrace capital controls, it has only two alternatives: make the local printing of money more difficult, or offer investment guarantees in countries that markets view as insecure.

The first option is the American way, which also demands that the buyers bear the risks inherent in public or private securities. The taxpayer is not called upon, even in extreme cases, and states can go bankrupt.

The second option is the socialist way. Investment guarantees will lead, via issuance of Eurobonds, to socialization of the risks inherent in public debt. Because all the member states provide one another with free credit guarantees, interest rates for government securities can no longer differ in accordance with creditworthiness or likelihood of repayment. The less sound a country is, the lower its effective expected interest rate.

The socialist way follows necessarily from the free access to the printing press that has so far characterized the eurozone. As long as banks – and thus governments, which sell their debt to the banks – can draw cheap credit up to any amount from the European System of Central Banks, Europe will remain volatile. The exodus of capital will continue, and enormous compensation claims of the European core’s central banks, particularly the German Bundesbank and the Dutch central bank, will pile up.

In Germany, these compensation claims amount to half of the country’s entire net foreign wealth, or €500 billion ($653 billion). Since these claims would probably be lost should the euro collapse, the political pressure to give way finally to Eurobonds is becoming overwhelming.

But German acquiescence would be a disastrous result for Europe. The European Financial Stability Facility in Luxemburg would become a socialist planning agency, organizing flows of public capital in Europe and thwarting markets’ allocative function. The consequence would be reduced growth, owing to a misallocation of scarce capital, and economic stagnation in the core areas.

Matters are made no better by controlling credit flows via a fiscal government, which is what the eurozone countries have now decided they want. As long as the debtors co-determine the rules, more capital will flow under such an arrangement than markets would permit.

That distortion will become apparent even within the countries that benefit from the additional credit, because Eurobonds will, for the time being, provide security only for government debt. Private debtors will continue to have difficulties finding capital, so the state will expand relative to the private sector. The ECB’s founding chief economist, Otmar Issing, has referred to this as a road to serfdom.

But it is not a smooth road, because it threatens resistance by the capital-exporting countries’ taxpayers and trade unions against the outflow of capital. In Germany, in particular, enormous resistance will build up if the country – via the introduction of Eurobonds – is driven back into the crisis that it underwent as a result of the interest-rate convergence that followed the introduction of the euro.

Only the American alternative is viable. Short- and long-term interest-rate spreads are determined by the economy’s creditworthiness, and whoever wants low interest rates has to provide real collateral.

The American route does not necessarily imply a heavy-handed approach vis-à-vis the crisis countries. It can be combined with a system of measured, limited help in the sense of partial coverage of investors against a country’s insolvency.

This model, contemplated by the European Economic Advisory Group at CESifo, would retain the disciplinary effects of interest-rate spreads while capping them in order to limit panicked extremes in the capital markets. It offers the last chance to avoid debt socialism.

Read more from our "Are Eurobonds a Silver Bullet?" Focal Point.