How Europe Should Treat Sovereign Debt in the Future
My preceding blog post identified three mistakes made by leaders of the European Economic and Monetary Union in dealing with Greece. But what is done is done. The mistakes now lie in the past. How can Europe’s fiscal regime be reformed to avoid future repeats of this crisis?
The reforms that are now underway are not credible. (”We are going to make the fiscal rules more explicit and make sure to monitor them more tightly next time.”) Similarly, most proposals for how to put teeth into the rules are not credible — penalties such as monetary fines or loss of voting privileges.
It is too late for Greece. But it is not too late for a euroland reform that would help avoid the re-emergence of unsustainable sovereign debt levels next time around by applying the lesson of mistake number two: to adjust the ECB policy of accepting the debt of all member states as collateral. This is the policy that short-circuited warning signals that the private markets would otherwise have sent via interest rates during 2002-2007.
My proposal: The eurozone should in the future adopt a rule that whenever a country violates the fiscal criterion of the Stability and Growth Pact (say, a budget deficit in excess of 3% of GDP, structurally adjusted), the ECB must stop accepting that government’s debt as collateral. This system would achieve the elusive objective of true automaticity. If a country exceeded the threshold for justifiable reasons, such as natural disaster, the private markets could perceive that and impose little or no default risk premium. No judgment of the merits by bureaucrats or politicians would be required. More likely, for periphery countries, the result of such a re-classification would be the re-emergence of sovereign spreads of moderate magnitudes, in between the extremes of the 2002-07 lows and the 2009-11 highs (see chart). The interest rate premium would send a message far more credibly, forcefully, and promptly than any warning that any Brussels bureaucracy will ever turn out.
This is how it works among the U.S. states and municipalities. Despite the absence of their own currencies, the recurrence of dysfunctional local politics and excessive deficits, and even a history of state defaults in the 19th century, federal bailouts are not delivered and are not expected. Without some such device, the new European Stability Mechanism is in danger of becoming a mechanism for instability.
[Niels Thygesen made the case in favor of the current reform track in "Governance in the Euro Area" at the Challenge of Europe session of INET's Annual Conference, Bretton Woods, NH, April 10, 2011. I gave mycomment there as well. (Video)]