Any solution to the eurozone crisis must meet a short-run objective and a long-run goal. Unfortunately, the two tend to conflict.
The short-run objective is to return Greece, Portugal, and other troubled countries to a sustainable debt path (that is, a declining debt/GDP ratio). Austerity has raised debt/GDP ratios, but a debt write-down or bigger bailouts would undermine the long-term goal of minimizing the risk of similar debt crises in the future.
Long-run fiscal rectitude is the only way to accomplish that goal. But it is hard to commit today to practice fiscal rectitude tomorrow. Official debt caps, such as the Maastricht fiscal criteria and the Stability and Growth Pact (SGP), failed because they were unenforceable.
The introduction of Eurobonds – joint, aggregate eurozone liabilities – could be part of the solution, if designed properly. There is certainly demand for them in China and other major emerging countries, which are desperate for an alternative to low-yielding US government securities.
But Germany remains opposed on moral-hazard grounds: a joint guarantee of Eurozone members’ liabilities would strengthen individual national governments’ incentive to spend beyond their means. Indeed, this version of Eurobonds would fail, both economically and politically.
But a different version has begun to gain traction in Germany. The German Council of Economic Experts has proposed a European Redemption Fund (ERF). The plan would convert into de facto 25-year Eurobonds the existing sovereign debt of member countries in excess of 60% of GDP, the threshold specified by the Maastricht criteria and the SGP. Steps toward this solution to the short-term debt problem would be paired with implementation of the “fiscal compact,” German Chancellor Angela Merkel’s proposed solution to the long-term problem.
But this seems upside down. To use Eurobonds as the mechanism for eliminating the big sovereign-debt overhang jeopardizes the longer-term objective of eliminating moral hazard: it offers absolution precisely on the 60%-of-GDP margin where countries will have the most trouble resisting temptation. After all, there is little reason to believe that the fiscal compact or proposed “debt brakes” will succeed where the Maastricht criteria and the SGP failed. Rules need a credible enforcement mechanism.
Misplaced hope that the enforcement problem can be solved by enshrining the fiscal compact in member states’ constitutions might be based on a misunderstanding of the US system. To be sure, the US federal government has never bailed out a state, 49 of which (all but Vermont) have laws or constitutional provisions that limit deficit spending. But the main explanation for the absence of US moral hazard is that the right precedent was set in 1841, when the federal government let eight states and the Territory of Florida default. Eurozone leaders should have done the same with Greece a year or two ago.
Ever since 1841, the market requires that US states running up questionable levels of debt pay an interest-rate premium to compensate for the default risk. By contrast, Greece and the eurozone’s other heavy borrowers were able to borrow at interest rates that had fallen to virtually the same level as German Bunds. Had the ECB operated from the outset under a rule prohibiting it from accepting SGP-noncompliant countries’ debt as collateral, the entire eurozone sovereign-debt problem might have been avoided.
Moreover, even the most fiscally dysfunctional US states, like California, do not operate on a scale remotely near that of European national governments. When citizens began in the twentieth century to demand more from their governments – defense, entitlement spending, etc. – the expansion in the US took place at the federal level, where spending today amounts to 24% of GDP, compared to just 1.2% of GDP for the European Union budget.
The version of Eurobonds that might work as the missing long-term enforcement mechanism is almost the reverse of the Germans’ ERF proposal: the “blue bonds” proposed two years ago by Jacques Delpla and Jakob von Weizsäcker. Under this plan, only debt issued by national authorities below the 60%-of-GDP threshold could receive eurozone backing and seniority. When a country issued debt above the threshold, the resulting “red bonds” would lose this status.
The point is that the enforcement mechanism would be truly automatic: market interest rates would provide the discipline that bureaucrats in Brussels cannot. If private investors judged that the new debt had been incurred in temporary circumstances genuinely beyond the government’s control (say, a natural disaster), they would not impose a large interest-rate penalty. Otherwise, the risk-premium mechanism would operate on the red bonds, much as it does on US states.
Of course, the eurozone cannot establish a blue-bond regime without first solving the problems of debt overhang and troubled banks. Otherwise, the plan itself would be destabilizing, because almost all countries would immediately be in the red. Many countries, with debt/GDP ratios already far in excess of 60%, face high borrowing costs and austerity-deepened recessions as well. Sharing their debt burden up to 60% of GDP would be substantial assistance, but it would not necessarily restore debt sustainability.
Thus, Eurobonds are not a complete solution. In the short term, Greece may well default and leave the euro. Governments and banks in other countries will then have to be insulated from the conflagration through a combination of bailout money and strong policy conditionality.
Creating this fire break between Greece and Europe’s core would have been far easier two years ago, before debt/GDP ratios and sovereign spreads climbed so high, and before eurozone leaders’ credibility sank so low, or even one year ago. It might or might not work today.
But one thing seems clear. German taxpayers, whose longstanding suspicion of profligate Mediterranean euro members has been vindicated, will not be happy when asked to pay still more for the cause of European integration. At a minimum, they will need some credible reason to believe that 20 years of false assurances have come to an end – that this is the last bailout.
The fiscal compact alone cannot provide that reason. The blue-bonds scheme just might.
Jeffrey Frankel is Professor of Capital Formation and Growth at Harvard University.
Copyright: Project Syndicate, 2012.