Any solution to the eurozone crisis must meet a short-runobjective and a long-run goal. Unfortunately, the two tend to conflict.
The short-run objective is to return Greece, Portugal, and other troubledcountries to a sustainable debt path (that is, a declining debt/GDP ratio).Austerity has raised debt/GDP ratios, but a debt write-downor bigger bailouts would undermine the long-term goal of minimizing therisk of similar debt crises in the future.
Long-run fiscal rectitudeis the only way to accomplish that goal. But it is hard to commit today topractice fiscal rectitude tomorrow. Official debt caps, such as the Maastricht fiscalcriteria and the Stability and Growth Pact (SGP), failed because they wereunenforceable.
The introduction of Eurobonds – joint, aggregate eurozoneliabilities – could be part of the solution, if designed properly. There is certainlydemand for them in China andother major emerging countries, which are desperate for an alternative tolow-yielding USgovernment securities.
But Germanyremains opposed on moral-hazard grounds: ajoint guarantee of Eurozone members’ liabilities would strengthen individualnational governments’ incentive to spend beyond their means. Indeed, thisversion of Eurobonds would fail, both economically and politically.
But a different version has begun to gain traction in Germany. The GermanCouncil of Economic Experts has proposed a EuropeanRedemption Fund (ERF). The plan would convert into defacto 25-year Eurobonds the existing sovereign debt of member countries inexcess of 60% of GDP, the threshold specified by the Maastricht criteria and the SGP. Steps towardthis solution to the short-term debt problem would be paired with implementation of the “fiscalcompact,” German Chancellor Angela Merkel’s proposed solution to the long-termproblem.
But this seems upside down.To use Eurobonds as the mechanism for eliminating the big sovereign-debt overhang jeopardizes the longer-term objective ofeliminating moral hazard: it offers absolutionprecisely on the 60%-of-GDP margin where countries will have the most troubleresisting 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. Rulesneed a credible enforcement mechanism.
Misplaced hope that the enforcement problem can be solvedby enshrining the fiscalcompact in member states’ constitutions might be based on amisunderstanding of the USsystem. To be sure, the USfederal government has never bailed out a state, 49 of which (all but Vermont) have laws orconstitutional provisions that limit deficit spending. But the main explanation for the absence of US moral hazard is that the rightprecedent was set in 1841, when the federal government let eight states and theTerritory of Florida default. Eurozone leaders shouldhave done the same with Greecea year or two ago.
Ever since 1841, the market requires that US states runningup questionable levels of debt pay an interest-rate premium to compensate forthe default risk. By contrast, Greeceand the eurozone’s other heavy borrowers were able to borrow at interest ratesthat had fallen to virtually the same level as German Bunds. Had the ECBoperated from the outset under arule prohibiting it from accepting SGP-noncompliantcountries’ debt as collateral, the entire eurozone sovereign-debt problemmight 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 theirgovernments – defense, entitlement spending, etc. – the expansion in the UStook 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 missinglong-term enforcement mechanism is almost the reverseof the Germans’ ERF proposal: the “bluebonds” proposed two years ago by Jacques Delpla and Jakob von Weizsäcker.Under this plan, only debt issued by national authorities below the60%-of-GDP threshold could receive eurozone backing and seniority. When a country issued debt above the threshold, theresulting “red bonds” would lose this status.
The point is that the enforcement mechanism would be trulyautomatic: market interest rates would provide the discipline that bureaucratsin Brusselscannot. If private investors judged that the new debt had been incurred intemporary circumstances genuinely beyond the government’s control (say, anatural disaster), they would not impose a large interest-rate penalty.Otherwise, the risk-premium mechanism would operate on the red bonds, much asit does on US states.
Of course, the eurozone cannot establish a blue-bond regimewithout first solving the problems of debt overhangand troubled banks. Otherwise, the plan itself would be destabilizing, becausealmost all countries would immediately be in the red. Many countries, withdebt/GDP ratios already far in excess of60%, face high borrowing costs and austerity-deepened recessions as well.Sharing their debt burden up to 60% of GDP would be substantial assistance, butit would not necessarily restore debt sustainability.
Thus, Eurobonds are not a complete solution. In the shortterm, Greecemay well default and leave the euro. Governments and banks in other countrieswill then have to be insulated from the conflagrationthrough a combination of bailout money and strong policy conditionality.
Creating this fire break between Greece and Europe’s corewould have been far easier twoyears ago, before debt/GDP ratios and sovereign spreadsclimbed so high, and before eurozone leaders’ credibility sank so low, or even oneyear ago. It might or might not work today.
But one thing seems clear. German taxpayers, whoselongstanding suspicion of profligateMediterranean euro members has been vindicated,will not be happy when asked to pay still more for the cause of Europeanintegration. At a minimum, they will need some credible reason to believe that20 years of false assurances have come to an end– that this is the last bailout.
The fiscal compact alone cannot provide that reason. Theblue-bonds scheme just might.