Solving the European Economic Crisis: Proposal of a "European Redemption Pact" - Foreign & Security Policy

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The proposal is part of the annual report of the German Council of Economic Experts, which advises the German government in economic problems. Leading economic experts support this proposal, which also has been endorsed by the Parliamentary Group of the Greens in the German Parliament.

Click here to read Euro Area in Crisis, Chapter 3 of the Annual Report 2011/2012 of the German Council of Economic Experts (48 pages, pdf, 768KB)

Excerpt

Prospects for the European Monetary Union

198. The current European Monetary Union crisis reflects a deep conceptual problem. While in the field of monetary policy very far-reaching integration has been achieved with the single currency and the common central bank system, in fiscal policy national jurisdiction continues to exist alongside common supervisory and crisis mechanisms, a situation that is as inefficient as it is prone to conflict. If the monetary union is to have a clearly more robust architecture in the future, then solutions must be found that will clearly strengthen fiscal discipline.

1. Reforms to date do not suffice

199. The Maastricht Treaty and the original Stability and Growth Pact based on it were intended to achieve fiscal discipline primarily leaving this within national jurisdiction, by a combination of binding rules, discretionary political decision-making processes and market discipline. With the 3 per cent limit for the deficit ratio and the 60 per cent limit for the debtto-GDP ratio, two rules were set for national fiscal policymakers. However, transgressors are not automatically sanctioned, and instead in the framework of the complex mechanisms of the Stability and Growth Pact subject to a discretionary decision-making process by the Council of Economic and Finance Ministers. The no bail-out clause and the conscious absence of an explicit crisis mechanism are intended at the same time to ensure that the financial markets exert sufficient disciplining pressure.

200. In retrospect, there are evidently clear weaknesses in that architecture. The rules set out in the Maastricht Treaty proved to be inadequate as they firstly ignored the possibility of excessive private-sector indebtedness. Thus, Spain and Ireland as late as 2007 were able to post public-sector budget surpluses and their debt-to-GDP ratio was 36 per cent and 25 per cent respectively, well below the ceiling of 60 per cent. Secondly, the discretionary sanction mechanism failed, as Greece never faced the Pact’s sanction process although it enduringly violated the two fiscal rules. Thirdly, market discipline has proved insufficient as for many years there was no anticipatory widening of risk premiums, although Greece’s fiscal misbehaviour was not to be ignored. At present, market discipline is coming up against its limits if the financial system is not sufficiently cushioned for the event of a country going bankrupt.

201. The reform of the Stability and Growth Pact now resolved in the framework of the “Six Pack” is intended to strengthen the preventative elements in the binding rules in particular by including an expenditure rule that is pegged to the growth rate of a country’s production potential (JG 2009, no. 126). The “corrective arm” implements a rules-based reduction in the debt-to-GDP ratio, according to which the volume of debt exceeding the 60 per cent limit has to be steadily reduced. The discretionary decision-making processes were, by contrast, only subjected to minor reform, as jurisdiction over the key steps of the process in the event of excessive debt is still held by the Council of Economic and Finance Ministers. The role of the Commission was only strengthened as regards imposing sanctions that can however first be resolved if the Council has determined that a country has acted incorrectly.

202. A contribution to creating stronger market discipline could have been achieved by using the European Stability Mechanism (ESM). Once this comes into force in July 2013 this for the first time explicitly foresees an inclusion of private creditors, although this is not tied to a firm rule but depends on a discretionary decision by the ESM. Inclusion of private investors shall henceforth always be required if the ESM ascertains as part of an sustainability analysis of whether a country can bear the weight of its debt, that it has not only a liquidity but also a solvency problem. To facilitate restructuring processes, as of July 2013 all newly issued euro area treasury bonds will come with debt rescheduling clauses (collective action clauses).

As with the Stability and Growth Pact, the ESM thus suffers from a credibility shortfall. In the ESM, the key issue whether a country is hit by a temporary liquidity problem or faces enduring solvency difficulties is decided politically, as the criteria are not defined according to which the decision should be taken. If potential sinners pass judgment on sinners, then the fear must be that unpleasant decisions will be postponed or never taken.

203. All in all, the reforms now resolved move in the right direction. But they fail to take the qualitative leap needed to guarantee stable future public-sector financing in the euro area.

2. Paths to more integration in fiscal policy

204. The increasing tension in the European Monetary Union have sparked a lively discussion on the further steps to be taken in the field of European integration. It has included proposals for a European finance minister, for a European fiscal union and for a commissioner for currency. What is decisive here is not only the institutional form to be taken but above all the issue of which fiscal competences should in future be located at the European level. Here, two different approaches are conceivable. Integration can be fostered firstly by increasing transfers of financial resources at the community level and secondly by transferring stringent control rights.

205. The first approach would involve transferring additional financial means to the community level in order to give it the option, like a federation, of discharging duties such as providing common unemployment insurance, or pursuing common education or social policy. In this way, as in the United States, there would be an automatic stabilizer at the community level which would ensure that shocks at the member-state level could be better coped with. In light of the very difficult fiscal situation in all the member states, something that will tend to worsen owing to the demographic, no political willingness can at present be discerned to transfer financial resources on a larger scale to the community level. Even if it is quite interesting to discuss what shape such a fiscal union could be given, such concepts are therefore hardly likely to assume a larger role in political debate in coming years.

206. Accordingly the second approach, on which most proposals tabled recently for a fiscal union are based, focuses primarily on how to establish stronger controls at the community level in order to bar aberrant fiscal behaviour more effectively than in the past and as early as possible.

207. As regards binding rules, a certain consensus has since emerged that a key precondition for fiscal stability is to anchor a debt brake in constitutional law. This can be additionally fortified by on-going community monitoring of the statistical data and computation methods.

208. As regards the unavoidable discretionary decision-making processes as part of the Stability and Growth Pact, as with monetary policy the focus must mainly be on strengthening the independence of the decision makers. The Council of Economic and Finance Ministers cannot be expected to coherently impose sanctions if, as at the moment, 14 of the 17 euro area member states are in the midst of excessive deficit proceedings. For this reason, the German Council of Economic Experts has for some time now advocated strengthening the role of the Commission in the excessive deficit proceedings such that it becomes the decision maker in all the relevant procedural steps and the Council of Economic and Finance Ministers can only reject its rulings by qualified majority (JG 2009 item 127).

Even greater independence could be created by furnishing the Commissioner for Currency with the same powers as the Commissioner for Competition, whose decisions as regards competition law do not require approval from the Council of Ministers. If this solution is transposed onto the Stability and Growth Pact, the Commissioner for Currency would be placed in charge of the proceedings and the Council of Economic and Finance Ministers would lose any decision-making powers in excessive deficit proceedings. The Commissioner for Currency should be granted the right to initiate proceedings before the European Court against a member state for breach of the treaty. Care would need to be taken here to ensure that a decision maker with such wide powers cannot be exposed to political influence in another way.

209. Alongside the institutional position of the committee responsible for fiscal policy discipline, what will count is its powers. A fundamental problem of the Stability and Growth Pact is that the worst sanction it can impose, namely that a non-interest-bearing deposit be made by way of a clear monetary fine, does not really help as it simply worsens the fiscal situation in the respective country (JG 2009 item 128). It would seem more appropriate that, if the Commission discerns a need for action, the participants undertake to charge a predefined tax on a prorated basis (“Stability solidarity surcharge”).

210. On this basis, one could then consider introducing the model of European finance minister as first mooted by Jean-Claude Trichet, then ECB president. In line with these ideas, this person would have the powers to set both the community’s competition policy and its economic and monetary policy. This would also include responsibility for the institutions that are in charge of supervising and regulating the financial system in the European Union. Moreover, the finance minister would represent the EU at all international institutions. While such a solution has advantages in terms of efficiency, from the political viewpoint the problem arises that (as with all forms of strengthening the Commission) ever more functions can transferred to the community without sufficient parliamentary control being guaranteed.

3. How to improve market discipline?

211. The architects of the Maastricht Treaty had expected that fiscal discipline would be asserted not only given the contractually stipulated rules and the agreed political decisionmaking processes but also, and crucially, by market discipline. The experience of the last 12 years shows that this hope was misleading to the extent that the financial market stimuli did not trigger a preventative response that ensured the countries counteracted indiscipline in time. Instead, the market signals as evidenced by interest mark-up as a rule first became noticeable when a severe and chronic erroneous trend had set in. In such a situation, the market response makes what is not exactly a simple therapy in the first place even harder.

212. In the current situation with in part unusually high deficit and debt-to-GDP ratios, the scope for improving market discipline is somewhat circumscribed. For this reason, the longterm structural framework for the euro area as proposed in the fourth chapter and described in detail as a solution is intended to cover the medium term, i.e., a phase with far lower debt-to-GDP ratios such as could be reached by consistent implementation of the redemption pact.

The preventative element derives from the three-stage approach, which is geared to the debt-to-GDP ratios. − Countries with a debt-to-GDP ratio below the 60 per cent ceiling and that have thus prequalified in this way as being stability-conscious, would in the event of liquidity problems have limited access to ESM loans.

− Given a debt-to-GDP ratio of between 60 and 90 per cent, ESM loans would depend on a country declaring itself willing to embark on a multi-year adjustment programme.

− Given a debt-to-GDP ratio of over 90 per cent in addition binding debt rescheduling with private-sector participation would be required.

Should, under these conditions, the debt-to-GDP ratio rise in a particular country, then the market players would see the gradual transformation of an initially almost safe bond into an instrument with the increasing risk of default. If such a regime is launched credibly, then this should be reflected in a divergence in risk premiums at an early date, which would enable a country to resort to fiscal adjustment measures before the “baby gets thrown out with the bathwater”.

213. While a credible insolvency regime for states can make an important contribution to market discipline, it is hard to reconcile it with the new supervisory regime for banks and insurance companies, which in fact reinforce the already privileged status of treasury bonds as absolutely safe assets. Thus, the rules in Basel III set liquidity buffers for banks (Liquidity Coverage Ratio and Net Stable Funding Ratio) that are preferentially to be held in the form of treasury bonds. In the new regulatory framework for insurance companies (Solvency II) that is supposed to come into force in 2013, European treasury bonds will likewise be classified as unconditionally safe assets for which no equity capital reserve need be maintained. Depending on the insolvency regime, the supply of safe assets may be inadequate.

214. The demand for absolutely safe assets could at least in part be covered by founding special purpose vehicles that by structuring a portfolio of treasury bonds create safe and less safe tranches (Brunnermeier et al., 2011). Here, a new European debt agency would need to be set up and would buy member states’ treasury bonds that are then covered in two different tranches.

− The default risks are primarily assumed by a risk tranche, which would primarily be acquired by non-risk-averse investors such as hedge funds.

− In this way, a safe tranche would be created with, in the ideal case, a negligible default risk (European Safe Bonds or ESBies).

Unlike in the case of the leveraging of the EFSF now being discussed, there is explicitly no joint and several liability for the SPV. At first sight the solution may appear attractive, but the fundamental problem arises (as with the collateralized debt obligations or CDOs that were so hard hit during the US subprime crisis) that the structuring only functions if the default risks seen in the past remain somewhat constant. If this is not the case, then even the seemingly safe tranche can be caught in the grip of massive default risks.

215. Alternatively, at the end of a successful consolidation strategy that leads to debt-to-GDP ratios of below or close to the 60 per cent ceiling, it would be worth considering whether that part of the national debt that is below the 60 per cent ceiling should be swapped for Eurobonds, for which joint and several liability is assumed. Each country would be individually responsible for the debt that exceeds that sum. A corresponding proposal has been put forward by Delpla and von Weizsäcker (2010), who distinguish between blue bonds (i.e., the Eurobonds issued bearing joint and several liability) and red bonds (i.e., the bonds issued for which a member state is individually responsible).

Compared to the ESBies, here a stock of European treasury bonds would be created that would be impervious to any default risk. This would place the euro area financial institutions back on a par with their US rivals, who can rely on US treasury bonds and thus an absolutely safe liquidity reserve that bears interest into the bargain. With this proposal, market discipline would be delivered by the interest that the member states have to pay on their portion of the debt that they have to issue at their own national responsibility. Since the default risk would then apply to comparably small sums and the risk of contagion would be excluded for the lion’s share of the euro area government debt, the threat of insolvency would be far more credible than in the current structure. This would be the decisive precondition for the desired preventative function of market discipline.

4. No easy path

216. The crisis in the euro area has been increasingly worsening for months now and makes it abundantly clear that politics can only regain the initiative in action if it is prepared to opt for solutions that enable the comprehensive coverage of member countries’ treasury bonds. An important step has been taken with the expansion and leveraging of the EFSF now resolved. Should it come up against its limits, not least given the now as good as opaque situation in Greece, Europe would face the alternative of the imponderable process of a selfreinforcing state and banking crisis or the unlimited purchase of treasury bonds by the European Central Bank. Before this scenario occurs, the politicians should assess whether it is not better to restore the stability of treasury bonds by assuming joint liability for them. Instead of Eurobonds unlimited in time and quantity, the model outlined in this chapter for a redemption fund presents a solution that combines short-term stabilization of the financial markets with a medium-term, credible consolidation of government finances covered by national guarantees.

217. The monetary union is worth making such efforts for. For all the problems, one should not overlook that in terms of debt levels and new indebtedness it is in a far better position than the United States, the United Kingdom or Japan. Nevertheless the EMU is assessed far more unfavourably by the financial markets. It would be fatal if a solution were not found that brings this unequal treatment to an end. The debt redemption fund outlined above can achieve this.

218. In the medium-term view, in the next few years every effort will need to be made to strengthen fiscal discipline by more intelligently tying it to rule and by more independent decision-making processes as part of the Stability and Growth Pact as well as by preventative market discipline. New institutions are not needed here, nor is an additional transfer of financial means at the European level.

Click here to read Euro Area in Crisis, Chapter 3 of the Annual Report 2011/2012 of the German Council of Economic Experts (48 pages, pdf, 768KB)

This text is a translation of the German version of the Annual Report 2011/2012 of the German Council of Economic Experts (status: November 18th, 2011)

The following experts are member of the German Council of Economic Experts

• Wolfgang Franz (May 1994 to February 1999, and since March 2003, Chairman since March 2009)
• Wolfgang Wiegard (since March 2001, Chairman April 2002 to February 2005)
• Peter Bofinger (since March 2004)
• Beatrice Weder di Mauro (since June 2004)
• Christoph M. Schmidt (since March 2009)