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Building a Bridge to Somewhere:
A Comprehensive Solution to Stabilize the Eurozone
Over the past year the Global Agenda Council on Fiscal Crises has focused almost exclusively on the ongoing crisis in the Eurozone. Although issues of fiscal sustainability exist in other regions of the world – the US, UK and Japan all have looming problems with public debt and deficits – the crisis in the Eurozone has escalated, threatening not only European prosperity but also growth prospects around the world. The escalation has continued despite a series of “comprehensive” policy packages announced by the European Union’s heads of state and government. Towards the end of 2011, an increasing number of market participants and observers were predicting an imminent break-up of the Eurozone. After an exceptionally generous long-term liquidity provision from the European Central Bank (ECB), funding markets calmed down and sovereign spreads narrowed in early 2012, but began to widen again in early April in some countries (notably Spain). A comprehensive solution to the euro crisis is still missing.
The Global Agenda Council on Fiscal Crises, in collaboration with experts from other Councils, developed a comprehensive strategy paper at the Summit on the Global Agenda in Abu Dhabi in October 2011 to contribute to resolving the Eurozone crisis. This strategy paper resulted from discussions among experts from several Councils, including the Global Agenda Councils on Europe, the International Monetary System, Systemic Financial Resilience, Banking & Capital Markets and Institutional Governance Systems. Experts from the private and public sectors, research institutions and think tanks united around one goal – saving the Eurozone from fiscal collapse. The paper was published on voxeu.org in October 2011(http://www.voxeu.org/index.php?q=node/7152). It was widely shared throughout the European policy community and was the basis of numerous policy discussions and developments through the latter half of 2011, including in the lead-up to and during the World Economic Forum Annual Meeting 2012 in Davos-Klosters.
The main goal of the Council has been to define a truly comprehensive solution for the Eurozone crisis and offer a vision – and indeed a timetable – for institutional reform that addresses the root causes of the crisis.
Bridges to Nowhere: Why the Policy Packages Were Insufficient
The October 2011 policy package announced by Eurozone heads of state and governments constituted an attempt to arrest the crisis by addressing problems of solvency in Greece in particular, extending the powers of the European Financial Stabilization Fund (EFSF) to combat contagion, and announcing a recapitalization programme for vulnerable banks. It nonetheless failed to restore confidence, for three reasons. It:
- did not go far enough in the main areas that it sought to address; in particular, it failed to achieve short-term stabilization through an immediate increase in firewalls
- underestimated the negative effects of the stress test and bank recapitalization exercise on the funding of vulnerable banks
- failed to offer a long-term perspective on the reform of Eurozone economic governance, which would have anchored medium-term market expectations and generated political support for exceptional short-term efforts, reassuring the public that these efforts would remain exceptional.
A truly comprehensive solution should start from the end point. It must offer a vision – and indeed a timetable – for institutional reform that addresses the root causes of the crisis and a credible short-term stabilization mechanism, and it must ensure that both sets of initiatives are consistent.
The bulk of existing reform proposals focus either on the short term or on the long-term problems and ignore the interactions between the two. The indiscriminate issuance of Eurobonds, for example, would have an immediately stabilizing short-term effect but would come at the expense of long-term destabilization. Similarly, large-scale purchases of sovereign debt on secondary markets through the ECB would be effective in the short term but would be destabilizing in the long term since the ECB cannot impose conditionality and could find itself trapped without an exit strategy. Proposals that focus solely on short-term stabilization are “bridges to nowhere” since they are not anchored in a sustainable future regime. On the other hand, proposals that focus on long-term schemes only, such as introducing a sovereign insolvency regime, are destabilizing in the short term as they put additional pressure on vulnerable countries and financial systems. In this report, the Council presents a plan for building a bridge to the long term, which is also stabilizing in the short term.
Any process that attempts to re-establish fiscal sustainability must include measures that promote economic recovery in the short term and higher potential growth in the medium term. Otherwise, weak growth can continue to complicate any adjustment process, both in terms of achieving the expected goals and gaining political support for the adjustment. While work on the specific elements that are required to promote higher growth in Europe is beyond the current focus of the Council on Fiscal Crises, it is clear that countries need to move from growth driven by large public or private sector deficits to growth based on more rapid increases in productivity.
The Other Side of the Bridge: Credible Eurozone Economic Governance
Eurozone governance reform must offer a plan for addressing the root causes of the crisis and confront the potential moral hazard arising from the crisis response. The latter is necessary both to convince market forces that fiscal problems will not simply resurface once stabilization efforts dissipate and to reassure a sceptical EU public that the large cross-border financial commitments that were necessary to bring the crisis under control will not be repeated, except within a framework which defines legitimate circumstances for future official assistance and limits its extent.
Breaking the link between sovereign and banking crises
In certain countries that have come under pressure in sovereign debt markets – particularly Ireland and Spain – the origin of the pressure has been financial rather than fiscal, as private sector liabilities turned into actual or potential sovereign liabilities. At the same time, spillovers from sovereign debt crises to the cross-border banking system have been the principal cause of the crisis’ spread. While recent reforms to unify and strengthen European regulation and supervisory institutions will go some way to creating financial systems that are less likely to become the source of problems and more capable of withstanding shocks, the reforms should be supplemented by transformations that specifically seek to de-link financial and sovereign risks:
- protecting the banking system from the sovereign requires a cap on exposures (single obligor limits, or the maximum amount a bank is authorized to lend a single borrower/individual) with respect to sovereign debtors, including and particularly with respect to the sovereign (including the home country) of a banking group;
- protecting the sovereign from the consequences of bank failures requires the creation of a European deposit insurance system, which ensures that the need to protect depositors and the payments system in the event of bank failures does not inevitably lead to the socialization of these losses at the national level. This must be matched by an appropriate concentration of supervisory power at the European level.
None of these institutional reforms requires a treaty change.
Ensuring fiscal responsibility
Reforms to strengthen fiscal and broader macroeconomic discipline have progressed both at the EU level, in the form of a new set of directives that strengthen and extend the Stability and Growth Pact, and at the national level, with 25 countries agreeing to a fiscal compact (“Treaty on Stability, Coordination and Governance”, signed on 2 March 2012), adopting national fiscal rules designed to prevent excessive debt accumulation.
These efforts go in the right direction but the present approach emphasizes formal commitments and penalties for deviating from commitments. Yet penalty-based mechanisms to enforce sovereign countries’ good fiscal behaviour are never fully credible, and it is not clear whether national-level reforms envisaged under the fiscal compact will constitute sufficiently strong and comprehensive commitment devices.
Thus EU leaders should consider medium-term reform initiatives in the areas described below. The first could complement the fiscal compact, while the second would eventually replace it.
- Strengthening market discipline. This strengthening could be achieved by introducing ex ante limits to national debt levels, beyond which the European Stabilization Mechanism (ESM) would only be allowed to provide crisis lending if private sector debt were restructured at the same time. As countries increase their non-guaranteed debts, risk premia on these debts would rise much more quickly than is presently the case.
- Delegating fiscal authority at the level of the Eurozone. Assigning some degree of fiscal authority to a central institution is more effective at constraining national fiscal policies than imposing sanctions on countries after fiscal actions have been taken. Several models are possible, ranging from giving power to the European Commission (or a new EU agency) to review and ask national authorities to amend budgets that result in excessive deficits before they become law, to establishing an ECB-style institution with the power to set the fiscal policy stance in Eurozone countries without taking a position on the composition of taxes or spending, all the way to putting in place full-fledged fiscal federalism, in which some spending and taxation decisions are taken at the EU level. These ideas would imply a significant shift of power away from national authorities and would require a treaty change.
Getting there: Problems of transition
As mentioned, the institutional reforms described in the previous section could have counterproductive effects in the short term. For example, establishing single obligor limits with respect to home country sovereigns could force some banks heavily exposed to sovereign debt risk to reduce government bond holdings, adding to market pressure; or add to pressures to raise additional capital.
In principle, the transition to the new regime could be dealt with through a flow approach, which would require defining a transition period – with well-defined intermediate steps – backed by incentives. Banks could be given a period to gradually adjust to the new limits, together with regulatory incentives for reaching the new ceilings early.
However, the flow approach remains vulnerable to shocks along the way. This problem could be avoided by achieving transition in one stroke through a stock operation. For example, banks whose single-obligor exposures to sovereigns exceed the new limits could be recapitalized through the EFSF. In effect, this amounts to swapping home country sovereign debt with the debt of other sovereigns. Similarly, the problems of excessive public debt could be solved through a one-time stock operation along the lines of “The European Redemption Pact” proposed by the German Council of Economic Experts.1
Designing a Stable Bridge: A European Redemption Pact
A European Redemption Pact (ERP) would have the following four design features:
- The pact would need to lead to an effective sovereign insolvency regime. In a long-term regime, access to the European Stabilization Mechanism for countries with debt in excess of 60% of GDP would only be admissible if private sector debt were restructured. In the future regime, sovereign risk pricing would take this threshold into account, which would create incentive for fiscal discipline. Market discipline would hence be forward-looking and preventive. Getting to the new regime will require that the national debt of every country in the Eurozone be brought down below 60% of GDP.
- The pact would need the credible long-term commitment of all participating countries to reduce their debts. To ensure the credibility of participating countries’ obligation to consolidation, they would need to incorporate national “debt brakes” in their constitutions and agree to a strengthening of surveillance at the EU level. To guarantee the repayment of their debts, countries would be under obligation to impose a mark-up on a national tax and to pledge reserves as collateral.
- The debt reduction paths must be designed to be sustainable. Fiscal consolidation would be stretched over time to avoid a collapse in growth and make the required primary surplus sustainable. To date, the maximum primary surpluses attained over a decade in industrialized countries were around 4% of GDP. This implies that the ERP would have to provide funding at lower interest rates and allow sufficient time for debts to be reduced.
- The pact would need to contain strong safeguards to ensure that this is a one-time operation, limited in time and scope. The German Constitutional Court has placed limits on Germany’s ability to take on liability for the Eurozone. Therefore, joint and several liability can at most be a temporary feature of any realistic solution.
The core instrument of the ERP is the European Redemption Fund (ERF), which would issue debt with the joint and several liability of all participating countries. Countries not currently under IMF/EU programmes that have debt levels above 60% would transfer their debts in excess of the reference figure to the fund.2 This would occur gradually over a period of five years, with transfers taking place as debt falls due. Nations would be individually responsible for the redemption of transferred debts within 20 to 25 years. The joint and several liability for the ERF would give highly indebted participating countries an interest advantage on the debt held in the fund, which would be used to ease the burden of the debt redemption. On the other hand, countries like Germany would have to face somewhat higher interest rates on their portion of debt in the ERF.
The debt profile of the ERF is shown in Figure 1. The largest participating countries would be Italy with about €960 billion, followed by Germany with €580 billion and France with about €500 billion. If it had been introduced in 2011, the ERF would peak at €2.3 trillion in 2015 and then gradually disappear by 2035.3
Adopting a European Redemption Pact would clearly require both vision and bold action from European leaders. But it would lay the foundation for the short- as well as the long-term stability of the Eurozone.
Although the situation in the Eurozone currently seems to be stable, this balance is fragile. Many steps must be taken to ensure the long-term health of public finances in Europe. In the coming months, the Council will continue the in-depth analysis of the proposed solutions to reach fiscal sustainability in the Eurozone.
Source: German Council of Economic Experts (2012): “The European Redemption Pact: An Illustrative Guide”
This report reflects contributions from the Global Agenda Council on Fiscal Crises. In addition it reflects discussions with Members of the Global Agenda Councils on Systemic Financial Resilience, on Europe, on Institutional Governance Systems, on the International Monetary System, and on Banking & Capital Markets during the 10-12 October 2011 Summit on the Global Agenda in Abu Dhabi. The opinions expressed here are those of the individual Members of the Council, and not of the World Economic Forum or any institutions to which they are affiliated.