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THEGOVERNANCEOFAFRAGILEEUROZONE
PaulDeGrauwe
UniversityofLeuvenandCEPS
Abstract:
Whenenteringamonetaryunion,member-countrieschangethenatureoftheir
sovereign debt ina fundamentalway, i.e. they cease tohave control over thecurrencyinwhich theirdebtisissued.Asaresult, financialmarkets can force
these countries’ sovereigns into default. In this sensemember countries of amonetary union are downgraded to the status of emerging economies. This
makes the monetary union fragile and vulnerable to changing market
sentiments.Italsomakesitpossiblethatself-fulfillingmultipleequilibriaarise.IanalyzetheimplicationsofthisfragilityforthegovernanceoftheEurozone.I
conclude that the new governance structure (ESM) does not sufficientlyrecognizethisfragility.Someofthefeaturesofthenewfinancialassistanceare
likely to increase this fragility. In addition, it is also likely to rip member-
countriesoftheirabilitytousetheautomaticstabilizersduringarecession.Thisis surely a step backward in the long history of social progress in Europe. I
suggestadifferentapproachtodealwiththeseproblems.
April2011
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1.Introduction
InordertodesigntheappropriategovernanceinstitutionsfortheEurozoneitis
important to make the right diagnosis of the nature of the debt crisis in the
Eurozone.Failuretodoso,canleadtodesigningagovernancestructurethatis
inappropriate for dealingwith the problemsof the Eurozone. In this paper I
arguethatthegovernancestructurethathasemergedafteraseriesofdecisions
ofsuccessiveEuropeanCouncilmeetings,althoughanimportantstepforwards,
failstoaddresssomefundamentalproblemsinamonetaryunion.
2.AParadox
IstartwiththeparadoxthatisimmediatelyvisiblefromacomparisonofFigures
1and2.Figure1showsthedebttoGDPratiosoftheUKandSpain.Itcanbe
seenthatsincethestartofthefinancialcrisisthegovernmentdebtratioofthe
UKhasincreasedmorethanthatofSpain.Asaresult,in2011asapercentof
GDPtheUKgovernmentdebtstood17%higherthantheSpanishGovernment
debt(89%versus72%).YetfromFigure2 itappearsthatthefinancialmarkets
havesingledoutSpainandnottheUKasthecountrythatcouldgetentangledin
agovernmentdebtcrisis.Thiscanbeseen fromthe factthatsincethestartof
2010theyieldonSpanishgovernmentbondshasincreasedstronglyrelativeto
theUK,suggestingthatthemarketspriceinasignificantlyhigherdefaultriskon
SpanishthanonUKgovernmentbonds.Inearly2011thisdifferenceamounted
to200basispoints.Whyisitthatfinancialmarketsattachamuchhigherdefault
risk on Spanish than on UK government bonds government bonds, while it
appearsthattheUKfacesalessfavourablesovereigndebtanddeficitdynamics?
Onepossibleansweristhatitmayhavesomethingtodowiththebankingsector.
Thisisunconvincing,though.ThestateoftheUKbankingsectoriscertainlynot
much better than the one of Spain. I will argue that this difference in the
evaluationofthesovereigndefaultrisksisrelatedtothefactthatSpainbelongs
toamonetaryunion,whiletheUKisnotpartofamonetaryunion,andtherefore
hascontroloverthecurrencyinwhichitissuesitsdebt.
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Figure1
Source:EuropeanCommission,Ameco
Figure2:
Source:Datastream
0
10
20
30
40
50
60
70
80
90
100
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Grossgovernmentdebt(%ofGDP)
UK
Spain
2
2.5
3
3.5
4
4.5
5
5.5
6
p e r c e n t
10-yeargovernmentbondratesSpainandUK
Spain
UK
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3.Onthenatureofsovereigndebtinamonetaryunion
Inanutshell the difference inthe nature ofsovereign debtbetweenmembers
andnon-membersofamonetaryunionboilsdowntothefollowing.Membersof
amonetaryunionissuedebt ina currencyoverwhich theyhavenocontrol.It
follows that financial markets acquire the power to force default on these
countries.Thisisnotthecaseincountriesthatarenotpartofamonetaryunion,
and have kept control over the currency in which they issue debt. These
countriescannoteasilybeforcedintodefaultbyfinancialmarkets.
Letmeexpand on this byconsidering indetail what happenswhen investors
starthavingdoubtsaboutthesolvencyofthesetwotypesofcountries.Iwilluse
theUKasaprototypemonetary“stand-alone”countryandSpainasaprototype
member-country of a monetary union (see Kopf(2011) for an insightful
analysis).
TheUKscenario
Let’s first trace what would happen if investors were to fear that the UK
governmentmightbedefaultingonitsdebt.Inthatcase,theywouldselltheirUK
governmentbonds,drivinguptheinterestrate.Aftersellingthesebonds,theseinvestorswouldhavepoundsthatmostprobablytheywouldwanttogetridof
bysellingthemintheforeignexchangemarket.Thepriceofthepoundwould
dropuntilsomebodyelsewouldbewillingtobuythesepounds.Theeffectofthis
mechanismisthatthepoundswouldremainbottledupintheUKmoneymarket
tobeinvestedinUKassets.Putdifferently,theUKmoneystockwouldremain
unchanged. Part of that stockof money wouldprobablybe re-invested inUK
government securities. But even if that were not the case so that the UKgovernment cannot find the funds to roll over its debt at reasonable interest
rates, itwouldcertainly force the BankofEngland tobuy upthe government
securities.Thus the UKgovernment isensured that the liquidity isaround to
funditsdebt.Thismeansthatinvestorscannotprecipitatealiquiditycrisisinthe
UKthatcouldforcetheUKgovernmentintodefault.Thereisasuperiorforceof
lastresort,theBankofEngland.
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TheSpanishscenario
Thingsaredramaticallydifferentforamemberofamonetaryunion,likeSpain.
Suppose that investors fear a default by the Spanishgovernment.Asa result,
theysellSpanishgovernmentbonds,raisingtheinterestrate.Sofar,wehavethe
sameeffectsasinthecaseoftheUK.Therestisverydifferent.Theinvestorswho
haveacquiredeurosarelikelytodecidetoinvesttheseeuroselsewhere,sayin
German government bonds. As a result, the euros leave the Spanish banking
system.Thereisnoforeignexchangemarket,noraflexibleexchangeratetostop
this.Thus the total amount of liquidity (money supply) in Spain shrinks. The
Spanishgovernmentexperiencesaliquiditycrisis,i.e.itcannotobtainfundsto
roll over its debt at reasonable interest rates. In addition, the Spanish
governmentcannot force theBankofSpain tobuygovernmentdebt.TheECB
canprovidealltheliquidityoftheworld,buttheSpanishgovernmentdoesnot
control that institution. The liquidity crisis, if strong enough, can force the
Spanishgovernmentintodefault.Financialmarketsknowthisandwilltestthe
Spanish government when budget deficits deteriorate. Thus, in a monetary
union,financialmarketsacquiretremendouspowerandcanforceanymember
countryonitsknees.
ThesituationofSpainisreminiscentofthesituationofemergingeconomiesthat
havetoborrowinaforeigncurrency.Theseemergingeconomiesfacethesame
problem,i.e.theycansuddenlybeconfrontedwitha“suddenstop”whencapital
inflowssuddenlystopleadingtoaliquiditycrisis(seeCalvo,etal.(2006)).
There is an additional difference in the debt dynamics imposed by financial
marketsonmemberandnon-membercountriesofamonetaryunion.IntheUK
scenariowehaveseenthatasinvestorsselltheproceedsoftheirbondsalesin
theforeignexchangemarket,thenationalcurrencydepreciates.Thismeansthat
theUKeconomyisgivenaboostandthatUKinflationincreases.Thismechanism
isabsentintheSpanishscenario.TheproceedsofthebondsalesinSpainleave
theSpanishmoneymarketwithoutchanginganyrelativeprice.
InFigure3and4IshowhowthisdifferencehasprobablyaffectedGDPgrowth
andinflationintheUKandSpainsincethestartofthesovereigndebtcrisisin
theEurozone.Itcanbeseenthatsince2010inflationisalmosttwiceashighin
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theUKthaninSpain(2.9%versus1.6%).InadditiontheyearlygrowthofGDPin
theUKaverages2%since2010againstonly0.2%inSpain.Thisiscertainlynot
unrelated to the fact that since the startof the financial crisis the pound has
depreciatedbyapproximately25%againsttheeuro.
Source:EuropeanCommission,Ameco
Thisdifference ininflationandgrowth canhaveaprofoundeffectonhowthe
solvency of the governments of these two countries is perceived. It will berememberedthatanecessaryconditionforsolvencyisthattheprimarybudget
-0.5%
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
2009 2010 2011
Figure3:InlationinUKandSpain
UK
Spain
-6.0%
-5.0%
-4.0%
-3.0%
-2.0%
-1.0%
0.0%
1.0%
2.0%
3.0%
2009 2010 2011
Figure4:GrowthGDPinUKandSpain
UK
Spain
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surplusshouldbeatleastashighasthedifferencebetweenthenominalinterest
rateandthenominalgrowthratetimesthedebtratio1.Iapplythisconditionand
showthenumbersintable1.IassumethatSpainandtheUKwillcontinuetoface
the long-term interest rates that the markets have imposed since the last 6months (on average 3.5% in the UK and 5% in Spain). Applying the average
nominalgrowthratessince2010(4.9%intheUKand1.8%inSpain)wecansee
thatintheUKthereisnoneedtogenerateaprimarysurplusinordertostabilize
thedebttoGDPratio(andassumingthesegrowthrateswillbemaintained).In
Spaintheprimarysurplusmustbemorethan2%toachieve thisresult.Thus,
SpainisforcedtoapplymuchmoreausteritythantheUKtosatisfythesolvency
condition.Putdifferently,SpaincouldnotgetawaywiththeUKbudgetarypolicy
withoutbeingbrandedas insolvent despite the fact that ithas a substantially
lowerdebtlevel.
Table1:Primarysurplusneededtostabilizedebtat2011level
(percentGDP)
UK
-1,21
Spain
2,30
Thepreviousanalysisillustratesan importantpotentiallydestructivedynamics
in a monetary union. Members of a monetary union are very susceptible to
liquiditymovements.Wheninvestorsfearsomepaymentdifficulty(e.g.triggered
by a recession that leads to an increase in the government budget deficit),
liquidityiswithdrawnfromthenationalmarket(a“suddenstop”).Thiscanset
inmotion adevilish interactionbetween liquidity and solvencycrises.Once a
membercountrygetsentangledinaliquiditycrisis,interestratesarepushedup.
Thus the liquidity crisis turns intoasolvencycrisis. Investors can thenclaim
thatitwasrighttopulloutthemoneyfromaparticularnationalmarket. Itisa
self-fulfillingprophecy:thecountryhasbecomeinsolventbecauseinvestorsfear
insolvency.
1TheformulaisS≥ (r–g)D,whereS istheprimarybudgetsurplus,r isthenominalinterestrateonthegovernmentdebt, gisthenominalgrowthrateof
theeconomyandDisthegovernmentdebttoGDPratio.
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NotethatIamnotarguingthatallsolvencyproblemsintheEurozoneareofthis
nature. In the case of Greece, for example, one can argue that the Greek
governmentwas insolvent before investorsmade theirmovesand triggered a
liquidity crisis in May 2010.What I am arguing is that in amonetary unioncountriesbecomevulnerabletoself-fulfillingmovementsofdistrustthatsetin
motionadevilishinteractionbetweenliquidityandsolvencycrises.
Thisinteractionbetweenliquidityandsolvencyisavoidedinthe“stand-alone”
country,wheretheliquidityisbottledupinthenationalmoneymarkets(thereis
no “sudden stop”), andwhere attempts to export it to othermarkets sets in
motion an equilibrating mechanism, produced by the depreciation of the
currency.Thus,paradoxically,distrustleadstoandequilibratingmechanismin
theUK,andtoapotentiallydisequilibratingmechanisminSpain.
From the preceding analysis, it follows that financial markets acquire great
powerinamonetaryunion.Willthispowerbebeneficialfortheunion?
Believersinmarketefficiencyhavebeentellingusthatthispowerissalutary,as
itwillactasadiscipliningforceonbadgovernments.Ihavelostmuchofmy
faithintheideathatfinancialmarketsareadiscipliningforce.Thefinancialcrisis
hasmade abundantlyclear that financialmarketsareoftendrivenbyextreme
sentiments of either euphoriaorpanic. During periods of euphoria investors,
cheeredbyratingagencies,collectivelyfailtoseetherisksandtakeontoomuch
of it. After the crash, fear dominates, leading investors, prodded by rating
agencies,todetectriskseverywheretriggeringpanicsalesmuchofthetime.
4.Multipleequilibria
The inherent volatility of financial markets leads to another fundamental
problem.Itcangiverisetomultipleequilibria,someofthemgoodones;others
bad ones.This arises from the self-fulfilling nature ofmarket expectations. In
appendix, I present a simple theoretical model showing more formally how
multipleequilibriacanarise.
SupposemarketstrustgovernmentA. Investorsthenwillshowawillingnessto
buy government bondsata low interest rate.A low interest rate embodies a
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belief that the default risk is low.But the same low interestrate alsohas the
effect of producing a low risk of default. This is made very clear from our
solvencycalculationsintable1.MarketstrustthattheUKgovernmentwillnot
default (despite its having a high debt ratio).Asa result, the UK governmentenjoysalowinterestrate.Oursolvencycalculationthenshowsthatindeedthe
UKgovernmentisverysolvent.FinancialmarketsgentlyguidetheUKtowardsa
goodequilibrium.
Suppose market distrusts government B. As a result, investors sell the
governmentbonds.Theensuingincreaseintheinterestrateembedsthebelief
thatthereisadefaultrisk.Atthesametimethishighinterestrateactuallymakes
default more likely. Thus in our calculation from table 1 it appears that the
market’s distrust in the Spanish government ina self-fulfilling way hasmade
defaultmorelikely.FinancialmarketspushSpaintowardsabadequilibrium.
The occurrence of bad equilibria ismore likely withmembers of amonetary
union,whichhavenocontrolofthecurrencyinwhichtheyissuetheirdebt,than
withstand-alonecountriesthathaveissueddebtinacurrencyoverwhichthey
havefullcontrol.Asmentionedearlier,themembersofamonetaryunionface
the same problem as emerging countries that because of underdeveloped
domesticfinancialmarkets,areforcedtoissuetheirdebtinaforeigncurrency
(Calvo,etal.(2006),seeEichengreen,atal.(2005)).InthewordsofEichengreen
etal.(2005)thisworksasthe“originalsin”thatleadsthesecountriesintoabad
equilibriumfullofpainandmisery.
Thereisanadditionalcomplicationinamonetaryunion.Thisisthatinsucha
union financial markets become highly integrated. This also implies that
government bonds of member countries are held throughout the union.
AccordingtotheBISdata,formanyEurozonemembercountriesmorethanhalf
ofgovernmentbondsare heldoutside the countryof issue. Thuswhen abad
equilibriumisforcedonsomemembercountries,financialmarketsandbanking
sectors in other countries enjoying a good equilibrium are also affected (see
Azerki,etal.(2011)whofindstrongspillovereffectsintheEurozone).
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Theseexternalitiesareastrongforceofinstabilitythatcanonlybeovercomeby
government action. I will return to this issuewhen I analyze the governance
questionoftheEurozone.
Towrapupthepreviousdiscussion:membersofmonetaryunionaresensitiveto
movementsofdistrustthathaveself-fulfillingpropertiesandthatcanleadthem
tobepushedintoabadequilibrium.Thelatterarisesbecausedistrustcansetin
motionadevilishinteractionbetweenliquidityandsolvencycrises.
Onceinabadequilibrium,membersofmonetaryunionfinditverydifficultto
useautomaticbudgetstabilizers:Arecessionleadstohighergovernmentbudget
deficits;thisinturnleadstodistrustofmarketsinthecapacityofgovernments
toservicetheirfuturedebt,triggeringaliquidityandsolvencycrisis;thelatter
thenforcesthemtoinstituteausterityprogramsinthemidstofarecession.In
the stand-alone country (UK) this does not happen because the distrust
generatedbyhigherbudgetdeficittriggersastabilizingmechanism.
Thus,membercountriesofamonetaryunionaredowngradedto the statusof
emergingeconomies,which find itdifficult ifnot impossible touse budgetary
policiestostabilizethebusinesscycle.Thisfeaturehasbeenshowntoproduce
pronounced booms and busts in emerging economies (see Eichengreen, et al.
(2005)).
Thisfeatureofamonetaryunionmakesitpotentiallyverycostly.Theautomatic
stabilizersinthegovernmentbudgetconstituteanimportantsocialachievement
inthedevelopedworldastheysoftenthepainformanypeoplecreatedbythe
boomsandbustsincapitalistsocieties.Ifamonetaryunionhastheimplicationof
destroying these automatic stabilizers, it is unclear whether the social andpolitical basisforsuchaunioncanbemaintained. Itis therefore important to
designagovernancestructurethatmaintainstheseautomaticstabilizers.
5.Competitivenessandsovereigndebt
The previous analysis allows us to connect sovereign debt dynamics and
competitivenessproblems.
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It is now widely recognized that one of the fundamental imbalances in the
Eurozoneistheincreaseddivergenceincompetitivepositionsofthemembersof
the Eurozone since 2000. The phenomenon is shown in figure 5, which I am
confidentmostreadersmusthaveseensomewhere.Onemaycriticizethisfigurebecauseofthechoiceof2000asthebaseyear.Indeed,thischoiceassumesthat
in 2000 there were no imbalances in competitive positions, so that any
movementawayfromthe2000-levelisadeparturefromequilibriumandthus
problematic.Thisissurelynotthecase(seeAlcidiandGros(2010).Anumberof
countries may have been far from equilibrium in 2000 so that movements
observedsincethatdatecouldconceivablybemovementstowardsequilibrium.
InordertotakethiscriticismintoaccountIpresentrelativeunitlabourcostsof
themembercountriesusingthelong-termaverageovertheperiod1970-2010as
thebase.Theresultsareshowninfigure6.Thedivergenceislessspectacular,
but stillvery significant. Figure 7 confirms this: the standarddeviation of the
yearlyindicesincreasedsignificantlysince1999.
Source:EuropeanCommission,Ameco
85
90
95
100
105
110
115
120
125
20002001200220032004200520062007200820092010
Figure5:RelativeunitlaborcostsEurozone(2000=100)
Italy
Greece
Portugal
Spain
Ireland
Netherlands
Finland
Belgium
France
Austria
Germany
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Source:EuropeanCommission,Ameco
Note:ComputedusingdataofFigure6.
The countries that lost competitiveness from1999 to2008 (Greece,Portugal,
Spain, Ireland) have to start improving it. Given the impossibility of using a
devaluation of the currency, an internal devaluationmust be engineered, i.e.
wagesand pricesmustbebrought downrelative tothoseof the competitors.
This can only be achieved by deflationary macroeconomic policies (mainly
budgetary policies). Inevitably, this will first lead to a recession and thus
(through the operation of the automatic stabilizers) to increases in budgetdeficits.
80
85
90
95
100
105
110
115
120
125
199920002001200220032004200520062007200820092010
Greece
Portugal
Spain
Italy
Belgium
Netherlands
Austria
Ireland
France
Finland
Germany
Figure6:RelativeunitlaborcostsinEurozone(average1970-2010=100)
4
5
6
7
8
9
10
11
199920002001200220032004200520062007200820092010
p e r c e n t
Figure7:Standarddeviationrelativeunitlabour
costsinEurozone(inpercent)
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Most of the analyses in textbooks nowstop by noting that this is a slow and
painfulprocess.Theanalysisoftheprevioussections,however,allowsustogoa
littlefurtherandtolinkitwiththedebtdynamicsdescribedearlier.Ascountries
experience increasing budget deficits while they attempt to improve theircompetitiveness,financialmarketsarelikelytogetnervous.Distrustmayinstall
itself. If strong enough, the latter may lead to a liquidity crisis as described
before.Thistheninevitablytriggersasolvencycrisis.
Thustheperiodduringwhichcountriestrytoimprovetheircompetitivenessis
likely to be painful and turbulent: Painful, because of the recession and the
ensuing increase in unemployment; turbulent, because during the adjustment
period,thecountycanbehitbyasovereigndebtcrisis.Ifthelatteroccurs,the
deflationaryspiralisboundtobeintensified.Forinthatcasethedomesticlong
terminterestrateincreasesdramatically,forcingtheauthoritiestoapplyeven
morebudgetaryausterity,whichinturnleadstoanevenmoreintenserecession.
Thecountrycanfinditselfstuckinabadequilibrium,characterizedbyausterity
programsthat fail toreducebudget deficitsbecausethey lead toadownward
economic spiralandpunishing interestrate levels.Thepath towardsrecovery
formembersofamonetaryunionislikelytobecrisis-prone.
Thecontrastwithstand-alonecountriesthathavethecapacitytoissuedebtin
their own currency is stark. When these countries have lost competitiveness,
theywilltypicallytrytorestoreitbyallowingthecurrencytodropintheforeign
exchangemarket.Thismakesitpossiblenotonlytoavoiddeflation,butalsoto
avoid a sovereign debt crisis. As we have seen earlier, these countries’
governmentscannotbeforcedintodefaultbytriggeringaliquiditycrisis.Whatis
morethewholeadjustmentprocessinvolvingcurrencydepreciationislikelyto
boostoutputandinflation,therebyimprovingthesolvencyofthesovereign.
6.Governanceissues
ThedebtcrisishasforcedEuropeanleaderstosetupnewinstitutionscapableof
dealingwiththecrisis.Themostspectacularresponsehasbeenthecreationof
the European Financial Stability Mechanism (EFSF) in May 2010 to be
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transformed into a permanent European rescue fund, the European Stability
Mechanism(ESM)from2013on.Surelythesewereimportantstepsthatwere
necessarytomaintainthestabilityoftheEurozone.
Yet the opposition against these decisions continues to be high especially in
NorthernEuropean countries. Opposition is also strong among economists of
these countries (see the statement of 189 German economistswarning about
futurecalamitiesiftheEFSFweretobemadepermanent,Plenumderökonomen,
(2011)).
This opposition is based on an incomplete diagnosis of the sovereign debt
problemintheEurozone.For the189Germaneconomists the storyissimple:
some countries (Greece, Ireland, Portugal, Spain) have misbehaved. Their
governmentshave irresponsiblyspenttoomuch,producingunsustainabledebt
levels.Theyarenowinsolventthroughtheirownmistakes.Thereisnopointin
providingfinancialassistancebecausethisdoesnotmakethemsolvent.Itonly
gives them incentives to persevere in irresponsible behavior (moral hazard).
Thus in this diagnostics, the problem is a debt crisis of a limited number of
individual countries, that can only be solved by an orderly debt default
mechanism.ThelatteriscrucialtoavoidthatGermantaxpayershavetofootthe
bill.
WhilethisanalysismaybecorrectinthecaseofGreece,itfailstounderstandthe
natureofthedebtcrisisinotherEurozonecountries,becauseittreatsthedebt
problem asa series of individual problems; not as the outcomeofa systemic
problemintheEurozone, that Ihavedescribedearlier.Thissystemicproblem
hasseveralingredients.First,byacquiringthestatusofemergingcountries,the
sovereigns of the member states in a monetary union are fragilized, as
unfavorablemarketsentimentscanforcethemintodefault.Thishastheeffectof
pushingthecountryinto abadequilibrium, characterizedbypunishinglyhigh
interest rates, chronically high budget deficits and low growth. Second, the
degree of financial integrationinthemonetaryunionissuch thatwhensome
sovereignsarepushedinabadequilibrium,thisaffectstheothercountries.In
particularitfragilizesthebankingsystemsintheseothercountries.Thus,strong
externalitiesarecreated,makingitimpossibletoisolateafinancialproblemof
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one country from the rest of the Eurozone. Put differently,when one country
experiencesadebtproblem thisbecomesaproblemofthe Eurozone. It ismy
contention that the governancestructure that isnowbeingdesigneddoesnot
sufficientlytakeintoaccountthesystemicnatureofthedebtproblem.
7.Whatkindofgovernance?
Likewithallexternalities,governmentactionmustconsistininternalizingthese.
ThisisalsothecasewiththeexternalitiescreatedintheEurozone.Ideally,this
internalization can be achieved by a budgetary union. By consolidating
(centralizing)nationalgovernmentbudgetsintoonecentralbudgetamechanism
of automatic transfers can be organized. Such a mechanism works as an
insurancemechanism transferring resources to the country hit by a negative
economic shock. In addition, such a consolidation creates a common fiscal
authoritythatcanissuedebtinacurrencyunderthecontrolofthatauthority.In
so doing, it protects the member states from being forced into default by
financialmarkets.
Thissolution of thesystemicproblemof theEurozone requires a far-reachingdegreeofpolitical union.Economistshave stressedthat such apolitical union
willbenecessarytosustainthemonetaryunioninthelongrun(seeEuropean
Commission(1977)andDeGrauwe(1992)).It isclear,however,thatthereisno
willingnessinEuropetodaytosignificantlyincreasethedegreeofpoliticalunion.
Thisunwillingnesstogointhedirectionofmorepoliticalunionwillcontinueto
maketheEurozoneafragileconstruction.
Thisdoesnotmean,however,thatoneshoulddespair.Wecanmoveforwardby
takingsmallsteps.Suchastrategyofsmallstepsnotonlyallowsustosolvethe
most immediate problems. It also signals the seriousness of European
policymakersinmovingforwardinthedirectionofmorepoliticalunion.
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8.AStrategyofsmallsteps
Idistinguishbetweenthreestepsthateachrequiresinstitutionalchanges.Some
ofthesestepshavealreadybeentaken.Unfortunately,asIwillarguetheyhave
beenloadedwithfeaturesthatthreatentounderminetheireffectiveness
8.1:AEuropeanMonetaryFund
AnimportantstepwastakeninMay2010whentheEuropeanFinancialStability
Facility(EFSF)wasinstituted.Thelatterwillbetransformedintoapermanent
fund, theEuropean StabilizationMechanism (ESM),whichwill obtain funding
from the participating countries and will provide loans to countries indifficulties.Thus,aEuropeanMonetary Fundwillbe inexistence, aswas first
proposedbyGrosandMaier(2010).
It is essential that the ESM take a more intelligent approach to lending to
distressedcountriesthantheEFSFhasbeendoinguptonow.Theinterestrate
appliedbytheEFSFintheIrishrescueporgramamountstoalmost6%.Thishigh
interestratehasaveryunfortunateeffect.First,bychargingthishighinterest
rate it makes it more difficult for the Irish government to reduce its budget
deficitandtoslowdowndebtaccumulation.Second,bychargingariskpremium
of about 3% above the risk free rate that the German, Dutch and Austrian
governmentsenjoy,theEFSFsignalstothemarketthatthereisasignificantrisk
ofdefault, and thus that the Irish governmentmay not succeed inputting its
budgetary house in order. No wonder that financial markets maintain their
distrust and also charge a high-risk premium.All this, in a self-fulfilling way,
increasestheriskofdefault.
Theintelligentapproachinfinancialassistanceconsistsinusingapolicyofthe
carrot and the stick. The stick is the conditionality, i.e. an austerity package
spelledoutoverasufficientlylongperiodoftime,sothateconomicgrowthgetsa
chance.Withouteconomicgrowthdebtburdenscannotdecline.Thecarrotisa
concessionalinterestratethatmakesiteasierforthecountryconcernedtostop
debtaccumulation.A lowinterestratealsoexpressestrustinthesuccessofthe
package;trustthat financialmarketsneed inordertoinduce themtobuy the
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governmentdebtata reasonable interestrate. Unfortunately, the futureESM
willapplyaninterestratethatis200basispointsaboveitsfundingrate.Thereis
nogoodreasonfortheESMtodothis.Byapplyingsuchariskpremium,theESM
willsignaltothemarketthatisdoesnottrulybelieveinthesuccessofitsownlendingprogram.
ThereareotherfeaturesoftheESMthatwillundermineitscapacitytostabilize
thesovereignbondmarketsintheEurozone.From2013on,allmembersofthe
Eurozone will be obliged to introduce “collective actions clauses” when they
issuenewgovernmentbonds.Thepracticalimplicationofthisisthefollowing.
Wheninthefuture,agovernmentoftheEurozoneturns totheESMtoobtain
funding,privatebondholdersmaybeaskedtoshareintherestructuringofthe
debt.Put differently, theymay beaskedto take someof the losses. Thismay
seemtobeagooddecision.Bondholderswillbeforcedtothinktwicewhenthey
invest in government bonds, as these bonds may not be as secure as they
thought.
Theintentionmaybegood;theeffectwillbenegative(seeDeGrauwe(2010)).In
factwehavealreadyseentheeffects.WhentheGermangovernmentmadethe
first proposal to introduce collective action clauses at the European Council
meetingofOctober2010,theimmediateeffectwastointensifythecrisisinthe
Eurozonesovereignbondmarkets.IshowevidenceforthisinFigure8,which
presentsthegovernmentbondspreadsofanumberofEurozonecountries.Itcan
beseenthatimmediatelyaftertheEuropeanCouncilmeetingofOctober28-29,
when the first announcement was made to attach collective action clauses
(CACs) to future government bond issues, the government bond spreads of
Ireland, Portugal and Spain shot up almost immediately. Since then these
spreadshaveremainedhigh.ThiscontrastswiththepreviousEuropeanCouncil
meetings,whicheitherdidnotseemtoaffectthespreads,orasinthecaseofthe
May2010meetingwasfollowedbya(temporary)declineinthespreads.
ThereactionofthemarketstotheannouncementoffutureCACsshouldnothave
beensurprising.Whenprivatebondholdersknowthatinthefuturetheirbonds
willautomaticallyloosevaluewhenacountryturnstotheESM,theywillwantto
becompensatedfortheaddedriskwithahigherinterestrate.Inaddition,and
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evenmore importantly,eachtime theysuspectthatacountrymayturntothe
ESMforfundingtheywillimmediatelyselltheirbonds,soastoavoidapotential
loss.Butthissellingactivitywillraisetheinterestrateonthesebonds,andwill
makeitmore likely thatthegovernmentwillhavetoask forsupportfromtheESM.
Figure8
Source:Datastream
Thusthecollectiveactionclauseswillmakethegovernmentbondmarketsmore
fragileandmoresensitivetospeculativefears.Iarguedearlierthatthesystemic
problemof theEurozoneliesin the factthat inamonetaryunionthenational
governmentsaremorevulnerabletoliquiditycrisestriggeredbymovementsin
confidenceinfinancialmarkets.Insteadofalleviatingthisproblemthecollective
action clauses will intensify it, because with each decline in confidence
bondholderswill“runforcover”toavoidlosses,therebytriggeringacrisis.
CACsdowngradethemembersofthemonetaryuniontothestatusofemerging
marketsforwhichtheseclauseswereinvented.Inawayitisquiteextraordinary
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thattheEuropean leadershave designed a “solution”to thesystemicproblem
thatwillturnouttomakethatproblemmoresevere.
There is another feature of the ESM that instead of solving a problem may
actually make it more pronounced. I argued earlier that when the member
countries of amonetary unionare pushed into a bad equilibrium, they loose
muchoftheirability toapplythe automatic stabilizers inthe budget during a
recession.CountriesthatapplyforfinancingfromtheESMwillbesubjectedtoa
tough budgetary austerity programas a condition forobtaining finance. Thus,
witheachrecession,whenanumberofEurozonecountriesmaybeforcedtoturn
totheESMtheywillbeobligedtofollowpro-cyclicalbudgetarypolicies,i.e.to
reducespendingandincreasetaxes.Asurewaytomaketherecessionworse.
Thepro-cyclicalityofgovernment budgets isan important achievement in the
developed world. It has led to greater business cycle stability and to greater
social welfare, shielding people from the harshness of booms and busts in
capitalist systems. The way the ESM has been set up, however, risks
underminingthisachievement.
All this is quite unfortunate. Especially because the existence of a financial
support mechanism in the Eurozone is a great idea and a significant step
forwardsinthebuildingofan integratedEurope.Unfortunately,byintroducing
allkindsofrestrictionsandconditions,theESMhasbeentransformedintoan
institutionthatisunlikelytoproducemorestabilityintheEurozone.
8.2:JointissueofEurobonds
A second step towards political union and thus towards strengthening the
EurozoneconsistsinthejointissueofEurobonds.AjointissueofEurobondsis
animportantmechanismofinternalizingtheexternalitiesintheEurozonethatI
identifiedearlier.
ByjointlyissuingEurobonds,theparticipatingcountriesbecomejointlyliablefor
the debt they have issued together. This is a very visible and constraining
commitmentthatwillconvincethemarketsthatmembercountriesareserious
about the future of the euro (see Verhofstadt(2009), Juncker and
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Tremonti(2010)). In addition, by pooling the issue of government bonds, the
member countries protect themselves against thedestabilizing liquidity crises
that arise form their inability to control the currency in which their debt is
issued.Acommonbondissuedoesnotsufferfromthisproblem.
TheproposalofissuingcommonEurobondshasmetstiffresistanceinanumber
of countries (see Issing(2010)). This resistance is understandable. A common
Eurobondcreatesanumberofseriousproblemsthathavetobeaddressed.
A first problem is moral hazard. The common Eurobond issue contains an
implicitinsurancefortheparticipatingcountries.Sincecountriesarecollectively
responsibleforthejointdebtissue,anincentiveiscreatedforcountriestorely
on this implicit insurance and to issue too much debt. This creates a lot of
resistanceintheothercountriesthatbehaveresponsibly.Itisunlikelythatthese
countrieswillbewillingtostepintoacommonEurobondissueunlessthismoral
hazardriskisresolved.
A second problem (not unrelated to the previous one) arises because some
countrieslikeGermany,FinlandandtheNetherlandstodayprofitfromtripleA
ratings allowing them to obtain the best possible borrowing conditions. The
questionarisesofwhatthebenefitscanbeforthesecountries.Indeed,itisnot
inconceivablethatbyjoiningacommonbondmechanismthatwillincludeother
countriesenjoyinglessfavourablecreditratings,countrieslikeGermany,Finland
andtheNetherlandsmayactuallyhavetopayahigherinterestrateontheirdebt.
Theseobjectionsareserious.Theycanbeaddressedbyacarefuldesignofthe
commonEurobondmechanism.ThedesignofthecommonEurobondsmustbe
such as to eliminate the moral hazard risk and must produce sufficientattractiveness for the countries with favourable credit ratings. This can be
achievedbyworkingbothonthequantitiesandthepricingoftheEurobonds.
Thus,myproposalwould betoseek a combinationof the Eurobond proposal
madebyBruegel (Delpla and vonWeizsäcker(2010) and the onemadebyDe
GrauweandMoesen(2009).Itwouldworkasfollows.Countrieswouldbeable
toparticipateinthejointEurobondissueupto60%oftheirGDP,thuscreating
“bluebonds”.Anythingabove60%wouldhavetobeissuedinthenationalbond
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markets (“red bonds”). This would create a senior (blue) tranche that would
enjoythebestpossiblerating.Thejunior(red)tranchewouldfaceahigherrisk
premium.Thisexistenceofthisriskpremiumwouldcreateapowerfulincentive
for the governments to reduce their debt levels. In fact, it is likely that theinterest rate that countries would have to pay on their red bonds would be
higherthantheinterestratetheypaytodayontheirtotaloutstandingdebt(see
Gros(2010) on this). The reason is that by creating a senior tranche, the
probabilityofdefaultonthejuniortranchemayactuallyincrease.Thisshould
increase the incentive for countries to limit the red component of their bond
issues.
TheBruegelproposalcanbecriticizedonthefollowinggrounds.Totheextent
that the underlying riskof the government bonds isunchanged, restructuring
thesebondsintodifferenttranchesdoesnotaffectitsrisk.Thus,ifthebluebond
carriesalowerinterestrate,theredbondwillhaveahigherinterestratesuch
thattheaverageborrowingcostwillbeexactlythesameaswhenthereisonly
onetypeofbond(seeGros(2011)).ThisisanapplicationoftheModigliani-Miller
theorem which says that the value of a firm is unaffected by the way the
liabilitiesofthatfirmarestructured.
All this is true tothe extent that the underlying risk isunchanged.The point,
however, is that the commonbond issue isan instrument to shield countries
frombeingpushedintoabadequilibrium.Ifthecommonbondissuesucceedsin
doingso,theunderlyingriskofthebondsofthesecountriesdoesindeeddecline.
Inthatcasethesecountriesareabletoenjoyaloweraverageborrowingcost.At
the same time the marginal borrowing cost is likely to be higher than the
average.Thisis exactlywhatonewantstohave:adeclineoftheaveragedebt
cost,andanincreaseinthemarginalcostofthedebt.Theformermakesiteasier
toservicethedebt;thelatterprovidesstrongincentivestowardsreducingthe
levelofthedebt.Thisfeatureisimportanttoreducethemoralhazardrisk.
ThesecondfeatureofourproposalworksonthepricingoftheEurobondsandit
follows theproposalmadebyDeGrauweandMoesen(2009). Thisconsists in
usingdifferentfeesforthecountriesparticipatinginthebluebondissue.These
feeswouldberelatedtothefiscalpositionoftheparticipatingcountries.Thus,
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countries with high government debt levels would face a higher fee, and
countrieswithlowerdebtlevelswouldpayalowerfee.Inpracticaltermsthis
meansthattheinterestratepaidbyeachcountryinthebluebondtranchewould
bedifferent. Fiscallyprudent countrieswould have topay a somewhat lowerinterestratethanfiscallylessprudentcountries.Thiswouldensurethattheblue
bondissuewouldremainattractiveforthecountrieswiththebestcreditrating,
therebygivingthemanincentivetojointtheEurobondmechanism.
It should be noted that if successful, such a common Eurobond issue would
createalargenewgovernmentbondmarketwithalotofliquidity.Thisinturn
wouldattractoutsideinvestorsmakingtheeuroareservecurrency.Asaresult
theeurowouldprofitfromanadditionalpremium.Ithasbeenestimatedthatthe
combined liquidity and reserve currency premium enjoyed by the dollar
amounts to approximately 50 basis points (Gourinchas and Rey(2007)). A
similarpremiumcouldbeenjoyedbytheeuro.Thiswouldmakeitpossiblefor
theeurozonecountriestolowertheaveragecostofborrowing,verymuchlike
theUShasbeenabletodo.
8.3:Coordinationofeconomicpolicies
A third important step in the process towards political union is to set some
constraints on the national economic policies of the member states of the
Eurozone. The fact that while monetary policy is fully centralized, the other
instruments of economic policies have remained firmly in the hands of the
national governments is a serious design failure of the Eurozone. Ideally,
countries should hand over sovereignty over the use of these instruments toEuropean institutions. However, the willingness to take such a drastic step
towards political union is completelyabsent. Here also small steps should be
taken.
The European Commission has proposed a scoreboard of macroeconomic
variables(privateandpublicdebt,currentaccountimbalances,competitiveness
measures,houseprices)thatshouldbemonitored,andthatshouldbeusedto
pushcountriestowardsusingtheireconomicpolicyinstrumentssoastocreate
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greaterconvergenceinthesemacroeconomicvariables.Failuretotakeactionto
eliminatetheseimbalancescouldtriggerasanctioningmechanismverymuchin
the spirit of the sanctioning mechanism of the Stability and Growth Pact
(EuropeanCommission(2010)).
While an important step forward, this approach is incomplete. National
governments have relatively little control over many of the macroeconomic
variablestargetedbytheEuropeanCommission.Infacttheevidencewehaveof
thepre-crisisdivergencedynamicsisthatmuchofitwasproducedbymonetary
andfinancialdevelopmentsoverwhichnationalgovernmentshadlittlecontrol.
Localboomsand bubblesdeveloped inthe periphery ofthe Eurozone. These
weredrivenmainlybybankcreditexpansion.ThisisvividlyshowninFigure9.It
is the combination of bubbles (especially in the housingmarkets) and credit
expansion that makes bubbles potentially lethal (see Borio(2003)). This has
beenmadevaryclearbytheexperienceofSpainandIreland.
Thus,anypolicyaimedatstabilizinglocaleconomicactivitymustalsobeableto
control localcredit creation. It isclear that because themember states of the
Eurozonehaveenteredamonetaryuniontheylacktheinstrumentstodealwith
this.Putdifferently,ifthemovementsofeconomicactivityaredrivenbycredit-
fueledanimalspiritstheonlyinstrumentsthatcaneffectivelydealwiththisare
monetary instruments. Members of a monetary union, however, have
relinquishedtheseinstrumentstotheEuropeanmonetaryauthorities.
The next question then becomes: can the European monetary authorities, in
particulartheECB,helpoutnationalgovernments?Wehavebeentoldthatthisis
impossible because the ECB should only be concerned by system-wide
aggregates.Itcannotbemaderesponsiblefornationaleconomicconditions.The
reasonisthatithasoneobjectivewhichisthemaintenancesofpricestabilityin
theEurozoneasawhole,andbecauseithasonlyoneinstrumenttoachievethis
goal.
ThisIbelieveistoocheapananswer.TheECBisnotonlyresponsibleforprice
stability but also for financial stability.The financial crisis that eruptedinthe
Eurozonein2010haditsorigininalimitednumberofcountries.Itistherefore
importantthattheECBfocusesnotonlyonsystem-wideaggregatesbutalsoon
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what happens in individual countries. Excessive bank credit creation in a
numberofmembercountriesshouldalsoappearontheradarscreenoftheECB
inFrankfurtuponwhichtheECBshouldact.
Figure9
Source:Kannan,etal.(2009)
One may object that the ECB does not have the instruments to deal with
excessive bank credit inpartsof the Eurozone. This,however, isnot so. The
Eurosystemhas the technical ability torestrictbank credit in some countries
morethaninothersbyapplyingdifferentialminimumreserverequirements,orby imposing anti-cyclical capital ratios. These can and should be used as
stabilizinginstrumentsatthenationallevel.
Anotherobjection is that it is theresponsibilityof thefinancial supervisors to
dealwithexcessive risk taking bybanks.Whenbanksextend toomuchcredit
andtherebyincreasetheriskoftheirbalancesheets,nationalsupervisorsshould
intervene. This is undoubtedly so. At the same time it does not absolve the
Eurosystem from its responsibility in maintaining financial stability. When a
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credit-fueledboomemergesinsomememberstates,it isalsotheresponsibility
oftheEurosystemtoact.TheEurosystemalsohasthemostpowerfultoolkitin
controllingthemacroeconomicconsequencesofboomsandbusts.
Therecentreformsinthesupervisory landscape in theEurozone increase the
scopeforactionbytheEurosystem.TheEuropeanSystemicRiskBoard(ESRB)
whichwascreatedin2010isofparticularimportancehere.Verypointedly,the
presidentof theECBwillalsopresideovertheESRB.Thus the creatorsof the
ESRBhaveclearlyunderstoodthattheECBisatthecenterofthemonitoringof
emergingsystemicrisksintheEurozone.Itwouldbequiteparadoxicalthatthe
presidentoftheESRB(ECB)wouldemitwarningsignalsaboutsystemicriskand
wouldthennotfollow-upthiswarningbyactiontoreducetherisks,leavingitto
thenationalsupervisorstoactalone.
The steps described in this and the previous sections, involving both the
responsibilities of national governments, the European institutions and the
Eurosystemare important tomove towards political union. They also give an
important signal in the financial markets that the member countries of the
EurozoneareseriousintheirdesiretoguaranteethesurvivaloftheEurozone.
These steps are also to be seen as commitment devices that enhance the
credibility of the monetaryunion. They are crucial in stabilizing the financial
marketsintheEurozone.
9.Conclusion
Amonetaryunionismorethanonemoneyandonecentralbank.Countriesthat
join a monetary union loose more than an instrument of economic policy
(interestrateorexchangerate).Whenenteringthemonetaryunion,theyloose
theircapacitytoissuedebtinacurrencyoverwhichtheyhavefullcontrol.Asa
result, a loss of confidence of investors can in a self-fulfilling way drive the
countryintodefault.Thisisnotsoforcountriescapableofissuingdebtintheir
own currency. In these countries the central bank can always provide the
liquiditytothesovereigntoavoiddefault.Thismayleadtofutureinflation,butit
shieldsthesovereignfromadefaultforcedbythemarket.
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Thus, member-countries of a monetary union become more vulnerable.
Changingmarket sentiments can lead to “sudden stops” in the funding of the
governmentdebt,settinginmotionadevilishinteractionbetweenliquidityand
solvency crises. There is an important further implication of this increasedvulnerability.Thisisthatmember-countriesofamonetaryunionloosemuchof
their capacity to apply counter-cyclical budgetary policies. When during a
recessionthebudgetdeficitsincrease,thisriskscreatinga lossofconfidenceof
investorsinthecapacityofthesovereigntoservicethedebt.Thishastheeffect
of raising the interest rate,making the recessionworse, and leading to even
higherbudgetdeficits.Asaresult,countriesinamonetaryunioncanbeforced
intoabadequilibrium,characterizedbydeflation,highinterestratesandhigh
budgetdeficits.
Thesesystemicfeaturesofamonetaryunionhavenot sufficiently been taken
intoaccountinthenewdesignoftheeconomicgovernanceoftheEurozone.Too
much of this new design has been influenced by the notion (based on moral
hazardthinking)thatwhenacountryexperiencesbudgetdeficitsandincreasing
debts,itshouldbepunishedbyhighinterestratesandtoughausterityprograms.
I have argued that this approach isusuallynot helpful inrestoring budgetary
balance.
In addition, a number of features of the design of financial assistance in the
EurozoneasembodiedintheESM,willhavetheeffectofmakingcountrieseven
moresensitivetoshiftingmarketsentiments.Inparticular,the“collectiveaction
clauses”whichwillbeimposedonthe future issue of governmentdebt inthe
Eurozone, will increase the nervousness of financial markets. With each
recessiongovernmentbondholders,fearinghaircuts,willrunforcover,thereby
making a default crisis more likely. All this is likely to increase the risk that
countriesintheEurozoneloosetheircapacitytolettheautomaticstabilizersin
thebudgetplaytheirnecessaryroleofstabilizingtheeconomy.
Amonetaryunioncreates collective problems.Whenone government faces a
debtcrisisthisislikelytoleadtomajorfinancialrepercussionsinothermember
countries. This is so because a monetary union leads to intense financial
integration.Whetherone likes itornot,member countries are forced tohelp
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each other out. Surely, it is important to provide the right incentives for
governmentssoastoavoidprofligacythatcouldleadtoadebtcrisis.Discipline
bythethreatofpunishmentispartofsuchanincentivescheme.Ihaveargued,
however, that too much importance has been given to punishment and notenoughtoassistanceinthenewdesignoffinancialassistanceintheEurozone.
This excessive emphasis on punishment is also responsible for a refusal to
introducenewinstitutionsthatwillprotectmembercountriesfromthevagaries
of financial markets that can trap countries into a debt crisis and a bad
equilibrium.Onesuchaninstitutionisthecollectiveissueofgovernmentbonds.
Iarguedthatsuchacommonbondissuemakesitpossibletohaveacollective
defense system against the vagariesof euphoria and fears that regularly grip
financialmarkets.
Amonetaryunioncanonlyfunctionifthereisacollectivemechanismofmutual
supportandcontrol.Suchacollectivemechanismexistsinapoliticalunion.In
the absence of a political union, the member countries of the Eurozone are
condemned tofill inthe necessary pieces ofsucha collectivemechanism.The
debtcrisishasmadeitpossibletofillinafewofthesepieces.Whathasbeen
achieved, however, is still far from sufficient to guarantee the survival of the
Eurozone.
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APPENDIX:AMODELOFGOODANDBADEQUILIBRIA
InthissectionIpresentaverysimplemodelillustratinghowmultipleequilibria
canarise.Thestartingpointisthatthereisacostandabenefitofdefaultingon
thedebt,andthatinvestorstakethiscalculusofthesovereignintoaccount.Iwill
assumethatthecountryinvolvedissubjecttoashock,whichtakestheformofa
declineingovernmentrevenues.Thelattermaybecausedbyarecession,ora
lossofcompetitiveness.I’llcallthisasolvencyshock.Iconcentratefirstonthe
benefitside.ThisisrepresentedinFigureA1.OnthehorizontalaxisIshowthe
solvencyshock.OntheverticalaxisIrepresentthebenefitofdefaulting.There
aremanyways and degreesofdefaulting. Tosimplify I assume this takes the
formofahaircutofa fixedpercentage.Thebenefitofdefaultingin thisway is
thatthegovernmentcanreducetheinterestburdenontheoutstandingdebt.As
aresult,afterthedefault itwill havetoapply lessausterity, i.e. itwill haveto
reducespendingand/or increasetaxesby less thanwithoutthe default. Since
austerityispoliticallycostly,thegovernmentprofitsfromthedefault.
Amajorinsightofthemodelisthatthebenefitofadefaultdependsonwhether
thisdefaultisexpectedornot.Ishowtwocurvesrepresentingthebenefitofa
default. BU is the benefit of adefault that investors do not expect tohappen,
whileBEisthebenefitofadefaultthatinvestorsexpecttohappen.Letmefirst
concentrateon theBU curve. It isupwardslopingbecausewhen the solvency
shockincreases,thebenefitofadefaultforthesovereigngoesup.Thereasonis
thatwhenthesolvencyshockislarge,i.e.thedeclineintaxincomeislarge,the
cost of austerity is substantial. Default then becomes more attractive for the
sovereign.Ihavedrawnthiscurvetobenon-linear,butthisisnotessentialfor
the argument. I distinguish three factors that affect the position and the
steepnessoftheBUcurve:
• Theinitialdebtlevel .Thehigher is this level, thehigher is thebenefitof a
default.ThuswithahigherinitialdebtleveltheBUcurvewillrotateupwards.
• Theefficiencyofthetaxsystem.Inacountrywithaninefficienttaxsystem,the
government cannot easily increase taxation. Thus in such a country the
optionofdefaultingbecomesmoreattractive.TheBUcurverotatesupwards.
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• Thesizeoftheexternaldebt. Whenexternaldebttakesalargeproportionof
total debt there will be less domestic political resistance against default,
makingthelattermoreattractive(theBUcurverotatesupwards).
FigureA1:Thebenefitsofdefaultafterasolvencyshock
B
Inow concentrate ontheBE curve. This showsthe benefitofadefaultwhen
investors anticipate such a default. It is located above theBU curve for the
following reason. When investors expect a default, they will sell government
bonds.Asaresult,theinterestrateongovernmentbondsincreases.Thisraises
the government budget deficit requiring amore intense austerity program of
spendingcuts andtaxhikes.Thus,defaultbecomesmore attractive.Forevery
solvencyshock,thebenefitsofdefaultwillnowbehigherthantheywerewhen
thedefaultwasnotanticipated.
Inowintroducethecostsideofthedefault.Thecostofadefaultarisesfromthe
factthat,whendefaulting,thegovernmentsuffersalossofreputation.Thisloss
ofreputationwillmakeitdifficultforthegovernmenttoborrowinthefuture.I
BU
Solvencyshock
BE
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willmakethesimplifyingassumptionthatthisisafixedcost.InowobtainFigure
A2whereIpresentthefixedcost(C)withthebenefitcurves.
FigureA2:Costandbenefitsofdefaultafterasolvencyshock
B
Inowhavethetoolstoanalyzetheequilibriumofthemodel.Iwilldistinguish
betweenthreetypesofsolvencyshocks,asmallone,anintermediateone,anda
largeone.Takeasmallsolvencyshock:thisisashockS<S1Forthissmallshock
thecostofadefaultisalwayslargerthanthebenefits(bothofanexpectedand
an unexpected default). Thus the government will not want todefault. When
expectationsare rationalinvestorswillnotexpectadefault.Asa result, ano-
defaultequilibriumcanbesustained.
Letusnowanalyzealargesolvencyshock.Thisisoneforwhich S>S2.Forall
theselargeshocksweobservethatthecostofadefaultisalwayssmallerthan
the benefits (both of an expected and an unexpected default). Thus the
governmentwillwanttodefault.Inarationalexpectationsframework,investors
willanticipatethis.Asaresult,adefaultisinevitable.
BUBE
C
S1 S2
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Inowturntotheintermediatecase:S1<S<S2.FortheseintermediateshocksI
obtainanindeterminacy,i.e.twoequilibriaarepossible.Whichonewillprevail
onlydependsonwhatisexpected.Toseethis,supposethesolvencyshockisS’
(seeFigureA3). Inthiscasethereare twopotentialequilibria,D andN.TakepointD.Inthiscaseinvestorsexpectadefault(DislocatedontheBEline).This
hastheeffectofmakingthebenefitofadefaultlargerthanthecostC.Thus,the
governmentwilldefault.Disanequilibriumthatisconsistentwithexpectations.
ButpointNisanequalcandidatetobeanequilibriumpoint.InN,investorsdo
notexpectadefault(NisontheBUline).Asaresult,thebenefitofadefaultis
lowerthanthecost.Thusthegovernmentwillnotdefault.ItfollowsthatNisalso
anequilibriumpointthatisconsistentwithexpectations.
FigureA3:Goodandbadequilibria
B
Thusweobtain two possibleequilibria,a bad one (D) that leads todefault, a
good one (N ) that does not lead to default. Both are equally possible. The
selectionofoneofthesetwopointsonlydependsonwhatinvestorsexpect.Ifthe
latterexpectadefault,therewillbeone;iftheydonotexpectadefaulttherewill
BU
BE
C
S1 S2
D
S’
N
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be none. This remarkable result is due to the self-fulfilling nature of
expectations.
Thepossibilityofmultipleequilibriaisunlikelytooccurwhenthecountryisa
stand-alone country, i.e. when it can iissue its debt in its own currency. This
makesitpossibleforthecountrytoalwaysavoidoutrightdefaultbecausethe
centralbankcanbeforcedtoprovidealltheliquiditythatisnecessarytoavoid
suchanoutcome.Thishastheeffectthatthereisonlyonebenefitcurve.Inthis
case the government can stilldecide todefault (if the solvencyshock is large
enough). But the country cannot be forced to do so by thewhim of market
expectations