Governance Fragile Eurozone s

8/2/2019 Governance Fragile Eurozone s

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THEGOVERNANCEOFAFRAGILEEUROZONE

PaulDeGrauwe*UniversityofLeuvenandCEPS

Abstract:

Whenenteringamonetaryunion,member-countrieschangethenatureoftheirsovereign debt in a fundamentalway, i.e. they cease to have control over thecurrencyinwhichtheirdebtisissued.Asaresult,financialmarketscanforce

these countries sovereigns into default. In this sensemember countries of amonetary union are downgraded to the status of emerging economies. Thismakes the monetary union fragile and vulnerable to changing marketsentiments.Italsomakesitpossiblethatself-fulfillingmultipleequilibriaarise.IanalyzetheimplicationsofthisfragilityforthegovernanceoftheEurozone.Iconclude that the new governance structure (ESM) does not sufficientlyrecognizethisfragility.Someofthefeaturesofthenewfinancialassistancearelikely 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. Isuggestadifferentapproachtodealwiththeseproblems.

April2011

*IamgratefultoDanielGros,MartinWolfandCharlesWyploszforcommentsandsuggestions


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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 theproblems of theEurozone. In this paper I

arguethatthegovernancestructurethathasemergedafteraseriesofdecisions

ofsuccessiveEuropeanCouncilmeetings,althoughanimportantstepforwards,

failstoaddresssomefundamentalproblemsinamonetaryunion.

2.AParadox

IstartwiththeparadoxthatisimmediatelyvisiblefromacomparisonofFigures

1and2. Figure1showsthedebttoGDPratiosof theUKandSpain. It canbe

seenthatsincethestartof the financialcrisisthegovernmentdebtratioofthe

UKhasincreasedmorethanthatofSpain.Asaresult,in2011asapercentof

GDPtheUKgovernmentdebtstood17%higherthantheSpanishGovernment

debt(89%versus72%).YetfromFigure2itappearsthatthefinancialmarkets

havesingledoutSpainandnottheUKasthecountrythatcouldgetentangledin

agovernmentdebtcrisis.Thiscanbeseenfromthefactthatsincethestartof

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

percent

10-yeargovernmentbondratesSpainandUK

Spain

UK


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3.Onthenatureofsovereigndebtinamonetaryunion

Inanutshellthedifferenceinthenatureofsovereigndebtbetweenmembers

andnon-membersofamonetaryunionboilsdowntothefollowing.Membersof

amonetaryunionissuedebtinacurrencyoverwhichtheyhavenocontrol.Itfollows 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.

Letme expand on thisby considering in detail what happenswhen investors

starthavingdoubtsaboutthesolvencyofthesetwotypesofcountries.Iwilluse

theUKasaprototypemonetarystand-alonecountryandSpainasaprototype

member-country of a monetary union (see Kopf(2011) for an insightful

analysis).

TheUKscenario

Lets first trace what would happen if investors were to fear that the UK

governmentmightbedefaultingonitsdebt.Inthatcase,theywouldselltheirUK

governmentbonds,drivinguptheinterestrate.Aftersellingthesebonds,theseinvestorswouldhavepoundsthatmostprobablytheywouldwanttogetridof

bysellingtheminthe foreignexchangemarket. Thepriceof thepoundwould

dropuntilsomebodyelsewouldbewillingtobuythesepounds.Theeffectofthis

mechanismisthatthepoundswouldremainbottledupintheUKmoneymarket

tobeinvestedinUKassets.Putdifferently,theUKmoneystockwouldremain

unchanged. Part of that stock of money would probably be re-invested in UK

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, itwould certainly force the BankofEngland tobuy up the government

securities. Thus the UKgovernment is ensured that the liquidity is around to

funditsdebt.Thismeansthatinvestorscannotprecipitatealiquiditycrisisinthe

UKthatcouldforcetheUKgovernmentintodefault.Thereisasuperiorforceof

lastresort,theBankofEngland.


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TheSpanishscenario

Thingsaredramaticallydifferentforamemberofamonetaryunion,likeSpain.

Suppose that investors fear a default by the Spanish government.Asa result,

theysellSpanishgovernmentbonds,raisingtheinterestrate.Sofar,wehavethesameeffectsasinthecaseoftheUK.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 SpanishgovernmentcannotforcetheBankofSpaintobuygovernmentdebt.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.theycansuddenlybeconfrontedwithasuddenstopwhencapital

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 start of the financial crisis the pound has

depreciatedbyapproximately25%againsttheeuro.

Source:EuropeanCommission,Ameco

Thisdifferenceininflationandgrowthcanhaveaprofoundeffectonhowthe

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

rateandthenominalgrowthratetimesthedebtratio 1.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%toachievethisresult.Thus,

SpainisforcedtoapplymuchmoreausteritythantheUKtosatisfythesolvency

condition.Putdifferently,SpaincouldnotgetawaywiththeUKbudgetarypolicy

without beingbranded as insolvent despite the fact that ithasa substantially

lowerdebtlevel.

Table1:Primarysurplusneededtostabilizedebtat2011level

(percentGDP)

UK

-1,21

Spain

2,30

Thepreviousanalysisillustratesanimportantpotentiallydestructivedynamics

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(asuddenstop).Thiscanset

inmotion a devilish interactionbetween liquidityandsolvencycrises. Once a

membercountrygetsentangledinaliquiditycrisis,interestratesarepushedup.

Thustheliquiditycrisisturnsintoasolvencycrisis.Investorscanthenclaim

thatitwasrighttopulloutthemoneyfromaparticularnationalmarket.Itisa

self-fulfillingprophecy:thecountryhasbecomeinsolventbecauseinvestorsfear

insolvency.

1TheformulaisS(rg)D,whereSistheprimarybudgetsurplus,risthenominalinterestrateonthegovernmentdebt,gisthenominalgrowthrateoftheeconomyandDisthegovernmentdebttoGDPratio.


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NotethatIamnotarguingthatallsolvencyproblemsintheEurozoneareofthis

nature. In the case of Greece, for example, one can argue that the Greek

governmentwas insolvent before investorsmade theirmovesandtriggereda

liquidity crisis in May 2010.What I am arguing is that in a monetary unioncountriesbecomevulnerabletoself-fulfillingmovementsofdistrustthatsetin

motionadevilishinteractionbetweenliquidityandsolvencycrises.

Thisinteractionbetweenliquidityandsolvencyisavoidedinthestand-alone

country,wheretheliquidityisbottledupinthenationalmoneymarkets(thereis

no sudden stop), and where attempts to export it to other markets sets in

motion an equilibrating mechanism, produced by the depreciation of the

currency.Thus,paradoxically,distrustleadstoandequilibratingmechanismintheUK,andtoapotentiallydisequilibratingmechanisminSpain.

From the preceding analysis, it follows that financial markets acquire great

powerinamonetaryunion.Willthispowerbebeneficialfortheunion?

Believersinmarketefficiencyhavebeentellingusthatthispowerissalutary,as

itwillactasadiscipliningforceonbadgovernments.Ihavelostmuchofmy

faithintheideathatfinancialmarketsareadiscipliningforce.Thefinancialcrisis

hasmadeabundantlyclearthatfinancialmarketsareoftendrivenbyextreme

sentiments of either euphoria orpanic. 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

badones. This arises from theself-fulfilling natureofmarket expectations. In

appendix, I present a simple theoretical model showing more formally how

multipleequilibriacanarise.

SupposemarketstrustgovernmentA.Investorsthenwillshowawillingnessto

buy government bonds at a low interest rate. A low interest rate embodiesa


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belief that thedefault risk is low. But the same low interest ratealso has 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). As a result, theUK 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 themarkets distrust in the Spanish government in a self-fulfilling wayhasmade

defaultmorelikely.FinancialmarketspushSpaintowardsabadequilibrium.

The occurrence of bad equilibria ismore likely with members of amonetary

union,whichhavenocontrolofthecurrencyinwhichtheyissuetheirdebt,than

withstand-alonecountriesthathaveissueddebtinacurrencyoverwhichthey

have fullcontrol.Asmentionedearlier, themembersofamonetaryunionface

the same problem as emerging countries that because of underdeveloped

domesticfinancialmarkets,areforced toissuetheirdebtina foreigncurrency

(Calvo,etal.(2006),seeEichengreen,atal.(2005)).InthewordsofEichengreen

etal.(2005)thisworksastheoriginalsinthatleadsthesecountriesintoabad

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

of government bonds areheld outside the countryof issue. Thuswhen a bad

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. Iwill return to this issue when I analyze the governance

questionoftheEurozone.

Towrapupthepreviousdiscussion:membersofmonetaryunionaresensitivetomovementsofdistrustthathaveself-fulfillingpropertiesandthatcanleadthem

tobepushedintoabadequilibrium.Thelatterarisesbecausedistrustcansetin

motion a devilish interaction between liquidity and solvency crises. Being

pushedintoabadequilibriumhastwofurtherconsequences.Ianalyzethesein

thefollowingsection.

5.Thebadnewsaboutabadequilibrium

Therearetwofeaturesofabadequilibriumthatareworthanalyzingfurther.

First, domestic banks are affected by the bad equilibrium in different ways.

When investors pull out from the domestic bondmarket, the interest rate on

government bonds increases. Since the domestic banks are usually the main

investors inthedomestic sovereign bondmarket, this showsupassignificant

lossesontheirbalancesheets.Inaddition,domesticbanksarecaughtupinafundingproblem.Asarguedearlier,domesticliquiditydriesup(themoneystock

declines)making it difficult for the domestic banks to rollover their deposits,

exceptbypayingprohibitiveinterestrates.Thusthesovereigndebtcrisisspills

overintoadomesticbankingcrisis,evenifthedomesticbanksweresoundto

startwith.Thisfeaturehasplayedanimportantrole inthecaseofGreeceand

Portugalwherethesovereigndebtcrisishasledtoafull-blownbankingcrisis.In

the case of Ireland, therewas a bankingproblemprior to the sovereign debtcrisis(whichinfacttriggeredthesovereigndebtcrisis).Thelatter,however,

intensifiedthebankingcrisis.

Second, once in a bad equilibrium, members of monetary union find it very

difficult to use automatic budget stabilizers: A recession leads to higher

government budget deficits; this in turn leads to distrust of markets in the

capacityofgovernmentstoservice theirfuturedebt, triggeringa liquidityand

solvencycrisis;thelatterthenforcesthemtoinstituteausterityprogramsinthe


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midst of a recession. In the stand-alone country (UK) this does not happen

because the distrust generated by higher budget deficit triggers a stabilizing

mechanism.

Thus,membercountriesofamonetaryunionaredowngradedtothestatusofemerging economies, 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 and

politicalbasisforsuchaunioncanbemaintained.Itisthereforeimportantto

designagovernancestructurethatmaintainstheseautomaticstabilizers.

6.Competitivenessandsovereigndebt

The previous analysis allows us to connect sovereign debt dynamics and

competitivenessproblems.

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.Onemaycriticizethisfigure

becauseofthechoiceof2000asthebaseyear.Indeed,thischoiceassumesthatin 2000 there were no imbalances in competitive positions, so that any

movementaway fromthe2000-level isa departure fromequilibriumandthus

problematic.Thisissurelynotthecase(seeAlcidiandGros(2010).Anumberof

countries may have been far from equilibrium in 2000 so that movements

observedsincethatdatecouldconceivablybemovementstowardsequilibrium.

InordertotakethiscriticismintoaccountIpresentrelativeunitlabourcostsof

themembercountriesusingthelong-termaverageovertheperiod1970-2010as


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thebase.The resultsare shownin figure6.Thedivergence islessspectacular,

but stillvery significant.Figure7 confirms this: the standard deviationof the

yearlyindicesincreasedsignificantlysince1999.



85

90

95100

105

110

115

120

125

20002001200220032004200520062007200820092010

Figure5:RelativeunitlaborcostsEurozone(2000=100)

ItalyGreecePortugalSpainIrelandNetherlandsFinland

BelgiumFranceAustriaGermany

80

85

90

95

100

105

110

115

120125

199920002001200220032004200520062007200820092010

GreecePortugal

Spain

Italy

Belgium

Netherlands

Austria

Ireland

France

Finland

Germany

Figure6:RelativeunitlaborcostsinEurozone

(average1970-2010=100)


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Note:ComputedusingdataofFigure6.

Thecountries 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 devaluation must be engineered, i.e.

wages andpricesmust bebrought down relative to those of thecompetitors.

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 budget

deficits.

Most of the analyses in textbooks now stop by noting that this is a slow and

painfulprocess.Theanalysisoftheprevioussections,however,allowsustogoa

littlefurtherandtolinkitwiththedebtdynamicsdescribedearlier.Ascountries

experience increasing budget deficits while they attempt to improve their

competitiveness,financialmarketsarelikelytogetnervous.Distrustmayinstallitself. 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, becauseduring the adjustment

period,thecountycanbehitbyasovereigndebtandbankingcrises.Ifthelatter

occur, the deflationary spiral is bound to be intensified. For in that case the

4

5

6

7

8

9

10

11

199920002001200220032004200520062007200820092010

percent

Figure7:Standarddeviationrelativeunitlabour

costsinEurozone(inpercent)


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domesticlongterminterestrateincreasesdramatically,forcingtheauthorities

toapplyevenmorebudgetaryausterity,which in turn leads toanevenmore

intense recession. The banks that are trapped ina funding crisis reduce their

credit to the economy. The country finds itself stuck in a bad equilibrium,characterizedbyausterityprogramsthatfailtoreducebudgetdeficitsbecause

theyleadtoadownwardeconomicspiralandpunishinginterestratelevels.The

pathtowardsrecoveryformembersofamonetaryunionislikelytobecrisis-

prone.

Thecontrastwithstand-alonecountriesthathavethecapacity toissuedebtin

their own currency is stark. When these countries have lost competitiveness,

theywilltypicallytrytorestoreitbyallowingthecurrencytodropintheforeignexchangemarket.Thismakesitpossiblenotonlytoavoiddeflation,butalsoto

avoid a sovereign debt crisis. As we have seen earlier, these countries

governmentscannotbeforcedintodefaultbytriggeringaliquiditycrisis.Whatis

morethewholeadjustmentprocessinvolvingcurrencydepreciationislikelyto

boostoutputandinflation,therebyimprovingthesolvencyofthesovereign.

7.Governanceissues

ThedebtcrisishasforcedEuropeanleaderstosetupnewinstitutionscapableof

dealingwiththecrisis.Themostspectacularresponsehasbeenthecreationof

the European Financial Stability Mechanism (EFSF) in May 2010 to be

transformed into a permanent European rescue fund, the European Stability

Mechanism(ESM)from2013on. Surely thesewere important stepsthatwere

necessarytomaintainthestabilityoftheEurozone.Yet the opposition against these decisions continues to be high especially in

Northern European countries. Opposition is also strong among economists of

these countries (see the statement of 189German economists warning about

future calamities if the EFSF were to be made permanent, Plenum der

konomen,(2011)).

This opposition is based on an incomplete diagnosis of the sovereign debt

problemintheEurozone.Forthe189Germaneconomiststhestoryissimple:


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some countries (Greece, Ireland, Portugal, Spain) have misbehaved. Their

governmentshaveirresponsiblyspenttoomuch,producingunsustainabledebt

levels.Theyarenowinsolventthroughtheirownmistakes.Thereisnopointin

providingfinancialassistancebecausethisdoesnotmakethemsolvent.Itonlygives 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,becauseittreatsthedebtproblemas a series of individual problems; not as the outcomeof a systemic

problemintheEurozone, that Ihavedescribedearlier.This systemicproblem

hasseveralingredients.First,byacquiringthestatusofemergingcountries,the

sovereigns of the member states in a monetary union are fragilized, as

unfavorablemarketsentimentscanforcethemintodefault.Thishastheeffectof

pushing thecountry intoabadequilibrium,characterized bypunishinglyhigh

interest rates, chronically high budget deficits, low growth and a domesticbankingcrisis.Second,thedegreeoffinancialintegrationinthemonetaryunion

issuchthatwhensomesovereignsarepushedinabadequilibrium,thisaffects

theothercountries.Inparticularitfragilizesthebankingsystemsintheseother

countries.Thus,strongexternalitiesarecreated,makingitimpossibletoisolatea

financialproblemofonecountryfromtherestoftheEurozone.Putdifferently,

whenonecountryexperiencesadebtproblemthisbecomesaproblemofthe

Eurozone.Itismycontentionthatthegovernancestructurethatisnowbeingdesigneddoesnotsufficientlytakeintoaccountthesystemicnatureofthedebt

problem.

8.Whatkindofgovernance?

Iidentifiedtwoproblemsofamonetaryunionthatrequiregovernmentaction.

First,thereisacoordinationfailure.Financialmarketscandrivecountriesintoa

badequilibriumthatistheresultofaself-fulfillingmechanism.Thiscoordination


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failurecaninprinciplebesolvedbycollectiveactionaimedatsteeringcountries

towardsagoodequilibrium.Second,theEurozonecreatesexternalities(mainly

throughcontagion).Likewithallexternalities,governmentactionmustconsist

ininternalizingthese.Collectiveactionandinternalizationcanbetakenattwolevels.Oneisatthelevel

ofthecentralbanks;theotheratthelevelofthegovernmentbudgets.

Liquiditycrisesareavoidedinstand-alonecountriesthatissuedebtintheirown

currencies mainly because the central bank can be forced to provide all the

necessary liquidity to the sovereign. This outcome can also be achieved in a

monetary union if the common central bank is willing to buy the different

sovereignsdebt.InfactthisiswhathappenedintheEurozoneduringthedebt

crisis. The ECB bought government bonds of distressed member-countries,

eitherdirectly,orindirectlybythefactthatitacceptedthesebondsascollateral

initssupportofthebanksfromthesamedistressedcountries.Indoingso, the

ECBrechanneledliquiditytocountrieshitbyaliquiditycrisis,andpreventedthe

centrifugalforcescreatedbyfinancialmarketsfrombreakinguptheEurozone.It

wastherightpolicyforacentralbankwhoseraisondtreitistopreservethe

monetary union. Yet, the ECB has been severely criticized for saving the

Eurozonethisway.Thiscriticism,whichshowsablatantincomprehensionofthe

fundamentalsofamonetaryunion,hasbeenpowerfulenoughtoconvincethe

ECB thatit shouldnotbe involvedinsuchliquidityoperation,andthatinstead

theliquiditysupportmustbedonebyotherinstitutions,inparticularaEuropean

MonetaryFund.Ireturntothisissueinthenextsection.

Collectiveactionand internalization can also be taken at the budgetary level.

Ideally, a budgetary union is the instrument of collective action and

internalization.Byconsolidating(centralizing)nationalgovernmentbudgetsinto

onecentralbudgetamechanismofautomatictransferscanbeorganized.Sucha

mechanism works as an insurance mechanism transferring resources to the

country hit by a negative economic shock. In addition, such a consolidation

createsacommonfiscalauthoritythatcanissuedebtinacurrencyunderthe

controlofthatauthority.Insodoing,itprotectsthememberstates frombeing


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forced into default by financialmarkets. It also protects themonetary union

fromthecentrifugalforcesthatfinancialmarketscanexertontheunion.

ThissolutionofthesystemicproblemoftheEurozonerequiresafar-reaching

degreeofpoliticalunion. Economists have stressed that such apolitical unionwillbenecessarytosustainthemonetaryunion inthelongrun(seeEuropean

Commission(1977)andDeGrauwe(1992)).Itisclear,however,thatthereisno

willingnessinEuropetodaytosignificantlyincreasethedegreeofpoliticalunion.

Thisunwillingnesstogointhedirectionofmorepoliticalunionwillcontinueto

maketheEurozoneafragileconstruction.

Thisdoesnotmean,however,thatoneshoulddespair.Wecanmoveforwardby

takingsmallsteps.Suchastrategyofsmallstepsnotonlyallowsustosolvethe

most immediate problems. It also signals the seriousness of European

policymakersinmovingforwardinthedirectionofmorepoliticalunion.

9.AStrategyofsmallsteps

Idistinguishbetweenthreestepsthateachrequiresinstitutionalchanges.Some

ofthesestepshavealreadybeentaken.Unfortunately,asIwillarguetheyhave

beenloadedwithfeaturesthatthreatentounderminetheireffectiveness

9.1:AEuropeanMonetaryFund

AnimportantstepwastakeninMay2010whentheEuropeanFinancialStability

Facility(EFSF)wasinstituted.Thelatterwillbetransformedintoapermanent

fund, the European StabilizationMechanism (ESM), whichwill obtain fundingfrom the participating countries and will provide loans to countries in

difficulties. Thus,aEuropeanMonetaryFundwill be inexistence, aswas first

proposedbyGrosandMaier(2010).

It is essential that the ESM take a more intelligent approach to lending to

distressedcountriesthantheEFSFhasbeendoinguptonow.Theinterestrate

appliedbytheEFSFintheIrishrescueprogramamountstoalmost6%.Thishigh

interestratehasa veryunfortunateeffect.First, bychargingthishigh interest


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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,theEFSFsignalstothemarketthatthereisasignificantriskof default, and thus that the Irish government maynot succeed in putting 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,sothateconomicgrowthgetsachance.Withouteconomicgrowthdebtburdenscannotdecline.Thecarrotisa

concessionalinterestratethatmakesiteasierforthecountryconcernedtostop

debtaccumulation.Alowinterestratealsoexpressestrustinthesuccessofthe

package;trustthatfinancialmarketsneedinordertoinducethemtobuythe

governmentdebt ata reasonable interestrate. Unfortunately, thefuture ESM

willapplyaninterestratethatis200basispointsaboveitsfundingrate.Thereis

nogoodreasonfortheESMtodothis.Byapplyingsuchariskpremium,theESMwillsignaltothemarketthatisdoesnottrulybelieveinthesuccessofitsown

lendingprogram.

ThereareotherfeaturesoftheESMthatwillundermineitscapacitytostabilize

thesovereignbondmarketsintheEurozone.From2013on,allmembersofthe

Eurozone will be obliged to introduce collective actions clauses when they

issuenewgovernmentbonds.Thepracticalimplicationofthisisthefollowing.

Wheninthefuture,agovernmentoftheEurozoneturnstotheESMtoobtain

funding,privatebondholdersmaybeaskedtoshareintherestructuringofthe

debt. Put differently, theymaybe asked to take some of 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

factwehavealreadyseen theeffects.WhentheGermangovernmentmadethe


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first proposal to introduce collective action clauses at the European Council

meetingofOctober2010,theimmediateeffectwastointensifythecrisisinthe

Eurozonesovereignbondmarkets.IshowevidenceforthisinFigure8,which

presentsthegovernmentbondspreadsofanumberofEurozonecountries.ItcanbeseenthatimmediatelyaftertheEuropeanCouncilmeetingofOctober28-29,

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.

Figure8

Source:Datastream

ThereactionofthemarketstotheannouncementoffutureCACsshouldnothave

beensurprising.Whenprivatebondholdersknowthatinthefuturetheirbonds

willautomaticallylosevaluewhenacountryturnstotheESM,theywillwantto

becompensatedfortheaddedriskwithahigherinterestrate.Inaddition,and

evenmoreimportantly,eachtimetheysuspectthatacountrymayturntothe

ESMforfundingtheywillimmediatelyselltheirbonds,soastoavoidapotential


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loss.Butthissellingactivitywillraisetheinterestrateonthesebonds,andwill

makeitmorelikelythatthegovernmentwillhavetoaskforsupportfromthe

ESM.

Thusthecollectiveactionclauseswillmakethegovernmentbondmarketsmorefragileandmoresensitivetospeculativefears.Iarguedearlierthatthesystemic

problemoftheEurozoneliesinthefactthatinamonetaryunionthenational

governmentsaremorevulnerabletoliquiditycrisestriggeredbymovementsin

confidenceinfinancialmarkets.Insteadofalleviatingthisproblemthecollective

action clauses will intensify it, because with each decline in confidence

bondholderswillrunforcovertoavoidlosses,therebytriggeringacrisis.

CACsdowngradethemembersofthemonetaryuniontothestatusofemerging

marketsforwhichtheseclauseswereinvented.Inawayitisquiteextraordinary

thattheEuropeanleadershavedesignedasolutiontothesystemicproblem

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

countriesofamonetaryunionarepushedintoabadequilibrium,theylosemuch

of their ability to apply the automatic stabilizers in the budget during a

recession.CountriesthatapplyforfinancingfromtheESMwillbesubjectedtoa

toughbudgetary austerityprogramasa condition for obtaining finance.Thus,

witheachrecession,whenanumberofEurozonecountriesmaybeforcedtoturn

totheESMtheywillbeobligedtofollowpro-cyclicalbudgetarypolicies, i.e.to

reducespendingandincreasetaxes.Asurewaytomaketherecessionworse.

Theanti-cyclicalityofgovernmentbudgets isanimportant achievement inthedevelopedworld. 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

forwards in the building of an integrated Europe (Peirce, Micossi,


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Carmassi(2011)). Unfortunately, by introducing all kinds of restrictions and

conditions,theESMhasbeentransformedintoaninstitutionthatisunlikelyto

producemorestabilityintheEurozone.

9.2:JointissueofEurobonds

A second step towards political union and thus towards strengthening the

EurozoneconsistsinthejointissueofEurobonds.AjointissueofEurobondsis

animportantmechanismofinternalizingtheexternalitiesintheEurozonethatI

identifiedearlier.

ByjointlyissuingEurobonds,theparticipatingcountriesbecomejointlyliableforthe debt they have issued together. This is a very visible and constraining

commitmentthatwillconvincethemarketsthatmembercountriesareserious

about the future of the euro (see Verhofstadt(2009), Juncker and

Tremonti(2010)). In addition, by pooling the issue of government bonds, the

member countriesprotect themselves against the destabilizing liquiditycrises

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


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inconceivablethatbyjoiningacommonbondmechanismthatwillincludeother

countriesenjoyinglessfavourablecreditratings,countrieslikeGermany,Finland

andtheNetherlandsmayactuallyhavetopayahigherinterestrateontheirdebt.

Theseobjectionsareserious.TheycanbeaddressedbyacarefuldesignofthecommonEurobondmechanism.ThedesignofthecommonEurobondsmustbe

such as to eliminate the moral hazard risk and must produce sufficient

attractiveness for the countries with favourable credit ratings. This can be

achievedbyworkingbothonthequantitiesandthepricingoftheEurobonds.

Thus,myproposalwould be toseek a combinationof theEurobondproposal

made byBruegel (Delpla andvonWeizscker(2010)and the onemade byDe

GrauweandMoesen(2009).Itwouldworkasfollows.Countrieswouldbeable

toparticipateinthejointEurobondissueupto60%oftheirGDP,thuscreating

bluebonds.Anythingabove60%wouldhavetobeissuedinthenationalbond

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 the

interest rate that countrieswould 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

probabilityofdefaultonthe junior tranchemayactuallyincrease. Thisshould

increase the incentive for countries to limit the red component of their bond

issues.

TheBruegelproposalcanbecriticizedonthefollowinggrounds.Totheextent

that theunderlying risk of the government bonds isunchanged, restructuring

thesebondsintodifferenttranchesdoesnotaffectitsrisk.Thus,ifthebluebond

carriesa lowerinterestrate,theredbondwillhaveahigherinterestratesuch

thattheaverageborrowingcostwillbeexactlythesameaswhenthereisonly

onetypeofbond(seeGros(2011)).ThisisanapplicationoftheModigliani-Miller

theorem which says that the value of a firm is unaffected by the way the

liabilitiesofthatfirmarestructured.


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All this is true to the extent that the underlying risk isunchanged. The point,

however, is that the common bond issue is an 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.Thisisexactlywhatonewantstohave:adeclineoftheaveragedebt

cost,andanincreaseinthemarginalcostofthedebt.Theformermakesiteasier

toservice thedebt;the latterprovidesstrong incentives towards reducing the

levelofthedebt.Thisfeatureisimportanttoreducethemoralhazardrisk.

ThesecondfeatureofourproposalworksonthepricingoftheEurobondsanditfollowstheproposalmadebyDeGrauweandMoesen(2009).Thisconsistsin

usingdifferentfeesforthecountriesparticipatinginthebluebondissue.These

feeswouldberelatedtothefiscalpositionoftheparticipatingcountries.Thus,

countries with high government debt levels would face a higher fee, and

countrieswith lowerdebtlevelswouldpaya lowerfee.Inpractical termsthis

meansthattheinterestratepaidbyeachcountryinthebluebondtranchewould

be different. Fiscally prudent 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.


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9.3: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 otherinstruments 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 to

European institutions. However, the willingness to take such a drastic step

towards politicalunion is completely absent. Here also small steps shouldbe

taken.

The European Commission has proposed a scoreboard of macroeconomic

variables(privateandpublicdebt,currentaccountimbalances,competitiveness

measures,houseprices)thatshouldbemonitored,andthatshouldbeusedto

pushcountriestowardsusingtheireconomicpolicyinstrumentssoastocreate

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.

LocalboomsandbubblesdevelopedintheperipheryoftheEurozone.These

weredrivenmainlybybankcreditexpansion.ThisisvividlyshowninFigure9.It

is the combination of bubbles (especially in the housing markets) and credit

expansion that makes bubbles potentially lethal (see Borio(2003)). This has

beenmadevaryclearbytheexperienceofSpainandIreland.

Thus,anypolicyaimedatstabilizinglocaleconomicactivitymustalsobeableto

control local credit creation. It is clear that because themember states of the

Eurozonehaveenteredamonetaryuniontheylacktheinstrumentstodealwith

this.Putdifferently,ifthemovementsofeconomicactivityaredrivenbycredit-


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fueledanimalspiritstheonlyinstrumentsthatcaneffectivelydealwiththisare

monetary instruments. Members of a monetary union, however, have

relinquishedtheseinstrumentstotheEuropeanmonetaryauthorities.

The next question then becomes: can the European monetary authorities, inparticulartheECB,helpoutnationalgovernments?Wehavebeentoldthatthisis

impossible because the ECB should only be concerned by system-wide

aggregates.Itcannotbemaderesponsiblefornationaleconomicconditions.The

reasonisthatithasoneobjectivewhichisthemaintenancesofpricestabilityin

theEurozoneasawhole,andbecauseithasonlyoneinstrumenttoachievethis

goal.

ThisIbelieveistoocheapananswer.TheECBisnotonlyresponsibleforprice

stabilitybutalsoforfinancialstability.Thefinancialcrisisthateruptedinthe

Eurozonein2010haditsorigininalimitednumberofcountries.Itistherefore

importantthattheECBfocusesnotonlyonsystem-wideaggregatesbutalsoon

what happens in individual countries. Excessive bank credit creation in a

numberofmembercountriesshouldalsoappearontheradarscreenoftheECB

inFrankfurtuponwhichtheECBshouldact.

Figure9

Source:Kannan,etal.(2009)


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One may object that the ECB does not have the instruments to deal with

excessive bank credit in parts of theEurozone. This, however, isnot so. The

Eurosystem has the technicalability to restrictbank credit in some countries

morethaninothersbyapplyingdifferentialminimumreserverequirements,orby imposing anti-cyclical capital ratios. These can and should be used as

stabilizinginstrumentsatthenationallevel.

Anotherobjectionisthatitistheresponsibilityofthefinancialsupervisorsto

dealwithexcessiverisktakingbybanks.Whenbanksextendtoomuchcredit

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 acredit-fueledboomemergesinsomememberstates,itisalsotheresponsibility

oftheEurosystemtoact.TheEurosystemalsohasthemostpowerfultoolkitin

controllingthemacroeconomicconsequencesofboomsandbusts.

TherecentreformsinthesupervisorylandscapeintheEurozoneincreasethe

scopeforactionbytheEurosystem.TheEuropeanSystemicRiskBoard(ESRB)

whichwascreatedin2010isofparticularimportancehere.Verypointedly,the

presidentoftheECBwillalsopresideovertheESRB.Thusthecreatorsofthe

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

Eurosystem are important tomove towards politicalunion. They also give an

important signal in the financial markets that the member countries of the

Eurozoneareserious intheirdesiretoguaranteethesurvivalof theEurozone.

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.


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10.Conclusion

Amonetaryunionismorethanonemoneyandonecentralbank.Countriesthat

joinamonetaryunionlosemorethananinstrumentofeconomicpolicy(interest

rate or exchange rate). When entering the monetary union, they lose theircapacitytoissuedebtinacurrencyoverwhichtheyhavefullcontrol.Asaresult,

alossofconfidenceofinvestorscaninaself-fulfillingwaydrivethecountryinto

default.Thisisnotsoforcountriescapableofissuingdebtintheirowncurrency.

In these countries the central bank can always provide the liquidity to the

sovereigntoavoiddefault.Thismayleadtofutureinflation,butitshieldsthe

sovereignfromadefaultforcedbythemarket.

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 increased

vulnerability.Thisisthatmember-countriesofamonetaryunionlosemuchof

their capacity to apply counter-cyclical budgetary policies. When during a

recessionthebudgetdeficitsincrease,thisriskscreatingalossofconfidenceof

investorsinthecapacityofthesovereigntoservicethedebt.Thishastheeffect

of raising the interest rate,making the recession worse, and leading to even

higherbudgetdeficits.Asaresult,countriesinamonetaryunioncanbeforced

into a bad equilibrium, characterized by deflation, high interest rates, high

budgetdeficitsandabankingcrisis.

These systemic featuresofamonetaryunionhave not sufficientlybeen taken

intoaccountinthenewdesignoftheeconomicgovernanceoftheEurozone.Too

muchof this new design has been influenced by the notion (based on moral

hazardthinking)thatwhenacountryexperiencesbudgetdeficitsandincreasing

debts,itshouldbepunishedbyhighinterestratesandtoughausterityprograms.

I have argued that this approach isusually not helpful in restoring budgetary

balance.

In addition, a number of features of the design of financial assistance in the

EurozoneasembodiedintheESM,willhavetheeffectofmakingcountrieseven

moresensitivetoshiftingmarketsentiments.Inparticular,thecollectiveaction


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clauseswhichwillbeimposedonthefutureissueofgovernmentdebtinthe

Eurozone, will increase the nervousness of financial markets. With each

recessiongovernmentbondholders,fearinghaircuts,willrunforcover,thereby

making a default crisismore likely. All this is likely to increase the risk thatcountriesin theEurozonelosetheircapacityto let theautomaticstabilizers in

thebudgetplaytheirnecessaryroleofstabilizingtheeconomy.

Amonetaryunion creates collective problems. When one government faces a

debtcrisisthisislikelytoleadtomajorfinancialrepercussionsinothermember

countries. This is so because a monetary union leads to intense financial

integration.Whether one likes it ornot,member countries are forced tohelp

each other out. Surely, it is important to provide the right incentives forgovernmentssoastoavoidprofligacythatcouldleadtoadebtcrisis.Discipline

bythethreatofpunishmentispartofsuchanincentivescheme.Ihaveargued,

however, that too much importance has been given to punishment and not

enoughtoassistanceinthenewdesignoffinancialassistanceintheEurozone.

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 vagaries of euphoria and fears that regularly grip

financialmarkets.

Amonetaryunioncanonlyfunctionifthereisacollectivemechanismofmutual

supportandcontrol. Suchacollectivemechanismexists ina politicalunion. In

the absence of a political union, the member countries of the Eurozone are

condemnedtofillinthenecessarypiecesofsuchacollectivemechanism.The

debtcrisishasmadeitpossibletofillinafewofthesepieces.Whathasbeen

achieved, however, is still far from sufficient to guarantee the survival of the

Eurozone.


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Adjustments,CEPSPolicyBrief,http://www.ceps.eu/book/european-experience-large-fiscal-adjustments

Arezki,R.,Candelon,B,andSy,A.,(2011),SovereignRatingNewsandFinancialMarketsSpillovers:EvidencefromtheEuropeanDebtCrisis,IMFWorkingPaper,11/69,March.

BorioC.,2003,TowardsaMacroprudentialFrameworkforFinancialSupervisionandRegulation?,BISWorkingPaper,n.128

BorioC.,2005,TheSearchfortheElusiveTwinGoalsofMonetaryandFinancialStability,NationalInstituteEconomicReview

Calvo,Guillermo(1988):ServicingthePublicDebt:TheRoleofExpectations,

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DeGrauwe,P.,andMoesen,W.,(2009),GainsforAll:AProposalforaCommonEurobond,Intereconomics,May/June

DeGrauwe,P.(2010),AMechanismofSelf-destructionoftheEurozone,CEPSPolicyBriefs,http://www.ceps.eu/book/mechanism-self-destruction-eurozone

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Brief,May.EC Commission (1977) Report of the Study Group on the Role of Public Finance in

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Eichengreen,B.,Hausmann,R.,Panizza,U.,(2005),ThePainofOriginalSin,inEichengreen,B.,andHausmann,R.,Otherpeoplesmoney:Debtdenominationandfinancialinstabilityinemergingmarketeconomies,ChicagoUniversityPress.

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short-termcreditors,CEPSCommentary,10November.

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Issing,O.,(2009),WhyacommonEurozonebondisntsuchagoodidea,Europes

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Kannan,K.,Rabanal,P.,andScott,A.,(2009),MacroeconomicPatternsandMonetaryPolicyintheRun-UptoAssetPriceBusts,IMFWorkingPaper,09,252

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APPENDIX:AMODELOFGOODANDBADEQUILIBRIA

InthissectionIpresentaverysimplemodelillustratinghowmultipleequilibria

canarise.Thestartingpointisthatthereisacostandabenefitofdefaultingon

thedebt,andthatinvestorstakethiscalculusofthesovereignintoaccount.Iwillassumethatthecountryinvolvedissubjecttoashock,whichtakestheformofa

decline ingovernmentrevenues.The lattermaybecausedbya recession,ora

lossofcompetitiveness.Illcallthisasolvencyshock.Thehigherthisshockthe

greater is the lossof solvency. I concentrate firston thebenefit side. This is

representedinFigureA1.OnthehorizontalaxisIshowthesolvencyshock.On

theverticalaxisIrepresentthebenefitofdefaulting.Therearemanywaysand

degreesofdefaulting.TosimplifyIassumethistakestheformofa haircutofafixedpercentage.Thebenefitofdefaultinginthiswayisthatthegovernmentcan

reducetheinterestburdenontheoutstandingdebt.Asaresult,afterthedefault

itwill have toapply less austerity, i.e. itwill have to reducespendingand/or

increase taxes by less than without the default. Since austerity is politically

costly,thegovernmentprofitsfromthedefault.

Amajorinsightofthemodelisthatthebenefitofadefaultdependsonwhether

thisdefault isexpectedornot.Ishowtwocurvesrepresenting thebenefitofa

default.BU is thebenefit of adefault that investorsdo notexpect to happen,

whileBEisthebenefitofadefaultthatinvestorsexpecttohappen.Letmefirst

concentrate on theBUcurve.Itisupwardslopingbecausewhenthesolvency

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.Thehigheristhislevel,thehigheristhebenefitofadefault.ThuswithahigherinitialdebtleveltheBUcurvewillrotateupwards.


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Theefficiencyofthetaxsystem.Inacountrywithaninefficienttaxsystem,thegovernment cannot easily increase taxation. Thus in such a country the

optionofdefaultingbecomesmoreattractive.TheBUcurverotatesupwards.

Thesizeoftheexternaldebt. Whenexternaldebttakesalargeproportionoftotal debt there will be less domestic political resistance against default,

makingthelattermoreattractive(theBUcurverotatesupwards).

FigureA1:Thebenefitsofdefaultafterasolvencyshock

B

Inowconcentrateonthe BEcurve.Thisshowsthebenefitofadefaultwhen

investors anticipate such a default. It is located above the BU curve for the

following reason. When investors expect a default, they will sell government

bonds.Asaresult,theinterestrateongovernmentbondsincreases.Thisraises

thegovernment budget deficit requiring amore intense austerityprogram of

spendingcutsandtaxhikes.Thus,defaultbecomesmoreattractive.Forevery

solvencyshock,thebenefitsofdefaultwillnowbehigherthantheywerewhen

thedefaultwasnotanticipated.

BU

Solvencyshock

BE


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Inowintroducethecostsideofthedefault.Thecostofadefaultarisesfromthe

factthat,whendefaulting,thegovernmentsuffersalossofreputation.Thisloss

ofreputationwillmakeitdifficultforthegovernmenttoborrowinthefuture.I

willmakethesimplifyingassumptionthatthisisafixedcost.InowobtainFigureA2whereIpresentthefixedcost(C)withthebenefitcurves.

FigureA2:Costandbenefitsofdefaultafterasolvencyshock

B

Inowhavethe toolstoanalyze theequilibriumofthemodel. Iwilldistinguish

betweenthreetypesofsolvencyshocks,asmallone,anintermediateone,anda

largeone.Takeasmallsolvencyshock:thisisashockSS2.(This

couldbetheshockexperiencedbyGreece).Foralltheselargeshocksweobservethatthecostofadefaultisalwayssmallerthanthebenefits(bothofanexpected

BUBE

C

S1 S2


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and an unexpected default). Thus the government will want to default. In a

rational expectations framework, investors will anticipate this. As a result, a

defaultisinevitable.

Inowturntotheintermediatecase:S1


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Thusweobtain twopossible equilibria, a bad one (D) that leads to default, a

good one (N ) that does not lead to default. Both are equally possible. The

selectionofoneofthesetwopointsonlydependsonwhatinvestorsexpect.Ifthe

latterexpectadefault,therewillbeone;iftheydonotexpectadefaulttherewillbenone.Thisremarkableresultisduetotheself-fulfillingnatureofexpectations.

Since there is a lot of uncertainty about the likelihood of default, and since

investorshaveverylittlescientificfoundationtocalculateprobabilitiesofdefault

(therehasbeennoneinWesternEuropeinthelast60years),expectationsare

likely to be driven mainly by market sentiments of optimism and pessimism.

Smallchangesinthesemarketsentimentscanleadtolargemovementsfromone

typeofequilibriumtoanother.

Thepossibilityofmultipleequilibriaisunlikely tooccurwhen thecountry isa

stand-alonecountry,i.e.whenitcanissuesovereigndebtinitsowncurrency.

Thismakesitpossibleforthecountrytoalwaysavoidoutrightdefaultbecause

thecentralbankcanbeforcedtoprovidealltheliquiditythatisnecessaryto

avoidsuchanoutcome.Thishastheeffectthatthereisonlyonebenefitcurve.In

thiscasethegovernmentcanstilldecidetodefault(ifthesolvencyshockislarge

enough). But the country cannot be forced to do so by the whim of market

expectations

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