HOW GERMANY COULD SAVE THE EURO
By John Muellbauer, Official Fellow, Nuffield College; Professor of Economics, Oxford University (Originally published at VOXEU)
For months economists have been arguing that Germany holds the key to ending the Eurozone crisis. Should it relax its anti-inflation stance and allow the ECB to inflate away sovereign debt? Or should it write a cheque of its own to the EFSF? Neither, says this column. There is a simple solution, if only Eurozone leaders can see it. Eurobonds are the answer – but with conditions.
Aided by market panic and confusion, it could be said that German toughness has transformed the reform prospects for Europe. Italy, Spain, and Greece now have credible, reform-committed governments. Ireland, bailed out under tough conditions, has cut its unit labour cost by 17% over 2 years and is showing growth. Portugal is strenuously reforming its public sector and labour markets. However, market panic has been costly for the European banking system and for short-run economic prospects.
All this would be a price worth paying, however, if Angela Merkel now completes the final stage of what would be seen as a remarkable moral, political, and economic triumph. A few years ago, a sleazy and ineffective Italian government could borrow on the markets at a cost scarcely higher than that of Germany. Last week, it cost the new Italian government over 6 percentage points more to borrow for two years than it cost the Germans. (see for example Manasse and Trigilia 2011). There is a way to put an instant stop to this absurdity without the European Central Bank and the European Stability Fund.
The German Ministry of Finance could offer a two-year loan to the Italian government at 3% above what it pays, and promise that next year, if the Italian reform programme is showing visible signs of success, the spread could fall to 2.5% and then to 2% if progress continues. With backsliding, the cost would rise. This solidarity gesture would be highly profitable for the German taxpayer. The conditionality of the offer would keep the new Italian government committed to reform, aiding Italy’s credibility as a Eurozone member. Conventional Eurobonds, meanwhile, with the same funding costs for every country but with risk collectively underwritten, would likely be a recipe for disaster. They would encourage lax fiscal policy, backsliding on reform, and moral hazard. But conditional lending as illustrated above could be institutionalised in conditional Eurobonds as explained in my CEPR Policy Insight 59 (Muellbauer 2011).
For the investor, conditional Eurobonds trade at the same price for all issuing countries, but the riskier countries pay a premium, or ‘spread’, to the safer countries for underwriting their common debt issuance. Conditional Eurobonds, with spreads linked to the ratios to GDP of government debt and deficits, were first proposed by Wim Boonstra, chief economist of Rabobank, even before monetary union (Boonstra 1991). Had they been part of Eurozone architecture, the current crisis could largely have been avoided, and even without fiscal centralisation.
Introducing conditional Eurobonds
Conditional Eurobonds would institutionalise, for all Eurozone countries, the simple example above of Germany lending to Italy. The conditional Eurobonds, issued on new borrowing, would be collectively underwritten by member governments of the Eurozone. Two design features would have to be settled: the formula that defines the spreads that each country has to pay into a central fund and the distribution of the payments resulting from the spreads to the guarantor governments. I argue that spreads should be determined by relative unit labour costs, and by relative government debt- and current account–to-GDP ratios. Including unit labour costs introduces incentives for improved competitiveness, promoting long-run economic growth.
The proceeds of the payments could be distributed in several ways. In the simple example of a bilateral loan from Germany to Italy, Germany would retain the entire spread. With multilateral underwriting, all Eurozone countries would receive shares of the payments into the central fund. The shares would be determined by the size of their own borrowings and their spreads relative to Germany. Per unit of borrowing, less risky countries such as France would receive more than riskier countries such as Belgium, but less than Germany itself. Boonstra recently suggested that part or all of the premium payments be retained in a central insurance fund against the possibility of a future debt writedown.
Clear as day
The new European Commission draft Green Paper on the feasibility of introducing ‘Stability Bonds’ does consider conditional Eurobonds with spreads. But by presenting this as just another option, the document fails to point out clearly enough that the difference between these and conventional Eurobonds is like the difference between day and night. A hugely important point about conditional Eurobonds with spreads is that they address the German fear about the Eurozone becoming ‘a transfer union’. The point is also not made clearly enough that this kind of bond, by creating the right fiscal incentives, allows a kind of fiscal decentralisation or subsidiarity, which addresses one of the key worries about democratic governance in the Eurozone.
The Green Paper’s discussion of previous literature does not give the credit to the Boonstra proposal that it deserves, particularly as his predates EMU. Though competitiveness is mentioned a few times, the document does not explain how incentives for improved competitiveness could be linked to Eurobonds, an important part of my own proposal.
The new 2011–12 report from the German Council of Economic Experts contains a chapter on the Euro crisis which proposes a kind of Stability Bond in the form of a ‘redemption fund’ subject to strict fiscal discipline. The idea is that sovereign debts exceeding the Stability and Growth Pact’s target of 60% of GDP would be pooled in a jointly guaranteed fund to be paid down over 20 to 25 years. Strict supervision, surveillance, country legislation to give priority for each country’s payments to service its debt, and penalties for noncompliance, it is hoped, would counter the moral hazard of cheap borrowing with joint liability. It would very likely require a renegotiation of EU treaties.
The German experts’ report expresses confidence that the German Constitutional Court would approve such a Eurobond. The following comment in the European Commission Green Paper raises a question on this score in footnote 14: “…the German Constitutional Court ruling of 7 September 2011 prohibits the German legislative body to establish a permanent mechanism, ‘which would result in an assumption of liability for other Member States’ voluntary decisions, especially if they have consequences whose impact is difficult to calculate’”. It also requires that in a system of intergovernmental governance, the parliament must remain in control of fundamental budget policy decisions. If the German experts’ confidence is well founded, it should presumably extend even more powerfully to conditional Eurobonds with spreads that reward the safer countries for assuming joint liability for new borrowing for all Eurozone countries, and which incentivise fiscal responsibility.
The ruling clearly would not prevent the temporary loan from Germany to Italy illustrated above. Such a loan could be quickly followed by setting up a Euro-treasury bill underwritten by all Eurozone countries but with a risk premium paid by the riskier countries to the safer ones.1 This stop-gap measure would buy time while the design of a more permanent conditional Eurobond is negotiated and passed through domestic political processes and through the German Constitutional Court.
Feedback on my own proposal has suggested possibly severe political obstacles2 to obtaining multilateral agreement on the spread-setting and distribution formulae needed to define conditional Eurobonds. These worries are exaggerated. Participation could be voluntary. As Boonstra (2011) points out, the AAA-rated countries could get together, agree the formulae, and issue Eurobonds. The other countries can then decide whether to accept the rules and be insured or try to borrow on their own.
Europe at a crossroads
Europe’s economic outlook could be rapidly transformed. A German bilateral loan offer to Italy, followed by the announcement that conditional Euro-treasury bills would follow shortly, and that consultations were beginning on conditional Eurobonds, could be made within days. The yields on Italian government bonds would drop, followed by those of Portugal and Spain. Share prices of European banks holding Italian bonds would rise, restoring their ability to lend. The ECB’s recent interventions in the Italian and Spanish bond markets would make a large profit. Speculators who have shorted sovereign debts of Italy and others could finds themselves skating on thin ice.
There is, however, an alternative. Germany could prove itself not to be a good European and instead clutch disaster from the jaws of victory over fiscal irresponsibility, unreformed labour markets, and corruption in the southern fringe of Europe. German inaction could trigger the most severe crisis since the collapse of Lehman Brothers.
References
Boonstra, Wim (1991), “The EMU and national autonomy on budget issues: an alternative to the Delors and free market approaches”, in R O’Brien and S Hewin (eds.), Finance and the international economy, Oxford University Press.
Boonstra, Wim (2004), “Proposals for a better Stability Pact”, Intereconomics.
Boonstra, Wim (2011), “Saving Emu”, Rabobank Working Paper 2011/2.
European Commission (2011), draft Green paper, ”Feasibility of introducing Stability Bonds”.
German Council of Economic Experts (2011), 2011-12 annual report, November.
Manasse, Paolo and Giulio Trigilia (2011) “Welcome to Eurotaly” VoxEU.org, 21 November.
Muellbauer, John (2011), “Resolving the Eurozone crisis: Time for conditional eurobonds”, CEPR Policy Insight 59, 12 October.
30 Comments
What about the risk? The value of the bond to Italy could collapse and that deteriorates the lending capacity(balance-position) of Germany and would drive rates higher for German lending
Yep, all roads in this ccy union lead to Germany … And we’re seeing the opening salvos as of this week. There is little doubt that the Tsy/Bund spread will continue to narrow (further negative) in my view.
Someone please explain to me:
- how a Eurobond is different to EFSF (other than the leverage aspect of the latter); and
- how current ECB purchases are nothing but a scaled down version of QE, the very idea that the ECB abhors
Either of the Eurobond or EFSF mean further significant financial pressure on Germany, through funding pressures and inhibited growth prospects which, in a currency union such as we now have, are self reinforcing. It is not odd at all to me that even European core members’ borrowing rates are under pressure in a negative growth scenario, but that countries such as the US, Australia and other ‘sovereign’ countries are seeing falling interest rates. Not enough people seem to have even noticed this to even ask the question.
The upshot of all this is that the GFC seems to have taught too may people precisely nothing. Up until the GFC the appreciation of the building blocks of finance and markets – ie. The short end of the yield curve, funding, fra/ois spreads, the true costs of doing business and so on – was almost nil. That is no longer the case, And these thing are no longer taken for granted. So in this sense a lesson has been learned. However, markets and academia have not applied this lesson to the current strains in markets and economies, which would be the true sign of having learned something – ie. The building blocks of monetary systems, how they truly operate, what the key differences are, what benefits and options are conferred by being truly sovereign and so on, are not finely enough appreciated. And we are now where we are…..
The problem with this proposal is that Germany does not issue currency – so it’s not a credible lender of last resort.
Same goes for China or the U.S.
The ECB is key.
Mr Muellbauer wrote: “German inaction could trigger the most severe crisis since the collapse of Lehman Brothers.”
German inaction … LOL … it is the responsibility of the southern european countries to operate in a condition that they are not a danger to the world economy. They must behave in a responsible fashion, if they voluntarily participate in EMU. Thats all.
BTW: Today Italy sold 6m Papers for 6.504 % compared to 3.535 a month ago. But in 1997 Italy had higher yields. Was this the apocalypse back in 1997? No!
So forget the fear mongerers like Muellbauer, Krugman, ….
You forgot MMT 101: in 1997 Italy still had its own currency.
This is a gold standard 7% which is self-fulfilling and leads straight to default in February – or toEurobonds.
It’s German’s decision which one will happen.
@Italys own currency: Good point
However I think that Italy will muddle through with 6 and 3 m Papers until Bernanke starts to ease and the liquidity stress is over. These guys are clever and experienced in muddling through crises. Don’t underestimate them.
Eurobonds are IMHO of no help, since EFSF-bonds are already sour. EFSF-bonds are guaranteed by the healthy nations while Eurobonds also contain exposure to Ireland, Portugal and Greece.
BTW: I am not an adcocate of MMT. I find just some ideas on this forum interesting.
You might want to educate yourself about MMT: Cullen’s primer is a good starting point.
Once you do that you’ll be able to counter many of your own arguments you have posted previously.
I predict this is the last we see of Dr Strebel. Few of these condescending, know it all detractors stick around when they realize MMT is actually correct. Some inconvenient facts are best ignored when they don’t fit your worldview.
I would happily swallow my words if he is open minded enough to actually understand MMT.
The simplest and most obvious way for Germany to save the Euro is to leave it. Indeed the other 26 countries should demand that it does so since its economy is completely incompatible with Euro stability. At present, fear of any country leaving is causing capital flight from perceived weaker countries, crowding into bunds, triggering a liquidity crisis. Who will buy an Italian bond if it might turn into a lira bond? As we found with ERM, no interest rate differential is going to compensate for a 25% depreciation. The end game of this is that the German Cuckoo kicks all other siblings out of the Euro nest as it imposes austerity and currency appreciation (the more DM like Europe becomes the higher the Euro goes)on countries already in recession. Turn it on its head now, and kick Germany out.
Germany is directly comparable with China, it rebuilt its economy by attatching itself at an ultracompetitive exchange rate to a consumer bloc, then recylced its current account surplus through the bond markets of its customers to create a consumption boom that fed back into its export sectors. It is a mercantilist currency manipulator just like China and needs to float its equivalent of the RMB.
In practical terms, Eurozone banks would get an immediate benefit on their holdings of bunds (then switch back into higher yielding “domestic” bonds), the competitiveness position would improve dramatically as the new DM floated up (encouraging recycling of German capital through Eurozone goods markets)and there would be no need for any haircuts. The liquidity crisis would dissappate and europe could easily self fund. The solvency issues of Greece, Eurobonds etc have not gone away, but Germany can influence them the same way the UK does; in Europe but not the Euro, only now retaining control of its own currency and being able to monetise (or not) via the Bundesbank. The ECB could then also move to a form of collective fiat currency without the German veto which would restore all European Bonds to proper Sovereign Debt status. No default in nominal terms at least.
The losers would be German Banks whose assets would depreciate (but most non German Debt is written down already (or should be) and German Exporters. But even this is not clear cut; VW makes a lot of cars in Portugal for example so would benefit from a massive drop in input costs.Also, Chinese exporters would struggle with a weaker Euro. The winners would be pretty much everyone else.
I would favor a helicopter drop style stimulus by the ECB, bypassing the governments…
Agree. And drop an equal amount on German savers so they can’t complain.
The debt can be eliminated without disadvantaging savers by simply increasing the balances of the entire population equally. Debtors pay off their debt and savers have a big chunk of new cash to honestly lend. Steve Keen has suggested this recently in http://www.guardian.co.uk/business/economics-blog/2011/nov/20/recession-sovereign-private-debt-recovery
And if it was desired that the general bailout be non-inflationary then further credit creation could be banned and the bailout metered to just replace existing credit as it is paid off.
Yes, if they drop they drop on everyone so no one can complain. This would also pressure those governments against ECB intervention into explaining why they disfavor their citizens getting some cash to spend (around the holidays).
Oh no they will still complain. The blood suckers truly believe they are more deserving than the feckless, jobless, unwashed masses. They will demand and get the lions share of any helicopter drop.
One banker lover I spared with was against a general bailout because the “prudent lenders” would do no better than the “imprudent lenders” since the loans of the “prudent lenders” are already performing.
His concern was with the villains, the banks, not the victims, the general population!
So if I understand this correctly, offer the Germans conditionality instead of collateral. I don’t think so. It seems like most solutions require Germany to take one for the team because everyone wants the team to continue. And most solutions require the Germans to lighten up on fiscal restraint… a trait that has served them well. If only the Germans weren’t Germans.
i disagree with much of this article, but at least it is an interesting idea
In California when a night club with lax security allows underaged children to consume alcohol at levels above legal limits. When that child crashes the family auto and often as these things do may harm or kill others we find it is not the child who bears the responsibility.
The parents and authorities of the child have legal recourse against the establishment.
Germany sure is teaching those children how irresponsible there alcohal consumption was they profited from.
In worrying about Weimar merkel forgot about Weiner. She may protect her face but she can’t save her ass .
The only way to save the euro is fiscal union to go along with monetary union. Germany decided to live in the same house as Italy, Portugal, and Greece.
You can draw lines on the floor like Les Nessman did at WKRP (i.e. conditional eurobonds, or a leveraged EFSF, or whatever crazy idea ivory tower academics can dream up trying to deny the reality of the situation), but they are not real walls.
How about a ‘fix’ for our economy:
http://press.princeton.edu/blog/category/books/the-darwin-economy/
The politics of this idea won’t work. How long will Italian politicians put up with Germany telling them what to do before some nationalist gets elected by telling the Germans to go pound sand. Even if it is not in their best interest voters will listen to politicians telling them that the problem is the other guy’s fault.
What if the spread between German and Italian bonds wasn’t closed by Italian yields falling, but by German yields rising? The cost to Italy remains the same, but the cost to Germany rises. Helping whom?
With peripheral countries paying a spread over Bund yields and Germany retaining the spread, would this not lead to the enrichment of Germany at the expense of the periphery? If I were in Greece, I wouldn’t be too happy about this idea.
What if the Eurobonds were priced at a yield of 7%?
This will definitely lead to an increase in German borrowing costs, which they don’t want. Germany want the periphery to take their deflationary medicine and live with it. The periphery want Germany to be a bit more profligate and a bit less competitive. One of these solutions will be enacted, they each have respective winners and losers. Currently looking like deflation in the periphery.
Changes in market yield don’t make a difference when the bonds are held to maturity, especially since the government doesn’t follow the same accounting rules as a private company would so there is no mark-to-market or things like that.
Apart from the countless legal and constitutional constraints which, fortunately, prevent your proposal from realization: did you do the maths on the amounts?
I mean, if the GIPSIFs need to roll over say 1 trillion Euro a year, who exactly is supposed to lent such mountains of money to Germany? Knowing that Germany would then forward most of it with a premium to sub-borrowers? This would immediately drive the yield on Bunds sky high, so the absolute interest rate for the sub-borrowers would as well explode. So, nothing would be gained – quite the contrary. Ah, and if the GIPSIFs then say, hey, Germany, thanks for all the fish, but now we leave the Eurozone / we default, you won’t get your money back?
This construction sounds, pardon my french, at least as mad as the structured ‘financial innovations’ which caused the whole mess the world is in.
Besides, it is not the task of a country to aggregate the debts of other countries.
You economist professionals should start to develop a way to fight the desaster which does not come down to the unintelligent bottomline ‘let the Germans pay’. No matter how elegantly hidden this bottomline is. Won’t work.
And ‘more of the same’, means more and more debt, won’t work generally for very much longer, no matter which source is tapped.
Ah, one commentator saw through the ruse. Again, a proposal that assumes everybody plays nicely and does not step out the rules. People are living in cloud cookoo land if you think things like this will work.
I don’t even understand why people discuss these things. Germany invaded most of the countries being discussed here in WW2. Do you really think these countries are looking to be invaded again….?
Well the German Banks so far have been gullible enough to believe that everybody plays fair. That’s why they bought all that American subprime CDO crap.
Test.
The main point to note here is that the three policies that make up the Modest Proposal address the concerns of both polarised camps: the one represented here by Herr Issing and the other expressed through Professor Straubhaar’s article. The former can rest assured that, when the ECB starts issuing its own bonds, the surplus countries’ interest rates will not be affected in the slightest (just like they were not when the European Investment Bank started issuing its own bonds); there will be no moral hazard problem necessitating the institutionalised loss of national autonomy (since the ECB-eurobonds will not finance debts over and above the Maastricht limit); and, lastly, the EFSF will not drag them down ( the way it is currently doing ). As for the other, pro-fiscal union, camp, the Modest Proposal gives them all they need while liberating them from the disadvantages of a fiscal union: A homogenisation of the Maastricht-compliant debt, the end of the euro’s unravelling, a pan-European New Deal-like investment-led Recovery Program and a future for the ideal of a United Europe.
All this convoluted ‘expert’ analysis serves only to obscure and confound; surely it is as obvious and simple as this- cyclic borrowing is RIDICULOUS. Trying to pay off a credit card by getting another, at ever-higher interest rates is self-defeating and must end in bankruptcy.
Seems to me that the sacred doctrine of growth underlies all these issues- David Suzuki rightly points out that “Endless growth cannot be sustained in a world with finite resources” (not an exact quote)
I cannot see how economists can provide the solution when their theories have created the problem.
Before anyone points out the obvious… yes, I am a naive non-expert!