When the fathers of the euro devised the common currency, they endowed it with a set of rules to buttress its credentials as a new global hard currency. According to the so-called Stability and Growth Pact, no member country was henceforth allowed to have budget deficits exceeding 3% of GDP, nor have public debt above 60% of GDP. In addition, a no-bailout clause was introduced to instil further discipline (Official Journal of the European Union 1997). With safeguards like that, what could possibly go wrong?
Well, if lack of enforcement makes the rules toothless and therefore less credible, quite a bit can go wrong. Until 2010, there were 97 (country/year) cases of deficits exceeding 3% (Figure 1). Fully two-thirds of such breaches were not justified by the occurrence of a significantly large domestic recession, the only condition that would have allowed them, so sanctions could and should have been imposed.1
That never happened. Member states were ready to “reinterpret and redefine” the Pact to oblivion. Debts and deficits grew unhindered, helped by the near-convergence of interest rates ushered in by the euro across all the member countries (Figure 2).
Figure 1. Member states with excessive deficits
Figure 2. Interest rates for 10-year government bonds
The global financial crisis, however, shook markets out of their complacency. And markets are less forgiving. When some Eurozone countries’ credit ratings began sliding down the alphabet, they took notice and started to demand much higher interest premiums. That put an abrupt end to careless lending and borrowing, but also brought about a serious crisis of the euro.
New proposal from the European Economic Advisory Group
In our latest report as part of the European Economic Advisory Group at CESifo, we argue that in order to keep check on the European countries, an effective economic governance system should not try to circumvent the market but instead should use its disciplinary force in a way that allows for a fine-tuning of the necessary checks to excessive public borrowing (EEAG 2011). This system must strike a balance between: on the one hand, providing a limited degree of protection to investors buying government bonds as well as useful support for troubled countries and, on the other hand, taking care of not turning into a full-coverage system for lenders or borrowers free of any deductibles.
We propose a three-stage crisis mechanism that is based on the EU countries’ decisions of December 20102, in particular the establishment of a European Stability Mechanism (ESM), specifying in detail how these decisions should be implemented. The new mechanism distinguishes between illiquidity, impending insolvency, and insolvency, placing most emphasis on the second of these concepts, because it acts as a “breakwater” barrier aimed at forestalling a full insolvency.3
- First, if a country cannot service its debt, a mere liquidity crisis will be assumed, i.e. a temporary difficulty due to a surge of scepticism in markets that will soon be overcome. The ESM would help to overcome the liquidity crisis by providing short-term loans, senior to private debt, for a maximum of two years in succession, a time span long enough for the country to raise its taxes or cut its expenditures so as to convince private creditors to resume lending.
- Second, if the payment difficulties persist after the two-year period, an impending insolvency is to be assumed. Collective Action Clauses, which must form part of all government bond contracts, will ensure that a country can choose a piecemeal approach when trying to find an agreement with its creditors, dealing with one maturity of bonds at a time without holders of other maturities having the right to also put their claims on the table.4 The negotiating country then would offer the creditors whose claims become due so-called replacement bonds, guaranteed by the ESM up to 80%, only under the condition that they accept a haircut, sized on the basis of the discounts already priced in by investors during the previous three months, but of at least 20% and at most 50%.5 The haircut will see to it that the banks and other owners of government bonds bear part of the risk of their investments. The fact that the haircut will be limited to the size of such discounts will help stabilise the markets.6
- Third, should the country be unable to service the replacement bonds and need to draw on the guarantees from the ESM, full insolvency must be declared for the entire outstanding government debt. A collective debt moratorium covering all outstanding government bonds would have to be sought between the insolvent country and its creditors.
The Collective Action Clauses bonds, backed by partially guaranteed replacement bonds, provide a possibility for troubled European countries to address their financing needs immediately. As these bonds define and limit the risk to investors, they provide a key instrument for countries to raise money from the market without having to resort to the funds of the ESM. For instance, issuing these bonds makes it possible for these countries to repurchase debt at today’s discounted market values, with the goal of significantly reducing their debt-to-GDP ratios.
The key prerequisite for maintaining market discipline is the sequencing and relative size of the haircut and government aid in the case of an impending insolvency. Before financial aid in the form of guaranteed replacement bonds may be granted, the creditors must initially offer a partial waiver of their claims. Only this order of events – with defined maximum losses for the investors – can guarantee that the creditors apply caution when granting loans, demanding suitable interest premiums. The interest premiums are an indispensable disciplinary device of markets that places an incentive for over-indebted countries to reduce their demand for credit.
Never again should a crisis mechanism be instituted in Europe that eliminates interest spreads, as happened in the first years of the euro. In particular, under no circumstances should the Eurozone move to Eurobonds as advocated by some European politicians and commentators. We can only warn that issuing such bonds will exacerbate the problems we see at the root of the crisis. Eurobonds will do nothing but strengthen incentives for opportunistic behaviour on the part of debtors and creditors, given that they prevent the emergence of fundamental risk premiums, by acting as full-coverage insurance against insolvency. Indeed, the former chief economist of the ECB, Otmar Issing, has called the idea that comprehensive insurance packages would increase the stability of the Eurozone “truly grotesque”. The same applies to debt repurchase programmes financed by the ESM, which are about the same as Eurobonds.
Appropriate pricing of sovereign risk is an essential feature of well-functioning financial markets. It induces debtors and creditors to keep capital flows within reasonable limits and to exercise caution in lending. This is the essential prerequisite for correcting European trade imbalances in future.
This column is based on EEAG (2011), The EEAG Report on the European Economy, “A New Crisis Mechanism for the Euro Area”, CESifo, Munich 2011, pp. 71–96 (http://www.cesifo.org/eeag). The EEAG members participate on a personal basis and do not represent the views of the organisations they are affiliated with.
Consolidated Version of the Treaty on the Functioning of the European Union (TFEU), Official Journal of the European Union C 115/99, 09/05/2008.
Council Regulation (EC) No 1467/97 of 7 July 1997 on speeding up and clarifying the implementation of the excessive deficit procedure, Official Journal of the European Union L 209, 02/08/1997.
Council Regulation (EC) No 1056/2005 of 27 June 2005 amending Regulation (EC) No 1467/97, Official Journal of the European Union L 174, 27/06/2005.
European Council (2010), Conclusions, EUCO 30/10, CO EUR 21, CONCL 5, Brussels, 17 December.
EEAG (2011), “A New Crisis Mechanism for the Euro Area”, The EEAG Report on the European Economy, CESifo, Munich, 71-96.
Issing, O (2010), “Die Europäische Währungsunion am Scheideweg”, Frankfurter Allgemeine Zeitung, 29 January.
Resolution of the European Council on the Stability and Growth Pact, Amsterdam, 17 June 1997, Official Journal of the European Union C 236, 02/08/1997.
Sinn, H-W, T Buchen, and T Wollmershäuser (2010), Trade Imbalances: Causes, Consequences and Policy Measures, Statement for the G20, Palais-Royale Initiative, CESifo, Munich, December, forthcoming in CESifo Forum.
Sinn, H-W and K Carstensen (2010), “Ein Krisenmechanismus für die Eurozone”, ifo Schnelldienst, Special Issue, November.
1 Resolution of the European Council on the Stability and Growth Pact (1997), pp. 1–2. Only during a severe recession or if the deficit is caused by unusual events outside its own control is a country allowed to increase its debt by more than 3% of GDP (Council Regulation (EC) No. 1467/97 of 7 July 1997, Article 2).
2 See European Council, Conclusions, EUCO 30/10, CO EUR 21, CONCL 5.
3 In doing this, the authors make use of a proposal by Sinn and Carstensen (2010), extended in Sinn et al. (2010).
4 In general, CACs can only be included in newly issued bonds. For this reason, a diminishing percentage of the bonds in the market over time will have non-CAC status.
5 For smaller discounts on the market value, the crisis mechanism might not be activated anyway.
6 With a ten-year bond, an interest premium of 4.8% over a market rate of 5% would be enough to fully compensate for an overall loss of 60% of the asset’s nominal value.