The path to sustainable recovery for the Eurozone

Christopher Sims interviewed by Viv Davies, 12 October 2012

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Viv Davies: Hello and welcome to Vox Talks, a series of audio interviews with leading economists from around the world. I’m Viv Davies from the Centre for Economic Policy Research, it’s 21 September 2012 and I’m talking with Christopher Sims, Nobel laureate and professor of economics and banking at Princeton University. We met at a meeting of the Euro Area Business Cycle Network in Brussels, where Professor Sims presented his ideas on what he referred to as a least unlikely path to a sustainable EMU. I began the interview by asking Chris to explain what he described in his presentation as being the long-term direction on institutional restructuring that would be required to put the Eurozone on the path to a sustainable recovery.

Christopher Sims: If you look at objective measures of the fiscal situation in the US and Japan, or the UK for that matter, they look worse than such objective measures for the Eurozone as a whole or even for most of the southern-tier countries. Debt to GDP ratios and deficit to GDP ratios are in dangerous territory in Japan and the US. And yet neither of those countries, and the same is true of the UK, is paying anywhere near the premium for default risk that the southern-tier European countries are paying. My view is that that reflects institutional structure that’s common across the UK, Japan and the US that’s missing in the euro area. The other three countries all have a central bank that corresponds to a single treasury. The single treasury issues nominal debt, and it answers to a legislator that’s in a national legislature. This has several consequences: one is that the lender of last resort function is much firmer in the US, the UK and Japan because the lender of last resort has to be an institution with deep pockets that can lend and itself be subject to very little or no worry about default risk. So at a time when liquidity dries up because everybody begins to feel that every counterparty might have substantial default risk, a big institution that can come in and lend to people who are unable to get credit can resolve the situation.

This has happened historically many times. It used to be that sometimes large private banks that were large on a national scale could perform this function. But even a large private bank can be subject to default risk itself, so in a big enough crisis it can’t act. But a central bank that can, if necessary, be recapitalised by a legislature that issues nominal government debt, has essentially unlimited pockets. Its debt issue involves no commitment to provide anything except paper, so nobody will have doubts about whether it’s going to default on the debt it issues. Of course if the legislature and the treasury are in a position where they might run deficits forever, then the nominal debt can become worthless. It can get inflated away.

But that’s not the situation in Europe now. Europe is not having a crisis because people think it can never run primary surpluses again; it’s having a crisis because the southern tier countries have promised to pay not paper they can issue but euros that they can’t issue on their own, and there’s a real possibility that they may not be able to raise the euros that they have promised. That’s the issue. So in going in to the euro area, the EMU countries have given up on this possibility of having a national lender of last resort that’s as effective as those in the UK, the US and Japan. And the ECB, in its original formulation, was never supposed to be a lender of last resort. But in the crisis we’ve seen, Europe, like other advanced economies, needs a sound lender of last resort. And in order for that to happen there has to be some kind of institutional mechanism that reflects political consensus that there can be such a thing as a euro area-level fiscal commitment. There has to be a recognition be financial markets that at the level of the euro there can be decisions to pay returns on assets and to issue debt that is backed by euro area commitment. So far that hasn’t happened, because there’s so much concern in the euro area about one country or group of countries being ripped off by other countries or groups of countries in any arrangement that actually involves shared fiscal commitments.

At some length, that’s what I think is the fundamental problem in the euro area, that finding ways to construct institutions that convince markets that there is such a thing as a shared fiscal commitment at the euro level.

VD: So you’d be in favour of eurobonds, then?

CS: Yes, some form of eurobonds. You don’t want to think of all countries’ debts being made into eurobonds, and I don’t think you even have to have eurobonds being most of the European area debt. Countries ought to be mostly issuing debt that’s their own obligation. They should be able to default on that debt. Default premia on country debt should be possible. But you could have eurobonds since European-level government organisations don’t have very big budgets, so the eurobonds might come through an agency that bought sovereign debt from individual countries and used eurobond issue to finance that. Of course, such an agency would be making political decisions, and it would need careful consideration of what kind of democratic backing to give such an agency. But what we have now is, in emergency after emergency, the ECB is moving closer and closer to being such an agency itself, and that necessarily weakens its independence as a central bank. It becomes involved in essentially political decisions, and the structure of that institution is not that of an agency that’s making political decisions. It’s meant to be a central bank with a narrow objective, that mainly technical problem of keeping inflation stable. It’s not meant to be making controversial judgements about which countries’ debt should be supported in value because markets have an exaggerated idea of default risk, versus which countries’ debts actually are insolvent and need to be at least partially defaulted. But that’s what it’s having to do in the current situation.

VD: So you see that a natural progression, maybe, is towards a more federal Europe?

CS: Yes, though right now the analogy with the US is certainly incomplete. US state budgets are non-trivial relative to the federal government budget, but their debts are small relative to the federal government. Whereas in Europe the central government’s budget is tiny relative to the country governments, and some of the individual countries have debts that are a substantial fraction of EU GDP, whereas that’s not really true of US states. Nonetheless, I think a movement in the direction of a federal Europe – banking union, some form of eurobonds – are the only way to provide a stable euro monetary unit.

VD: You wrote somewhat of a prophetic paper in 1999, outlining the challenges that would face the EMU. Could you give us a little of an explanation of that?

CS: That paper was called “The precarious fiscal foundations of EMU”, and it was written from the perspective of the fiscal theory of the price level, which I worked on before. Most of the models in that strand of literature had worked with single-country models, but what you thought about EMU from the perspective of these models you saw two things. One is that, so long as there’s country debt or euro debt or equivalent, and the central bank was controlling the interest rate on government debt, there would be a free-rider problem. That a single country wouldn’t directly face any consequences form issuing steadily growing debt. And in effect what would happen if it did that would be that, if the price level remained stable, it would remain stable through other countries running steady surpluses that offset the steady deficits of the free-riding countries. I argued that that wouldn’t be sustainable, that there would be a necessity for some kind of fiscal discipline or control. This was assuming that the ECB did what it essentially did, which was to treat all kinds of sovereign debt of European countries as essentially equivalent in its monetary operations. At the beginning it managed to keep interest rates constant across countries, for all practical purposes. So the debts were equivalent, you would think of the ECB as controlling the interest rate on safe securities – safe securities were euro area government debt. But if it were going to do that there would have to be some kind of fiscal backstop, and I argued that what was in the Maastricht treaty, which were penalties for countries that violated these fixed limits on deficits, the debt-to-GDP ratio, were not credible. My view was then, and still is, that the way countries get in to a situation where they are violating these limits, is something really bad happens to their economy. It didn’t seem credible that something bad would happen to one country and the other countries would then say: “Okay, you have to pay a fine.” And in fact we’ve seen that this is exactly how it worked. That there were such penalties supposedly, but that the first countries to violate the limits were not penalised, because everybody could see that they had a good excuse.

My feeling is that attempting to create fiscal discipline without punishments is not going to work. And I think that as long as everyone’s issuing debt denominated in euros, there’s a common currency. One has to admit that there is a possibility of country-level default, and that it can occur without exit from the euro. And at the beginning of the crisis, the ECB was thinking of monetary policy in the traditional way and was thinking that there is no provision for default or for exit from the euro, so it had to act on the assumption that default was impossible. And that’s part of why we’ve got to the difficulty we have. There should be a eurobond, a common fiscal commitment, and at the same time an admission that country-level default is possible.

VD: That’s a great summary. Christopher Sims, thanks very much.

Topics:  Global crisis

Tags:  ECB, Eurozone crisis, eurobonds

Sims, Christopher (2012), "A least unlikely path to a sustainable EMU", presentation at the EABCN workshop in Brussels, 23 September.

Sims, Christopher (1999), "The precarious fiscal foundations of EMU"

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Professor of Economics and Banking at Princeton University


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