The Solution to the Euro Zone Debt Crisis
by Dennis J. Snower, President of the Kiel Institute for the World Economy, President of the GES
Greece. Ireland. Portugal. Spain. Cyprus. And now Slovenia? The euro zone debt crisis remains unsolved. A solution to that crisis could be quite easy though. To discover the solution, we need to understand that the crisis has been generated by five interlocking problems:
(1) Fiscal profligacy and rising national debt: Some governments have spent much more than their tax revenues over many years. Thus national debt soared.
(2) Shaky banks that are too big to fail: These banks have taken risks that have gone wrong, but since they are too big to fail, governments have assumed their debts, thereby causing the national debt to explode.
(3) Panic and self-fulfilling prophecy: When financial markets doubt that vulnerable countries can repay their debts, the holders of these countries’ bonds demand higher interest rates to compensate them for the risk of default. The higher interest rates makes it more difficult for the countries to repay their debt. No country that has substantial national debt to be recapitalized is immune from such self-fulfilling prophecy. Furthermore, there is the risk of financial contagion, since the countries are financial interdependent.
(4) Fiscal austerity and the debt trap: In return for bailouts, the most vulnerable countries were forced to slash government expenditures and raise taxes. The aim was to reduce their debt. But this policy failed because it deepened their recessions, which lowered tax receipts and raised government transfers. So these countries fell into the debt trap: their debts grew while their ability to repay them shrank.
(5) Fiscal autonomy and weak European identity: The crisis could be overcome if all euro area countries combined their budgets and centralized their budgetary decisions. This would require large, long-term, open-ended fiscal transfers from creditor countries (like Germany) to debtors (like Greece). But popular consent for such transfers is lacking. The creditor countries’ populations are unwilling to support the debtors, since their common European identity is not sufficiently strong. If governments conducted such transfers anyway, voters would revolt and thereby put European integration in jeopardy.
Thus far, the euro crisis has remained unresolved since politicians have failed to tackle all five of these problems. The euro area is like a hospitalized patient, surrounded by doctors. The patient has several interrelated diseases, and each doctor proposes a treatment for a different disease. No treatment on its own can be successful, however, and the doctors are talking past one another.
Having identified the problems underlying the crisis, it is not difficult to identify a solution. It runs like this: Each euro area government that wishes to have access to the euro rescue package should be required to fulfill three requirements:
Formulate a fiscal rule: This rule must specify (1) the country’s long-run debt ratio (the ratio of national debt to national product), (2) the fiscal convergence rate (the average rate at which this debt ratio is to be approached and (3) the degree of fiscal counter-cyclicality (how much fiscal stimulus the economy should receive in a recession and, correspondingly, how much fiscal contraction it should get in a boom).
Pass a constitutional amendment ensuring that the rule is implemented: The constitutional amendment sets limits on the government deficit or surplus in each phase of the business cycle. These limits ensure that the country’s long-run national debt remains below 60 percent of GDP, as specified by the European Stability and Growth Pact. The constitutional limits will also ensure that the country will approach this long-run debt ratio in accordance with the government’s specified fiscal convergence rate and its desired degree of fiscal counter-cyclicality. For this purpose, country’s business cycle needs to be estimated; this should be done by a independent experts.
Solvency criteria and central bank lending: The European Central Bank (ECB) must develop clear, transparent and public criteria for evaluating whether a country is solvent. Solvent countries are the ones that can implement their fiscal rules while pursuing positive long-term growth per capita. The ECB has a mandate to lend to such countries when they encounter temporary liquidity problems. An insolvent country would follow a specified default procedure, whereby the country’s bondholders would accept a haircut on repayments. Commercial banks must be required to cover their debts at market rates – rather than the currently practice of borrowing at artificially low rates from central banks, who borrow do the same from the ECB.
The strengths of this plan are straightforward. Since each government formulates its own fiscal rule and passes its own constitutional amendment, it retains fiscal sovereignty. The fiscal rule eliminates the possibility of fiscal profligacy, thereby reassuring financial markets and preventing panic. Since the fiscal rule permits countercyclical fiscal policy, countries no longer fall into the debt trap. Insolvent countries are no longer financially contagious, since the reputations of the other countries are protected through their fiscal rules. Commercial banks would be required to pay for the costs of their risks. ECB lending in times of crisis is then no longer problematic, since solvent countries are able to service their debt. Thus the ECB could remain credibly committed to its objective of keeping inflation under 2 percent.
Overcoming the euro crisis is not difficult. All that is required is the political will to deal with the actual problems underlying the crisis. Let’s hope that Europe’s politicians are up to it.