We seem to be watching a delicate ballet. All of a sudden, Angela Merkel envisions fiscal discipline and ECB action. Soon after, Mario Draghi talks about sequencing – first fiscal discipline, then ECB action. For those of us who have been arguing for months that we need both together, this is music to our ears. But for all of us who have seen so often vague statements concealing an inability to understand what financial crises are, it is a bit early to cheer up.
Angela Merkel’s vision of fiscal discipline combines the authority to tell undisciplined countries what to do and enforce long periods of austerity in order to inject them with Germany’s cherished ‘culture of stability’. This will not work.
Enforcing fiscal discipline is indeed essential, both in the long run for the euro’s survival and in the short run for markets to start relaxing. But the problem is that the proposed model, reflected in the agreement between Germany and France overnight, is one of centralised enforcement. The Stability and Growth Pact has been a tragic failure, in part because it sought to apply top-down pressure on sovereign governments. Merkel is clinging to this approach, which is the German federal model, but even in Germany this model is not working too well (some lenders went bankrupt and had to be bailed out, and this may happen again). Moreover, the German chancellor wants significant transfers of sovereignty, which have dubious democratic appeal. Neither the Commission, which is volunteering for the job, nor the European Court of Justice, the preferred enforcer in the latest Merkozy proposal whose competence in judging excessive deficits is questionable, are obvious recipients of such fiscal authority.
This is why many countries will block the proposed Treaty revisions. The alternative of circumventing opposition by pushing through bilateral agreements among the willing is bound to be extraordinarily divisive.
This would be a pity because there is another option – decentralised discipline. This is a model that has worked well in the US. Each state has its own fiscal stability rule, backed by its own constitution and enforced by its own supreme court. Yes, I know, the state of California may default soon because it has cheated with its own rule and can’t find any more loopholes to keep the ball rolling. So what? Its debt amounts to 7 per cent of its GDP, so no one cares. The worst that can happen with a default is that Californian voters will ponder why they have elected inept representatives while reckless lenders will suffer losses. The system works because the debt is very small, so innocent bystanders will not be hurt.
I also know that the US has a large federal budget, which is used as an important counter-cyclical policy instrument, making up for state-level pro-cyclical implications of the rules (and piling up indebtedness). But this does not mean that the US model of decentralised fiscal discipline cannot be applied in the eurozone. It merely means that counter-cyclical policies can only be enacted at the national level, and that national fiscal policy rules must be subtler than US state rules. The Swiss debt brake formula, adopted by Germany as well, provides for counter-cyclical policies as it allows for temporary deficits in bad years, under the condition that they are eventually compensated for in good years.
While the view that countries must atone for past fiscal indiscipline may be acceptable to public opinion in some countries, others will see it as unnecessary self-inflicted pain. Yet, beyond collective preferences, no one denies that the current treatment of the crisis has created a serious moral hazard problem. This problem requires that incentives to respect the fiscal discipline be put in place eventually. There is no urgency, except that the moral hazard issue acts as a major roadblock for the ECB to intervene as lender of last resort. Incentives are an attractive alternative to collective memories of acute pain, which is politically dangerous, as Germans well know. This will require more thought than is currently given to the issue.
The ritual promise of strengthening the Stability and Growth Pact, in particular making sanctions heavier and more automatic, is deeply rooted in the centralised view. It is possible, however, to build solid incentives within a decentralised system. For instance, for its refinancing operations the ECB could only accept as collateral bonds issued by governments that rigorously operate a well-designed fiscal rule. The blue-red eurobond proposal is another, additional solution. Independent national and eurozone-level fiscal policy committees can also play a useful role. More ideas could be forthcoming. The point is that the policymaker mindset seems to remain stuck in the centralisation track, which requires further integration that may not pass the hurdle of increasingly eurosceptic public opinions.
A necessary condition for the crisis to come to an end is that all eurozone countries recover market access. In a world of multiple equilibria, debating whether a country is solvent is a vacuous exercise. Countries lose access because markets are scared, and once this has happened reverting to the ‘good’ equilibrium is unlikely. Current efforts to reassure markets with austerity measures are visibly failing because the markets correctly conclude that insufficient growth will undermine efforts at reducing deficits. Chances are that many countries will only recover market access after they have restructured their debts.
The second attempt at a voluntary private-sector-involvement scheme is bound to follow the fate of the previous one. Debt-restructuring arrangements negotiated by banks and their own governments on behalf of the other governments, those that lost market access, are highly unlikely to serve the interests of the latter. This is yet another version of the centralised view, which seeks to disempower hard-pressed governments. The decentralised alternative is that each government enters into direct negotiations with its creditors. In the absence of collective action clauses, the process is unlikely to be orderly, but it does not have to be disastrous either.
An important step was already taken in October when policymakers finally admitted their dark little secret that many eurozone banks are too weak to function. The numbers that have been floated since then show that, once again, policymakers are bent on solving yesterday’s problem, not tomorrow’s. Debt restructuring will hurt many banks – some of them may even fail. Proper policy planning should aim at restructuring banks sufficiently enough for them to be able to absorb the forthcoming blow or, in some cases, to take them over.
As with debt restructuring and bank recapitalisation, the ECB’s role as lender of last resort has been a taboo. Sporadic purchases of bonds have provided temporary relief, but the ECB’s own insistence that each intervention was exceptional has undermined longer-run effectiveness. The grand bargain underway may shatter that taboo.
There are two ways in which the ECB can intervene. The one that seems under consideration is large-scale bond purchases. Unfortunately, this is bound to lead to a huge increase in the ECB’s balance sheet and to major risk-taking by the central bank on behalf of the eurozone taxpayers. A more effective, and much less risky, approach is a partial guarantee of all eurozone public bonds. The beauty of a guarantee is that it is virtually costless if it is credible, and a central bank is infinitely credible when it guarantees a finite volume of assets, no matter how large it is. The guarantee must be partial for two reasons. First, the ECB must avoid bailing out the bondholders. Second, the guarantee should not stand in the way of debt restructuring.
For the first time since the eurozone crisis, governments and the ECB are focusing their attention on the necessary steps. This is not luck nor virtue; it is simply that all the wrong solutions that have already been tried have failed, many of them repeatedly. Now Europe’s leaders can start detailing the right course of action, but these details matter enormously. Hold your breath; we may be getting there.
This is an edited version of an article originally published on www.VoxEU.org. Reproduced with permission.