The euro zone’s credibility took a significant beating in
the wake of the Greek debt crisis which began to spiral out of control a decade
ago. By 2012 it was clear that the monetary union project would have to be
reformed, with more emphasis on building internal shock absorbers if it was to
avoid the fate of previous attempts to create a union based on fixed exchange
rates. Despite all the warm words, however, little progress has been made to
create any form of fiscal union. Indeed, the efforts of Emmanuel Macron after
he assumed office in 2017 have fallen on deaf ears, particularly in Germany. We
now find ourselves faced with the deepest economic crisis since 2008 and arguably
the most severe social crisis since WW2 with a fiscal framework which is not
fit for purpose. This will be an existential test for the euro zone which
cannot afford a rerun of the events of the past decade.
One of the most contentious issues in European economics right now is the prospect of issuing coronabonds – a common debt instrument that will enable the hardest hit countries, such as Italy and Spain, to issue securities guaranteed by all euro zone nations, including Germany. It is, as one might imagine, a hard sell in Germany where the idea of debt mutualisation contravenes the spirit of what the German public thought they had signed up to when agreeing to a single currency (not that they were ever asked). We have been here before: It was a major topic of discussion in 2012 when the prospect of Eurobonds was floated – and rejected – as a solution to help out highly indebted euro members.
To understand today’s concerns we need to recall our history. Whilst it is true that a number of euro zone members were heavily indebted, they were financed by capital flows from surplus countries prior to 2008. But when the music stopped, their creditors decided no longer to play ball. This was understandable but we should not overlook the fact that the heavily-indebted southern nations were allowed to become members of EMU despite not fulfilling the excessive debt criterion. Their creditors actually gave them the keys to the kingdom only to throw them away a few years later. Part of the reason for this lax attitude was because in the late-1990s, the EU only paid lip service to sovereign debt issues. After all, it had been on a downward trend relative to GDP for the preceding 50 years. The real focus was on deficits. Yet when France and Germany continually flouted the 3% of GDP deficit threshold just after the turn of the millennium, they escaped without any fiscal sanctions. Then the bust came and governments started to worry about debt again. Greek anger at the way they were treated in the wake of the 2008 bust is not without foundation.
Today’s problems are different. The world faces a humanitarian crisis and nowhere is suffering more at the present time than Italy or Spain, where coronavirus-related deaths continue to rise. The measures required to curb the spread of the disease are expensive, entailing massive wage subsidies and potentially a nationalisation programme as states are forced to prop up large parts of the economy. Italian anger at Germany’s refusal to sanction coronabonds is thus understandable. But as Lorenzo Bini Smaghi, a former ECB Council member, pointed out whilst coronabonds are a great idea in theory, in practice they “entail a major political choice to transfer sovereignty, on a whole range of issues, from the national to the European level.” He has a point: If the euro zone is to act as guarantor for debt, it needs to be backed up by tax raising powers. As Bini Smaghi put it, “Eurobonds cannot be issued to finance current expenditure, unless such expenditure and the resources to cover it are brought under the responsibility of the EU.” Moreover, if we introduce such mutual bonds today, what is to stop countries from issuing them in future to finance pet projects backed by Germany’s excellent credit rating?
Instead, Bini Smaghi and large parts of the northern European establishment prefer the idea of using the European Stability Mechanism, established in 2012, to disburse the funds. Unfortunately, any funds disbursed by the ESM are conditional on an adjustment programme, whereby borrowers must agree to abide by a series of conditions. Some form of legal change would thus be required to make it acceptable to Italy because as it currently stands, the ESM has a stigma attached to it.
Whilst the arguments against coronabonds have a sound legal basis, this is not the time to be hiding behind the letter of the law. Something has to give, and the longer northern European EMU members drag their feet, the more pressure will build up inside the euro zone. And as I have pointed out before, Italy is not Greece – it has the largest sovereign bond market in the euro zone which is five times that of Greece, and it will not be so easy to intimidate. And if we do not get some form of common bond and Italy is forced to issue BTPs and significantly expand its debt-to-GDP ratio, it will certainly not accept a period of austerity after the crisis has passed, simply to placate those who believe its debt level is too high.
It may be stretching it too far to suggest that failure to act on this issue will precipitate a breakup of the single currency. But the bloc simply does not have the automatic stabilisers which are necessary to combat shocks in a fixed exchange rate system. And the longer this problem is ignored, the greater will be the problems in the longer term. As the German economic historian Albrecht Ritschl has pointed out “Germans prefer to let their history start with the zero hour of 1945“. But German historians know the price of failing to tackle deep-seated economic problems, particularly when it comes to debt.
One of the most contentious issues in European economics right now is the prospect of issuing coronabonds – a common debt instrument that will enable the hardest hit countries, such as Italy and Spain, to issue securities guaranteed by all euro zone nations, including Germany. It is, as one might imagine, a hard sell in Germany where the idea of debt mutualisation contravenes the spirit of what the German public thought they had signed up to when agreeing to a single currency (not that they were ever asked). We have been here before: It was a major topic of discussion in 2012 when the prospect of Eurobonds was floated – and rejected – as a solution to help out highly indebted euro members.
To understand today’s concerns we need to recall our history. Whilst it is true that a number of euro zone members were heavily indebted, they were financed by capital flows from surplus countries prior to 2008. But when the music stopped, their creditors decided no longer to play ball. This was understandable but we should not overlook the fact that the heavily-indebted southern nations were allowed to become members of EMU despite not fulfilling the excessive debt criterion. Their creditors actually gave them the keys to the kingdom only to throw them away a few years later. Part of the reason for this lax attitude was because in the late-1990s, the EU only paid lip service to sovereign debt issues. After all, it had been on a downward trend relative to GDP for the preceding 50 years. The real focus was on deficits. Yet when France and Germany continually flouted the 3% of GDP deficit threshold just after the turn of the millennium, they escaped without any fiscal sanctions. Then the bust came and governments started to worry about debt again. Greek anger at the way they were treated in the wake of the 2008 bust is not without foundation.
Today’s problems are different. The world faces a humanitarian crisis and nowhere is suffering more at the present time than Italy or Spain, where coronavirus-related deaths continue to rise. The measures required to curb the spread of the disease are expensive, entailing massive wage subsidies and potentially a nationalisation programme as states are forced to prop up large parts of the economy. Italian anger at Germany’s refusal to sanction coronabonds is thus understandable. But as Lorenzo Bini Smaghi, a former ECB Council member, pointed out whilst coronabonds are a great idea in theory, in practice they “entail a major political choice to transfer sovereignty, on a whole range of issues, from the national to the European level.” He has a point: If the euro zone is to act as guarantor for debt, it needs to be backed up by tax raising powers. As Bini Smaghi put it, “Eurobonds cannot be issued to finance current expenditure, unless such expenditure and the resources to cover it are brought under the responsibility of the EU.” Moreover, if we introduce such mutual bonds today, what is to stop countries from issuing them in future to finance pet projects backed by Germany’s excellent credit rating?
Instead, Bini Smaghi and large parts of the northern European establishment prefer the idea of using the European Stability Mechanism, established in 2012, to disburse the funds. Unfortunately, any funds disbursed by the ESM are conditional on an adjustment programme, whereby borrowers must agree to abide by a series of conditions. Some form of legal change would thus be required to make it acceptable to Italy because as it currently stands, the ESM has a stigma attached to it.
Whilst the arguments against coronabonds have a sound legal basis, this is not the time to be hiding behind the letter of the law. Something has to give, and the longer northern European EMU members drag their feet, the more pressure will build up inside the euro zone. And as I have pointed out before, Italy is not Greece – it has the largest sovereign bond market in the euro zone which is five times that of Greece, and it will not be so easy to intimidate. And if we do not get some form of common bond and Italy is forced to issue BTPs and significantly expand its debt-to-GDP ratio, it will certainly not accept a period of austerity after the crisis has passed, simply to placate those who believe its debt level is too high.
It may be stretching it too far to suggest that failure to act on this issue will precipitate a breakup of the single currency. But the bloc simply does not have the automatic stabilisers which are necessary to combat shocks in a fixed exchange rate system. And the longer this problem is ignored, the greater will be the problems in the longer term. As the German economic historian Albrecht Ritschl has pointed out “Germans prefer to let their history start with the zero hour of 1945“. But German historians know the price of failing to tackle deep-seated economic problems, particularly when it comes to debt.
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