Making the Eurozone work better: sovereign default

Given the current problems in the Eurozone, it is understandable that many non-Eurozone economists remind us that they had doubts from the beginning. That, unfortunately, is not very helpful criticism, except in so far as it tells us how these problems were originally wished away. One lesson from the Greek tragedy is that voters' faith in the Euro project can survive even under tremendous strain. [1] The Euro was always a political project, and the political reasons for it have not gone away. For the governing elite of Europe this is likely to remain the case. So going backwards is not an option.

Yet while the people and the elite both want to keep the Euro, they part company when it comes to moving to a complete fiscal and political union: a United States of Europe. As Philippe Legrain notes, ever since the French and Dutch voted No, voter attitudes to further central control have hardened - and with good reason. If what he describes as the “Monnet method” (use any crisis to increase integration) continues, and as Andrew Watt points out it is continuing in a big way, the threat to the Eurozone could become existential. European policy makers have taken far too many liberties with democracy as it is: they should not take even more. Which is why I tend to get a little impatient with economists and institutions that spend a lot of time designed schemes for further substantial integration.

So the critical issue for now is whether the way the current union is run can be improved? I see three key unresolved areas here: sovereign default, competitiveness imbalances and the ECB. I talked about how to cope better with potential competitiveness imbalances recently. This post is about default.

I agree with Philippe Legrain that we need to have more decentralised fiscal control, and less rules from the centre. As I have noted before, there now exists in the Eurozone a system that is parallel to monitoring from Brussels, based instead on national fiscal councils. Can we design a system around that which negates any need for central control?

One way of making this work would be to deny any support to any EZ government that gets into trouble with the market. When the EZ was set up, its architects worried that market discipline would be too weak for this to work, so centralised controls were also necessary (the Stability and Growth Pact). In one sense they were right: the markets started treating Greek government debt as if it was German debt. But once a crisis happened they were wrong: governments with lower deficits than the UK were regarded as riskier by the markets.

What should now be clear is that the debt of member governments of a monetary union are subject to much greater rollover risk than equivalent countries outside the union because they do not control their own currency. That problem has been dealt with (for the moment) by OMT. But you cannot have OMT without conditions. For obvious reasons OMT cannot be a blank cheque to a monetary union member to run ever higher deficits.

So OMT has to be conditional, but who should set the conditions? Who decides that a future Greece has to default, but that a future Ireland should get the OMT guarantee without the need to default? At the moment the answer is both the other Eurozone governments and the ECB decide. But Eurozone governments have shown themselves to be hopeless at this task (see actual Greece), partly because they are subject to pressure from creditors. To leave this all to the unelected, unaccountable ECB is just asking for problems, and would represent too great a strain on ECB independence.

Let’s imagine the following. The Italian government at some time in the future finds that interest rates on its debt begin to rise well above average Eurozone levels. We get into a situation where a self-fulfilling default is possible. Should the ECB supply OMT cover to end that possibility or not? What conditions should be imposed on Italy as the price for that cover?

It would be nice if we could write down some simple rules (even complex rules) that could choose between a Greece and an Ireland. Fabian Lindner discusses some possibilities here. The major problem is that a great deal depends on something that embodies a political judgement: just how large will future primary surpluses be? Italy, because of its large debt, is used to running much larger primary surpluses than other countries. How do you judge what the upper limit is?

This is why ‘leaving it to the market’ is so attractive, because you appear to be asking a huge number of people to take a bet on the answer. But that method is flawed, because with rollover risk what they are actually taking a bet on is what they think other market participants think about rollover risk. OMT removes that rollover risk.

So if the market cannot do this, and the ECB and EZ governments should not do this, who is left? Do we set up a new institution of experts to decide and set conditions? (Conditions have to be set, because actions may change after OMT is granted.)

One obvious response is that we do not need a new institution, because we already have one, and it is called the IMF. It is imperfect, with at the moment too much influence from EZ governments on its decisions, but that means reforming the IMF rather than reinventing it. This may happen as a result of the Greek debacle. Philippe Legrain suggests using the IMF in a similar role here, although as a transitional measure while a new EZ institution is set up. However it is difficult to imagine EZ governments setting up a new institution that was truly independent of political pressure from member states.

The proposal would work like this. When Italy got into difficulties, it would go to the IMF. No EZ assistance would be allowed before this. The IMF would decide what level of default (if any) was required. The IMF, and not EZ governments, would set any conditionality thought necessary to return deficits to a sustainable level. That would include a path for deficits that the country could reasonably achieve without creating unnecessary unemployment. (If the country was uncompetitive, some unemployment would be inevitable.)

If Italy agreed to those conditions, then OMT would automatically be extended by the ECB. It is quite possible that in those circumstances Italy would regain market access at reasonable rates. If it did not, the IMF (and NOT other EZ governments) should provide the finance necessary to cover transitional deficits.

I suspect this scheme would not be attractive to many Eurozone policy makers, because they would be losing influence and control. But a better way to think about it is that the Eurozone contracts out (to the IMF) the tricky business of deciding whether a government’s debt is sustainable or not. That seems to me to be a small price to pay to avoid the kind of conflict between governments that became so clear in the recent Greek ‘negotiations’.

[1] Of the countries polled here, only two had more people thinking the euro had been bad rather than good for their country: Italy and Cyprus. See also Andrew Watt here.