November 27, 2011
Euro Bonds
The Question of Eurobonds—Posner
Several countries that belong to the Eurozone and thus use the euro as their currency are in peril of defaulting on their sovereign debt. (In fact Greece is certain to default.) If they default it will probably alleviate their economic woes, because their sovereign debt will (in a total default) be wiped out. They may not even have to pay high interest rates to borrow more money, because with their existing debt wiped out their ability to pay interest on new debt will be greater. Nations have defaulted in the past without terrible consequences; and the deeper the economic hole a nation finds itself in, the less costly default is.
Still, these countries would prefer not to default. They would prefer to borrow at low interest rates. (Who wouldn't?) They want the European Central Bank to buy their sovereign debt with bonds issued by the bank, bonds that these countries would pay back at their leisure. Naturally the stronger countries of the EU, especially Germany, do not want to throw good money after bad by lending on generous terms to the PIIGS (as they are no longer called in respectable circles—now they are called GIIPS, an acronym that is not be pronounced with a soft g). Instead they want to secure these debts by persuading or coercing the PIIGS to slash their government spending, so that their revenues, diminished by the worldwide depression though they are, will cover their debt service and thus stave off default.
The PIIGS don't want to slash their spending, and for good reason; the standard recipe for combating depression is to increase government spending. If consumers are reluctant to consume, and as a result production and employment fall, and with it borrowing and hence interest rates, government can borrow cheaply from the private sector, and it can use the borrowed money to stimulate production and employment. That was Keynes's recipe for fighting unemployment, and it is a sensible recipe if the stimulus program is timely, well designed, and well executed. That's a big if, but it's unclear what alternative the PIIGS have. In the long run they could increase government revenues by a combination of tax reform, more aggressive tax collection, reduction of bureaucratic impediments to the formation and expansion of businesses, deregulation (especially of labor markets) and privatization, reduction of public employment, and shrinkage of entitlements programs. But such reforms would take years to bear fruit, and might be reversed at any time, and their short-term impact on the economies of these countries would probably be negative. The PIIGS, with the exception of Ireland, have very bad political cultures, and bondholders would be unlikely to trust the governments of these countries to make timely and effective reforms.
At present the European Central Bank and the wealthy northern European EU members are in a game of chicken with the PIIGS. The former want reform and the latter want handouts. Games of chicken can end badly. This one would not, were it not for the fact that all the countries involved share one currency. Indeed, were it not for the single currency there probably wouldn't be a game of chicken because, as Becker emphasizes, the single currency is preventing the PIIGS from devaluing, and devaluation is the standard solution to depression for a country that has a large external trade. By devaluing it reduces the prices of its exports, increasing demand, which in turn increases domestic employment because exports are domestically produced. At the same time, devaluation increases the price of the country's imports, which reduces the demand for imports but increases the demand for domestically produced goods and services, as they are substitutes for imported goods and services. (A complication is that imports include inputs into exports, and so an increase in import prices will offset to an extent the reduction in the price of exports brought about by devaluation.)
A common currency wouldn't be a problem if it were easy to change currencies, but it is very difficult, especially when the country wanting to change its currency is economically weak. Devaluation by definition reduces the value of a currency, so anticipating that abandoning the euro would result in its replacement (in Greece, say) by a devalued local currency (the drachma), Greek holders of euros would be quick to exchange them for dollars or yen. The rate of exchange would be disadvantageous to them, however, and so there would be a net money flow out of Greece, making the country's economic state even more desperate than it is. Moreover, the change in currency would affect not only sovereign debt, but all private contracts in euros as well, which would greatly impede the country's foreign trade. And setting up a new currency takes time and cannot be concealed, so as soon as the setting up began, the run on euros would begin.
What a mess! Which is why the wealthy eurozone countries are frightened by the prospect of some or all of the PIIGS dropping out of the eurozone and why therefore the PIIGS have some leverage in demanding handouts in exchange for promises (unlikely, in my opinion, to be fulfilled) of austerity and reform.
The Euro Crisis and Euro Bonds-Becker
After the financial crisis erupted in 2008, continental Europe on the whole appeared to be in better shape than the US. The main reason was that the big EU banks held smaller amounts of questionable mortgage-backed securities than did American (and British) banks. The housing markets in Germany, France, Italy, and most other member countries-Spain and Ireland are two exceptions- had not boomed as much as the American and British markets.
Unfortunately, the apparent more solid position of EU banks has turned out to be an illusion because these banks held large amounts of euro-denominated sovereign debt of Greece, Portugal, Italy, and other economically weak members of the EU. The presumption of EU banks in holdong so much sovereign debt of weak members was that the strong members would not allow defaults on any sovereign debts issued in Euros. This same presumption led the now bankrupt American fund, MF Global Holdings, to bet billions of dollars on the expectation that sovereign debt of all members of the euro-zone would be paid off in full.
This same expectation explains why initially the weaker "Mediterranean" countries were the most eager to join the euro bloc. They anticipated much lower interest costs on their sovereign debt because they expected the strong EU nations to provide a guarantee of their debt. These countries also expected that the Maastricht Treaty and other fiscal rules would prevent their governments from running up large deficits. At first, these expectations were met, as interest rates on the sovereign debt of weaker countries fell to levels not much above that of Germany's, the strongest member of the EU. The significant fiscal deficits of the weaker EU members did not seem important in a world with booming EU and world economies.
All these expectations crashed with the onset of the Great Recession, and the resulting decline in government revenues, and the retreat by banks and other investors from risky assets. As a result, interest rate spreads between sovereign debt of Germany and France and countries like Greece, Portugal, and Italy have soared, and some direct or indirect default on the sovereign debt of these weak countries seems highly likely- which is why they are being forced to pay higher interest rates on new debt.
What can be done now to prevent a catastrophe in the EU that would plunge Europe into another recession, and hurt badly the world economy as well? I opposed the formation of a common European currency because it did not allow weaker members enough levers to adjust to various idiosyncratic shocks they would inevitably face. This view has turned out to be correct, but a return to separate currencies in the middle of the crisis is likely to be highly disruptive.
At the opposite extreme of a break-up of the euro are proposals for some or all of the sovereign debts of individual member countries to be replaced by euro bonds guaranteed by the EU community as a whole (read mainly Germany and France). One recent idea advanced by Germany's Council of Economic Experts is to have joint liability for all euro-zone debt above 60% of a country's GDP, while each country would still have to manage payments on the rest of its debt. Even with high interest rates of 7% or more, weaker countries might be able to manage interest payments on debt equal to 60% of its GDP. Presumably, moreover, these interest rates will fall when the EU is guaranteeing a good portion of the total debt. The EU share of the debt would be paid off over a 25-year time period through tax revenues set aside for this purpose.
In the short run this is likely to reduce significantly the crisis. This is especially so if taxpayers in Germany and elsewhere do not rebel either at the additional taxes they will have to pay to fund the sovereign debts of weak members, or if banks get off lightly despite their risky investments in sovereign debt. In the longer run, this plan for euro bonds backed by joint liability of EU countries would require joint control over issue of debt above the 60% mark since that debt would be the obligation of all euro-zone countries. This would necessarily lead to some type of at least temporary fiscal union regarding sovereign debt issue.
Many have recognized that fiscal union is a necessary part of any long-term solution to maintaining the euro. The euro bond approach set out in the previous paragraph is an indirect way to achieve at least partial fiscal union. It will be helpful in the short run, but I doubt if fiscal union alone will preserve the euro in the long run. Weaker member nations will continue to be stressed by shocks to their economy and to their fiscal balance sheets, with many of these shocks not easy to anticipate in advance. The crisis helps demonstrate that a common currency makes adjustment to individual country shocks far more difficult than when countries can devalue their own currencies. This will continue to be a devastating weakness of the euro unless labor and product markets became much more flexible in the euro-zone, and unless labor mobility across member nations increases greatly.