Any solution to the euro crisis must meet two objectives.  One is short run and the other is long run.  Unfortunately they tend to conflict.

The first necessary objective is to put Greece, Portugal, and other troubled countries back on a sustainable debt path, defined as a long-term trajectory where the ratio of debt to GDP is declining rather than rising.  Austerity won’t restore debt sustainability.  It has raised debt/GDP ratios, not lowered them.   A write-down would do it.  New bigger bail-outs might too, or might not.  But either write-downs or bailouts would then create moral hazard and thus make even it even harder to satisfy the second necessary objective.

That second objective is to reform the system so as to make it less likely that similar debt crises will recur anew in the future.   Fiscal rectitude in the long run is indeed the way to accomplish this.  But it is hard to commit today to fiscal rectitude in the future.  Rules to cap debt such as the Maastricht fiscal criteria, “no bailout” clause and Stability and Growth Pact (SGP) didn’t work because they were not enforceable.

Eurobonds could be part of the solution, if designed properly to take into account fiscal fundamentals, both short term and long term.  These are defined as government bonds that would be the liability of euroland in the aggregate.

The creation of a standardized Eurobond market would bring a boost to help a reform plan come together, badly needed in light of the damage that years of failed European summits have done to official credibility.  That boost is the latent global portfolio demand for a good eurobond. 

Even when the euro was at the height of its success five years ago, its international currency status suffered from lack of a counterpart to the US Treasury bill market, a deep, liquid, standardized market in low-risk bonds.  Bonds are issued by the 17 member governments.  This fragmentation has hindered European financial integration and impeded any bid by the euro to rival the US dollar as international reserve currency.  Central banks in China and other big developing countries are still desperate for an alternative form in which to hold their foreign exchange reserves – an alternative to holding US government securities, that is.   US Treasury bills pay extremely low interest rates, and the value of the dollar has been on a negative downward trend for 40 years (ever since President Richard Nixon took the dollar off gold and devalued in 1971).   Despite all of Europe’s problems, a Eurobond would be attractive to central bankers and other portfolio investors around the world, both to achieve higher expected returns than on US treasury bills and to diversify risk.

But that latent global demand for Eurobonds will not come to the table unless they are by design backed up with solid economic and political fundamentals.

Germany opposes Eurobonds on the sensible grounds that if individual national governments were allowed to issue them freely, the knowledge that somebody else was paying the bill would make the incentive for member countries to spend beyond their means worse than ever.  This version of Eurobonds would be bound to fail, both economically and politically.   This seems to be the version that some opponents of austerity have in mind, such as the new French president, François Hollande, though it is hard to tell.

A different version of the Eurobond proposal has recently begun to gain traction in Germany.  The German Council of Economic Experts - usually called “wisemen,” although the council includes a woman — proposed last year a European Redemption Fund (hence yet another new acronym, ERF).   The plan would convert into defacto Eurobonds the existing debt of (approved) member nations in excess of 60% of GDP, the supposed threshold specified in the Maastricht and SGP criteria.  The ERF bonds would then be paid off over 25 years.   Steps toward this proposed solution to the short-term debt problem would be paired - politically and logically - with approval of the Fiscal Compact, Angela Merkel’s proposed solution to the long-term problem.

But this seems upside down.  Yes, any solution to save the euro will have to ask German taxpayers to put still more money on the line.   But to use Eurobonds as the mechanism for eliminating the big debt overhang looks like the nail in the coffin of the longer term moral hazard objective.  It offers absolution precisely on the margin where countries in the future will in any case have the most trouble resisting the temptation to sin again, the margin where they cross the 60% threshold.

If the Fiscal Compact or proposed “debt brakes” could be relied on as a firm constraint on future behavior, then fine.  But there is little reason to believe that they could, especially after confirmation of the precedent that individual spendthrifts are relieved of their excess debt burdens.

The new Fiscal Compact is unlikely to succeed where the Maastricht criteria failed, the “no bailout” clause failed, and the SGP failed.  It is less credible that excessive deficits will be punished than it was three years ago - and it wasn’t credible even then.   Rules don’t work without some enforcement mechanism.   The problem with the SGP wasn’t that it wasn’t written strictly enough or even that it wasn’t incorporated into the constitutions of the member countries as the Fiscal Compact would have it.  The problem with the SGP was that no matter how many times a member government’s deficit or debt exceeded the specified limit, the country’s officials could say (often sincerely) that the gap was the fault of unexpected circumstances such as slow growth and low tax receipts and that they expected to do better next time.  Even if some court in Brussels or Frankfurt were given life-and-death power to enforce the rules, exactly which officials would it punish for violations, and how?  No version of the SGP or Fiscal Compact or debt brake proposals has ever provided a satisfactory answer to that question.

Hope by some Europeans that the Fiscal Compact would finally make enforcement credible by writing the constraints into the constitutions of member states might be based on misunderstanding of the US system.   One can see the logic:   The US federal government has never bailed out one of the 50 states and nobody expects it to do so in the future.  How has the US solved the problem of moral hazard that so plagues euroland?  The states have rules to limit deficit spending.  That must be the answer !  (Well, 49 of the states have rules; these laws are voluntary on the part of the states, and Vermont does not have one).  State laws are not the primary explanation for the absence of US moral hazard.  The primary explanation is that the right precedent was set in 1841 when the federal government declined the opportunity to bail out 8 troubled states and let them default.  Euro leaders should have done the same with Greece a year or two ago. A second (related) explanation for absence of moral hazard in the US federal system is that, ever since the 1840s, when American states start to run up questionable levels of debt the private market demands an interest rate premium to compensate for the default risk.   The premium acts as an automatic disincentive to further profligacy.  This mechanism should have operated after the euro was created in 1999, but it never did:  Greece and the other high-borrowers were able to borrow at interest rates that — disturbingly – had fallen virtually to the same levels as German bunds.  

The final explanation is that when citizens started to ask more from their public sectors governments in
the 20^th century (defense, entitlement spending, etc.), the expansion in the case of the United States took place at the federal level, not the state level.  For this reason even the fiscally most dysfunctional of the American states, which is probably California, does not operate on a scale remotely like European national governments.   US federal spending is 24% of GDP versus an EU budget of 1.2% of GDP.  Europeans are not ready to transfer most spending and taxation from the national to the federal level.   And even if they decide some day that they are ready, if the bailout precedent still stands then this federalization will not solve the moral hazard problem regarding the spending that remains at the national level.

The version of Eurobonds that might work is almost the reverse of the Germans’ Redemption Fund proposal.  It goes under the more colorful name of “blue bonds,” originally proposed two years ago by Jacques Delpla and Jakob von Weizäcker at the think tank Bruegel.   Under this plan, only debt issued by national authorities below the 60% criteria could receive eurozone backing, be declared senior, and effectively become Eurobonds.  These are the “blue bonds” that would be viewed as safe by investors.  When a country issued debt above the 60% threshold, the resulting junior “red bonds” would lose eurozone backing.   The individual member state would be liable for them.  This proposal structures the incentives “right side up.”

The blue bonds proposal has been extensively debated in Europe.  As usual in such controversies, many participants in the euro debate fixate on one evil or the other –moral hazard or austerity — and fail to grapple with practical proposals to balance the two.

As I see the plan, the private markets could make the judgment as to whether a country was in the process of crossing the threshold, even before the final statistics were available, and therefore assess whether default risk on the new red bonds required an interest rate premium.  If private investors judged that the new debt had genuinely been incurred in temporary circumstances beyond the government’s control (say a weather disaster), then they would not impose a large interest rate penalty.  Otherwise, the sovereign risk premium mechanism would operate on the red bonds, much as it does among American states, and much as it did in Italy, Greece and the others before they joined the euro.   Similarly, if the ECB after 2000 had operated under a rule prohibiting it from accepting as collateral the debt of SGP-noncompliant countries, the resulting default risk premum might possibly have headed off the entire euro sovereign debt problem early in the decade.

The point is that the red-bond mechanism would be truly automatic, as desired.  Perhaps in ambiguous borderline cases the judgment whether a country had truly exceeded the limit, or whether it was still in good standing so that its debt qualified for eurobond status, would ultimately have to be made by a eurozone agency or court, with an inevitable lag.  But, in the meantime, private investors could apply informed views about the merits from moment to moment.  The resulting market interest rates would provide the missing discipline. Compliance would not rely on discretionary letters from Brussels bureaucrats, which have proven toothless no matter how many exclamation points are put at the end of their penalty threats.  Nor would it require unenforceable debt ceilings legislated at the national level.  The U.S. has one of those too.  It has never had any effect, except on a very few occasions, when Congress has actively used the debt ceiling law to make everything worse.

Of course the euro countries cannot jump to a blue bond regime without first solving the problems of debt overhang and troubled banks that are front and center.   Otherwise, in today’s world, the plan by itself would be destabilizing since it would put almost all countries immediately into the red.   The debt paths that are currently unsustainable in many countries result from the combination of debt/GDP ratios that are already far in excess of 60%, combined with very high sovereign spreads and recessions.    Relieving them of responsibility for debt up to 60% would be substantial assistance, but would not in itself restore sustainability to all members.

Thus Eurobonds are emphatically not the complete solution to these vexing problems.  It is hard to say, at this late date, what the right short-term solutions are.   In Greece’s case, it may be forced to default and to drop out of the euro.  The banks and sovereigns in other countries will then have to be insulated from the conflagration through a combination of acronymic “bailout” money (EFSF, ESM, ECB…) and serious policy conditionality, as always.  Creating this fire break between Greece and the heart of Europe would have been far easier two years ago, before debt/GDP levels and sovereign spreads climbed so high and before the credibility of the euro leaders sank so low, or even one year ago.  Now the fire has spread over a much larger area and there are no natural gaps in sight for creating firebreaks.

But one thing seems clear.  German taxpayers, whose longstanding fears that they would be asked to bail out profligate Mediterranean euro members have been proven correct, will not be happy when asked to put up still more money in the cause of European integration by the same elites whose assurances of the last 20 years have proven false.   They will at a minimum need some credible reason to believe that future repetitions have been rendered unlikely, that the bailout is “just this once.”   Official assurances do not constitute that credible reason.    Nor does the Fiscal Compact, in itself.   The red bonds / blue bonds scheme just might.

[A much condensed version of this posting appears in Project Syndicate, June 14, 2012.  This fuller version also appears on Vox, June 28, 2012.]

[This column is co-authored with Carlos Végh and Guillermo Vuletin and was published in VoxEU.]

Everywhere one looks, problems of fiscal policy are now center stage.   Among advanced countries, the news is bad:   Europe’s periphery teeters, the U.K. slashes, the U.S. deadlocks, Japan muddles.  But in the rest of the world there is better news:   In an historic reversal, many emerging market and developing countries have over the last decade achieved a countercyclical fiscal policy.

In the past, developing countries tended to follow procyclical fiscal policy:   they increased spending (or cut taxes) during periods of expansion and cut spending (or raised taxes) during periods of recession.  Many authors have documented that fiscal policy has tended to be procyclical in developing countries, in comparison with a pattern among industrialized countries that has been by and large countercyclical. (References for this proposition and others are available.)   Most studies look at the procyclicality of government spending, because tax receipts are particularly endogenous with respect to the business cycle.  Indeed, an important reason for procyclical spending is precisely that government receipts from taxes or mineral royalties rise in booms, and the government cannot resist the temptation or political pressure to increase spending proportionately, or even more than proportionately. One can find a similar pattern on the tax side by focusing on tax rates rather than revenues, though cross-country evidence is harder to come by.

Figure I (which is a version of evidence presented in Kaminsky, Reinhart and Vegh, 2004) depicts the correlation between government spending and GDP for 94 countries over the period 1960-1999.   More precisely, it shows the correlation between the cyclical components of spending and GDP;  the longer term trends are taken out.   The set includes 21 developed countries, which are represented by black bars, and 73 developing countries, represented by yellow bars.  A positive correlation indicates government spending that is procyclical, that is, destabilizing.  A negative correlation indicates countercyclical spending, that is, stabilizing.  

[Click here for enlargement of Figure I.] 

There is no missing the message.  Yellow bars lie overwhelmingly on the right hand side:  more than 90 percent of developing countries show positive correlations (procyclical spending).  Black bars dominate the left hand side:  around 80 per cent of industrial countries show negative correlations (countercyclical spending).

 Over the last decade there has been a historic shift in the cyclical behavior of fiscal policy in the developing world.     Figure II updates the statistics, showing the period 2000-2009.  The number of yellow bars on the left side of the graph (negative correlations) has greatly increased.   Around 35 percent of developing countries [26 out of 73] now show a countercyclical fiscal policy, more than quadruple the share during the earlier period.  

[Click here for enlargement of Figure II.] 

Figure III presents a scatter plot with the 1960-1999 correlation on the horizontal axis and the 2000-2009 correlation on the vertical axis.  The lower right quadrant shows the graduates from procyclical to countercyclical fiscal policy.  The star performers include Chile and Botswana; but 24 developing countries altogether (out of 73) have made this historic shift.  

[Click here for enlargement of Figure III.] 

The evidence of countercyclicality among many emerging market and developing countries matches up with other criteria for judging maturity in the conduct of fiscal policy:    debt/GDP ratios, rankings by rating agencies, and sovereign spreads.  Low income and emerging market countries in the aggregate have achieved debt/GDP levels around 40 percent of GDP over the last four years.  [The IMF estimates the 2011 ratio at 43 per cent among emerging market countries and 35 per cent among low-income countries]. This is the same period during which debt in advanced countries has risen from about 70 per cent of GDP to 102 percent.   The financial markets have ratified the historic turnaround.   Spreads are now lower for many emerging markets than for some “advanced countries.”    Rating agencies rank Singapore as more creditworthy than Belgium, Korea ahead of Portugal, Mexico ahead of Iceland, and just about everybody ahead of Greece.    Euromoney ranks Chile as less risky than Japan, Korea less risky than Italy, Malaysia less risky than Spain, and Brazil less risky than Portugal.

Largely as a result of their improved fiscal situations during the period 2000-2007, many emerging markets were able to bounce back from the 2008-2009 global financial crisis more quickly than advanced countries.   

What explains the ability of some countries, particularly emerging market and developing countries, to escape the trap of procyclical fiscal policy? Many researchers have pointed to the importance of institutions.  In new research we find that the cyclicality of a country’s fiscal policy is inversely correlated with the country’s institutional quality (which includes measures of law and order, bureaucracy quality, corruption, and other risks to investment).    The relationship holds also when instrumental variables are used.

Although one thinks of institutions as slow-moving, they can change over time.   Chile’s institutional quality has risen strongly since the early 1980s, during which time its fiscal policy has turned from procyclical to countercyclical.   A country with good institutional quality in the general sense of rule of law can help lock in countercyclical fiscal policy through specific budget institutions.   Chile did it with the structural budget reforms of 2000 and 2006.   Chile’s approach could be emulated by others.

Fiscal rules, such as euroland’s  Stability and Growth Pact, may accomplish little in themselves.   Rules can actually worsen the tendency of governments to make overly optimistic forecasts for economic growth and budget balance.   Chile’s key innovation was to give responsibility for forecasting to independent expert commissions, insulated from politicians’ wishful thinking.

Even advanced countries have something to learn about countercyclical fiscal policy from Chile and others to the South.  Saving during expansions such as 2001-06 is critical for weathering the storm in recessions such as 2008-09.  Otherwise there may be no way out but to adjust at the worst possible time.

By now just about everybody agrees that the European bailout of Greece has failed:  The debt will have to be restructured.    As has been evident for well over a year, it is not possible to think of a plausible combination of Greek budget balance, sovereign risk premium, and economic growth rates that imply anything other than an explosive path for the future ratio of debt to GDP.

There is plenty of blame to go around.  But three big mistakes can be attributed to the European leadership.  This includes the European Central Bank - surprisingly, in that the ECB has otherwise been the most competent and successful of Europe-wide institutions.

Mistake number 1 was the decision in 2000 to admit Greece in the first place.   The country was an outlier, geographically and economically.  It did not come close to meeting the Maastricht Criteria, particularly the 3 % ceiling on the budget deficit as a share of GDP.  No doubt most Greeks would agree with the judgment that they would be much better off today if they were outside the euro, free to devalue and restore their lost competitiveness.

The second mistake was to allow the interest rate spreads on sovereign bonds issued by Greece (and other periphery countries) to fall almost to zero during the period 2002-2007.   Despite budget deficits and debt levels that far exceeded the limits of the Stability and Growth Pact, Greece was able to borrow almost as easily as Germany.  Part of the blame belongs to international investors who grossly underestimated risk on all sorts of assets during this period.  And part of the blame belongs to the rating agencies who, as usual, have been lagging indicators of European debt troubles, rather than leading indicators.  But in this case, both groups might justify their attitudes by pointing out that the ECB accepted Greek debt as collateral, on a par with German debt.

The third mistake was the failure to send Greece to the IMF early in the crisis, before Greek interest rates went to 600 basis points (see graph).  By January 2010 the need to go to the Fund should have been clear.  Rather than going into shock, leaders in Frankfurt and Brussels could have welcomed the Greek crisis as a useful opportunity to establish a precedent for the long-term life of the euro.   The idea that a debt problem of this sort would eventually arise somewhere in euroland cannot have come as a surprise.  After all, why had the architects of the Maastricht fiscal criteria and the No Bailout Clause (1991) and the Stability & Growth Pact (1997) written them in the first place?   Skeptical German taxpayers believed that, before the project was done, they would be asked to bail out some spendthrift Mediterranean country.  European elites adopted the fiscal rules precisely to combat these fears.   

When the rules failed and the crisis came, the leaders should have thanked their lucky stars that the first test case had arisen in a country that met two characteristics admirably:   
(i) The Greek government had broken the rules so egregiously and so frequently that one could with a clear conscience judge that a firm stand was merited.  The only alternative was to risk establishing the precedent that even profligate governments can expect ultimately to be bailed out, with all the moral hazard headaches that precedent implies.    (ii) The Greek economy was small enough to make it feasible for Europe to come up with the funds necessary to insulate others who were vulnerable to contagion but not as blameworthy:  banks that hold Greek debt and governments such as Ireland that had tried to follow responsible policies in the period before the global financial crisis.

European leaders also should have thanked their stars that the IMF exists.   Instead of acting as if such a crisis had never been seen before, they should have realized that imposing policy conditionality in rescue loan packages is precisely the IMF’s job.  International politics is less likely to prevent the Fund from enforcing painful fiscal retrenchment and other difficult conditions than it is among regional neighbors or other political allies.   Europe is no different in this respect than Latin America or Asia.  

But the reaction of leaders in both Frankfurt and Brussels was that going to the Fund was unthinkable, that this was a problem to be settled within Europe.   They chose to play for time instead, to treat insolvency as illiquidity.  Against all evidence — despite a decade of SGP violations — they still wish to believe that they can impose fiscal discipline on member states.  Despite two decades in which citizens of Germany and other European countries have expressed clearly that they do not share their leaders’ enthusiasm for Economic and Monetary Union, the latter apparently still wish to believe that further progress to political and fiscal union is possible.  The emu has long since become an ostrich, burying its head in the sand.

It turned out that the German taxpayers had been right all along.   How, in light of that democratic deficit, can anyone think that Europe is ready for a transfer union? 

Next week’s post:   A proposal to avoid future repeats of Europe’s sovereign debt crisis.

These matters were discussed in a session on the Challenge of Europe at the Annual Conference of George Soros’ INET, April 10, 2011.  Video & slides are available, including my own comment.

[Comments can be posted on the Vox.eu site.]

Most prominent economists and the sensible political middle ground in Washington agree that the federal government must eventually address its long run fiscal problem; but they also know that it is not possible to begin to eliminate the budget deficit if tax increases and entitlements cuts are ruled out. The Bowles-Simpson Commission in December made specific proposals, many of which are the sort that we are going to need — all of them highly unpopular….proposals like raising the retirement age, limiting tax expenditures, and raising the gas tax. Many reasonable-sounding editorialists and commentators have said recently that President Obama ought to be brave enough to lead, by coming out in favor of unpopular measures such as those in the Commission’s report.  Supposedly the American public is mature enough to rally around such a candid position.

I think not.  (Whenever a candidate promises to “give the American people a government as good as they deserve,” I can’t help thinking, “no, no; don’t do that!”)   If Obama were to come out in support of the report’s specific proposals, his opponents would reliably and successfully attack him for wanting to raise taxes and “hurt seniors.”  As the White House puts it, this would poison the well:  After these attacks, the country would be a step farther from coming to grips with the problem, not a step closer.

I have a proposal. President Obama should send to Congress a bill to establish a bipartisan National Commission on Fiscal Responsibility and Reform. The body would be chaired again by Bowles and Simpson, who would be able to move more quickly this time, refining their previous proposals. (Ideally they would drop the tax cuts for the rich, the inadequate detail on medical costs, and the pipe dream that spending can be brought down to a lower level of GDP than where Reagan had it.)  One hopes that a majority of the Commission members, from both parties, would agree to join hands and come out together in support of a good package of fiscal measures.  (Of course, grandstanders like Paul Ryan will again vote no.)

How could yet another commission solve the problem? Why would it succeed when the first Bowles-Simpson Commission failed? Obama should include in the legislation a provision that the recommendations of the Commission would automatically go to Congress for an up-or-down vote. Those knowledgeable in the ways of Washington have long known that this is the way to solve the problem, by giving individual politicians in each party some protection against the attacks from opportunistic critics in the opposite party.

Does the idea of a bipartisan ex ante agreement to promote the Commission’s findings, before the gory details are visible, sound familiar? President Obama pushed for precisely such legislation in Congress in January 2010. Among the sponsors of the bill had been John McCain and five other Republican Senators. But when they saw that Obama was for it, the Republican sponsors switched sides and voted the other way. (They were for it before they were against it.) The bill was defeated 53-46. Obama, in February 2010, was then forced to create the Bowles-Simpson commission by Executive Order instead, knowing full well that without the critical congressional pre-commitment the Commission was unlikely to be able to break partisan logjams. And so it was.

Why did these supposedly “fiscal conservative” sponsors vote against the bill? So far as I know, nobody has ever offered any explanation other than the obvious one: they would rather make political hay out of trying to pin unpopular tax increases or medicare cuts on Obama in the 2010 congressional elections, than to make progress on the deficit. As Alan Simpson (R - Wyo) said, their purpose was “to stick it the President.” Well, they got their 2010 congressional elections. So let’s try the same proposal again now. Maybe it would pass this time. More likely it would fail, for the same political reasons. But at least if the Republicans again refused to support the commission when it is an ex ante abstraction, then it would be hard for anyone to deny that they would be sure to oppose the White House if it were to support the specific recommendations after they became known.  The exercise should at least clarify who is serious about necessary reforms and who is more interested in political gamesmanship.

The current economic question is what to do about budget deficits.   The Greek crisis has made sovereign debt a genuine concern even among advanced countries.  (I should say “especially among advanced countries,” because developing countries now have stronger fiscal positions, in a historic reversal of roles.)   At this weekend’s G-20 Summit, Germany and the UK are defending strong fiscal austerity, with language that doesn’t even allow for the idea that short-term spending might be expansionary under severe recessionary conditions such as 2008-09.   In the US, Peter Orszag is reported this week to have resigned as OMB Director, not just to get married, but supposedly in part out of frustration about the fiscal outlook and President Obama’s refusal, as part of any comprehensive deficit correction program, to reverse his campaign pledge against raising taxes on those earning less than $250,000.

American economists have no shortage of ideas for cutting the US budget deficit in the long run, in economically efficient ways.   (Among other steps: limit tax expenditures.)   There are two big obstacles.  (more…)