25 November 2011

John Muellbauer: Germany and the eurozone - clutching disaster from the jaws of victory?

For months economists have been arguing that Germany holds the key to ending the eurozone crisis. There is a simple solution, if only eurozone leaders can see it. Eurobonds are the answer – but with conditions.

Introducing conditional eurobonds

Conditional eurobonds, issued on new borrowing, would be collectively underwritten by member governments of the eurozone. Two design features would have to be settled: the formula that defines the spreads that each country has to pay into a central fund and the distribution of the payments resulting from the spreads to the guarantor governments. Muellbauer argues that spreads should be determined by relative unit labour costs, and by relative government debt- and current account–to-GDP ratios. Including unit labour costs introduces incentives for improved competitiveness, promoting long-run economic growth.

The proceeds of the payments could be distributed in several ways. In the simple example of a bilateral loan from Germany to Italy, Germany would retain the entire spread. With multilateral underwriting, all eurozone countries would receive shares of the payments into the central fund. The shares would be determined by the size of their own borrowings and their spreads relative to Germany. Per unit  of borrowing, less risky countries such as France would receive more than riskier countries such as Belgium, but less than Germany itself. Boonstra recently suggested that part or all of the premium payments be retained in a central insurance fund against the possibility of a future debt writedown.

Clear as day

The new European Commission draft Green Paper on the feasibility of introducing ‘Stability Bonds’ does consider conditional eurobonds with spreads. But by presenting this as just another option, the document fails to point out clearly enough that the difference between these and conventional eurobonds is like the difference between day and night. A hugely important point about conditional eurobonds with spreads is that they address the German fear about the eurozone becoming ‘a transfer union’. The point is also not made clearly enough that this kind of bond, by creating the right fiscal incentives, allows a kind of fiscal decentralisation or subsidiarity, which addresses one of the key worries about democratic governance in the eurozone.

Europe at a crossroads

Europe’s economic outlook could be rapidly transformed. A German bilateral loan offer to Italy, followed by the announcement that conditional euro-treasury bills would follow shortly, and that consultations were beginning on conditional eurobonds, could be made within days. The yields on Italian government bonds would drop, followed by those of Portugal and Spain. Share prices of European banks holding Italian bonds would rise, restoring their ability to lend. The ECB’s recent interventions in the Italian and Spanish bond markets would make a large profit. Speculators who have shorted sovereign debts of Italy and others could finds themselves skating on thin ice.

There is, however, an alternative. Germany could prove itself not to be a good European and instead clutch disaster from the jaws of victory over fiscal irresponsibility, unreformed labour markets, and corruption in the southern fringe of Europe. German inaction could trigger the most severe crisis since the collapse of Lehman Brothers.

Full article

© VoxEU.org