17 October 2013

Bundesbank/Dombret: The yin and yang of resolving the European sovereign debt crisis

Equity versus efficiency

The economic versions of yin and yang are not opposing forces but interrelated concepts. In the end, it is not a matter of "either/or" but a matter of degree. And this is at the core of the debate on how to resolve the sovereign debt crisis: Some analysts tend more towards equity or, more specifically, towards burden-sharing. Other analysts tend more towards efficiency, that is, towards setting the right incentives to ensure a stable monetary union in the future.

Before the crisis, there were large imbalances in the current accounts of euro area countries. In a monetary union, the only option is an internal adjustment through prices, wages, employment and output. Such internal adjustment certainly places a burden on the economy of the affected country. There is consequently an intense debate as to which countries should adjust – those with a current account deficit or those with a surplus. And in essence, this debate is the debate between burden-sharing and efficiency. There are many who fear that it would be too much of a burden for the deficit countries alone to adjust. They therefore suggest that surplus countries should also adjust so that the burden can be shared. I would like to challenge this view by raising two objections: one relating to the effectiveness of such an approach and the other relating to its consequences.

In order to share the burden of adjustment, commentators have suggested that surplus countries should lower their competitiveness. Thus, rather than just some countries going all the way in terms of adjusting their competitiveness, all countries should meet in the middle – those with a current account surplus should become a bit less competitive, those with a deficit should become a bit more competitive. The burden of rebalancing would be shared. But how far would that approach take us? Given the nature of trade flows within the euro area, the estimated effect turns out to be close to nil.

Also, Europe is not an island but part of a globalised world. And at the global level, we are competing with economies such as the United States and China. So if the euro area countries followed the approach of meeting in the middle in terms of competitiveness, it would, as a whole, become less competitive vis-à-vis the rest of the world. In my view, this is not the right path to follow.

In my view, the initial adjustment has to take place in the deficit countries. At the end, they operated an unsustainable model based on structural deficiencies. Reforming this model is the most promising approach to facilitate rebalancing. Not every deficit country needs the same structural reforms, of course, but all require some sort of adjustment. And a number of reforms have already been undertaken and show results.

The case of eurobonds

Some commentators argue that eurobonds would solve many of the euro area’s problems. In my view, eurobonds would be another case of burden-sharing that would come at the expense of efficiency and would endanger the stability of monetary union. The imbalance of responsibilities within the monetary union gives individual countries an incentive to borrow – a "deficit bias" is introduced into the system. Our objective should be to counter that deficit bias to ensure a stable monetary union. This can only be achieved by realigning responsibilities – liability and control have to be in balance.

Would eurobonds contribute to this objective? Granted, eurobonds would offer temporary relief to heavily indebted Member States of the euro area. But eventually they would distort the already lopsided balance between liability and control even further. While spending decisions would essentially remain a national prerogative, liability would become truly European. Incentives to incur further debt would thus be strengthened, not weakened.

Other ways forward

If we really want to realign liability and control to stabilise monetary union, we have two options. The first option would be to match European liability with European control. This would amount to what is known as a fiscal union. Creating a fiscal union, however, would depend on the countries of the euro area transferring national sovereignty to the European level. However, giving up sovereignty in this way would represent a radical change and require wide-ranging legislative changes nationally and at the European level. Such changes would need the support not only of policymakers but also of the general public. And, on this point, we should be realistic. There is no willingness to do that at present – not in Germany or in any other country of the euro area. Thus, a fiscal union is a long way off.

For the time being, that leaves us with the second option: implementing both liability and control at the national level. This would mean strengthening the original Maastricht framework, creating a "Maastricht 2.0". Among other things, that would require strengthening the rules on borrowing – not only does the Stability and Growth Pact need teeth, it also has to be able to bite. The rules have since been tightened – now they have to be applied and compliance has to be ensured.

Full speech

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