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A grand bargain could be struck along the following lines:
First, each eurozone government would formulate a “stabilising fiscal rule”, specifying the long-run ratio of national debt to gross domestic product (not more than 60 per cent), the convergence rate (how fast the debt ratio would reach its long-run value) and the counter-cyclicality of fiscal policy. The greater the fiscal stimulus permitted in recessions, the greater the fiscal contraction in booms...
Second, the eurozone should adopt transparent criteria for sovereign solvency, so that a country whose national debt is too high relative to its performance (making it unable to reach a stable growth path while adhering to its fiscal rule) could be declared insolvent and submit to an orderly restructuring process.
Third, all eurozone countries would adopt a common system of financial regulation, including common supervision of banking and shadow banking systems, bank resolution, deposit insurance mechanisms, catastrophic loss insurance and incentives to avoid systemic risk.
Once all eurozone countries met their fiscal rules, the European Stability Mechanism could be restricted to support for financial institutions. Institutions that were not eligible for ESM financing would submit to the common debt restructuring and resolution regime.
Fourth, European structural funds should be targeted at investment to promote growth in countries with persistent current account deficits, with support from the European Investment Bank. This would make debtor countries more competitive.
With these measures in place, the European Central Bank could devote itself primarily to controlling inflation. Under the current regime, the risk of conflict between the ECB’s two goals – the stability of the financial system and price stability – raises fears of future inflation.
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