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A successful strategy would have to address one of the eurozone’s main design flaws: member governments issue debt in euros, a currency that they cannot control. As a result, they cannot provide a guarantee to bondholders that the cash will be available to pay them at maturity. The mistrust and fear that this elicits in the bond markets can lead to liquidity crises that, creating a self-fulfilling prophecy, drive countries closer to default. They are then forced to implement austerity programmes that lead to deep recessions and, ultimately, to banking crises.
While austerity measures are appropriate in countries that have overspent in the past, the austerity that panic-stricken financial markets force upon a country can trigger a major social and political backlash. In fact, several southern European countries – such as Greece, Italy, Portugal, and Spain – are currently experiencing exactly that.
To overcome this fundamental design flaw, government debts must be pooled. This would protect the weakest economies from destructive, panic-fuelled movements in financial markets, which, in theory, can hit any member country – even those that are strongest today. But it is not the only obstacle. A debt-pooling scheme must also address the fact that the strongest countries will inevitably face higher interest rates on their own debts when they become jointly liable for the debts of less credit-worthy governments.
To overcome these obstacles, a eurozone debt-mutualisation scheme must satisfy three crucial requirements. First, the share of government debt that can be pooled must be strictly limited, leaving each country responsible for a significant portion of its national debt, and therefore motivated to maintain sound public finances. (Several initiatives have aimed to achieve this, notably Jakob von Weizsäcker and Jacques Delpla’s 2010 Blue Bond proposal.)
Second, an internal transfer mechanism between eurozone Member States is needed in order to ensure that less credit-worthy countries compensate, at least partly, their more economically sound counterparts.
Finally, a supervisory authority must be established to monitor governments’ progress toward achieving sustainable debt levels – and to create clear consequences for those that break the eurozone’s budgetary rules. The Padoa-Schioppa group recently proposed that rule-breaking governments should gradually lose control over their own national budgetary processes.