Jean-Claude Trichet, president of the European Central Bank until October, last week floated two proposals aimed at dealing with Greece and related eurozone public-debt problems.
The first idea would allow European Union authorities to override the policy decisions of member governments that can’t come up with sustainable budgets, implying the creation of an external control board for the likes of Greece. This approach has been used in the past for very weak countries (as well as for the cities of New York and Washington in recent decades). In Europe today, it would have no political legitimacy and would be completely unworkable -- imagine the street protests it would spark.
The second idea would, down the road, create a finance ministry for the European Union. It would issue debt and have responsibility for a unified financial sector. This is just as brilliant as Alexander Hamilton’s fiscal and financial integration proposals for the young American Republic and, if implemented properly, would fix the deep problems caused by the original design of the eurozone.
The politicians who negotiated the monetary union -- in the Maastricht Treaty of 1992 and in the details worked out prior to the euro’s January 1999 launch -- had three choices. First, they could have created a unitary fiscal system. It was rejected because there was no appetite for this in any member country’s electorate. National politicians were comfortable giving up their central banks, which were becoming more independent in any case, but knew they would have far less power if they lost control of taxation and spending.
Second, the architects could have created something akin to the U.S. and Canada: a federal authority with its own budget authority and the presumption that states (or provinces) are on their own fiscally, albeit with transfers of revenue for various national programs. The U.S. government doesn’t guarantee the debt of any state and nobody tells the states that they must balance budgets (most do, but many also have large off-balance sheet liabilities, particularly unfunded pensions.) If, for example, California were to get deeper into trouble, there is an almost zero probability that Massachusetts or any other state would come to its rescue. And the obligations of state authorities cannot generally be used as collateral for banks to borrow from the Federal Reserve.
Instead, European leaders opted for a middle way. To join the monetary union, each country’s budget deficit had to be less than 3 percent of gross domestic product and government debt could be no more than 60 percent of the total economy. Once a country met these criteria, it could be admitted to the union. The problem was that all government debt -- regardless of the size or condition of the national economy -- was presumed to be essentially equal, including in determining whether it could be used as collateral for European Central Bank borrowing.
This fatal flaw made possible a complete mispricing of risk across the eurozone, meaning all sovereign obligations were deemed “risk-free debt” (surely an oxymoron). Under the prevailing Basel II rules, banks could hold a great deal of such zero-risk debt -- essentially allowing them to have very high leverage. Prior to 2008, it wasn’t unusual for big European banks to have assets 30 or 50 times equity. The interest-rate spread across different eurozone government bonds was just a few basis points -- significantly less than the analogous spread observed across Canadian provinces.
The problem was neatly stated by Trichet last week. “Interdependence means that countries de facto do not have complete internal authority,” he said. “They can experience crises caused entirely by the unsound economic policies of others.”
But who pursued these unsound economic policies? Was it the Greeks with their current-account and budget deficits? Or was it creditor countries, including Germany, whose banks mispriced the risk of lending to Greece? Or was the culprit the eurozone fiscal arrangements that create the perception of mutual guarantees that aren’t backed by any legal authority, but become a reality because the Continent’s entire banking system could implode if even one country were to slightly restructure its debt? How else did the ECB end up holding so much Irish, Greek and Spanish credit risk?
The situation today isn’t hopeless and the Europeans are good at coming up with short-term fixes that push them toward more sensible integration, a point made by my colleague, Jacob Kirkegaard, at the Peterson Institute for International Economics. He proposes specific ways that existing European fiscal mechanisms can readily morph into more centralized control.
But the long-term solution must involve the creation of a European Ministry of Finance that could issue a reasonable amount of well-managed debt, supported by credible revenue. That would put both public finances and the financial system on a sounder footing. Hamilton faced heavy odds when he pulled off a similar feat, albeit with the help of a miracle at the Constitutional Convention, in 1787.
The goal is simple: Make it possible for a country such as Greece to default on its debt without threatening to bring down the entire eurozone financial system. Trichet, in his speech, quoted Jean Monnet, the visionary of an integrated Europe: “Nothing is possible without men and women, but nothing is lasting without institutions.” The institutional arrangements created by Maastricht have brought millions of people into economic jeopardy. It’s time for the men and women of Europe to rebuild again.
(Simon Johnson is a Bloomberg View columnist. The opinions expressed are his own.)
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