The latest effort by European policy makers to contain the debt crisis offers only temporary relief for the euro area.
The involvement of private creditors is a step in the right direction, though it is quantitatively too limited, and the buyback program may end up rewarding banks’ shareholders and bondholders. Most importantly, the plan doesn’t address a fundamental problem: Any support designed to backstop Spain and Italy would be funded mostly by Germany, the region’s largest national economy.
The latest measures still involve two massive transfers of wealth. The first is from German taxpayers to those of southern Europe. If the aim is to destroy the idea of Europe for a generation, we could do no better. The resentment of German taxpayers will weigh on the continent for decades. To get a sense of the reaction, consider that Italy was unified 150 years ago, yet even small transfers of taxpayer money from the Treasury to the south of the country prompt the Northern League political party to call for secession.
The second movement of funds in the European rescue is from taxpayers to banks. The 2008 bailouts of the financial industry generated enough populist anger. This time, we may face a revolt.
Even putting aside political considerations, the current plan has big economic drawbacks, which can be summarized in two words: moral hazard. Most policy makers, and many economists, think that when a house is on fire, you first extinguish the flames, and then you catch the arsonists. But if you put out the blaze in a way that makes it impossible to catch the arsonists, you are almost certain to have a lot more fires later.
Yet there is an alternative that is fair to taxpayers and still preserves the incentives for the future. In addition, it would enhance transparency and accountability by relying on three visible and dedicated taxes. There is no free lunch, and this proposal would be costly to investors, particularly holders of bank debt and of distressed sovereign debt.
The first part of our proposal is a eurotax on bank debt -- not on bank profit (an idea that was killed at the meeting of European leaders on July 21). Such a levy would have the double advantage of raising revenue and penalizing careless creditors. By assessing the tax based on the previous month’s credit-default-swap prices, it would also serve to reward the good banks and punish the bad ones.
The second eurotax would be imposed on sovereign debt, and also would be proportional to the previous month’s CDS prices. This would force creditors to take a haircut, without triggering a default. It would be applied to the stock of debt but not to future issues, so it wouldn’t affect the marginal cost of borrowing. As with the bank tax, it would have the double benefit of raising revenue and of penalizing careless creditors. In this respect, it is the opposite of a debt-buyback program, which will reward creditors by increasing the market value of sovereign debt.
Our proposal has one potential downside: By decreasing the value of debt, it might push banks below their capital requirements, and possibly into default. However, with the revenue raised, the European Union would be able to make the banks an offer they couldn’t refuse: Either they recapitalize immediately in the private market or they are recapitalized by European authorities. This ensures the banks won’t fail. The equity that is raised in this way wouldn’t be held by a national government, but by the European Financial Stability Facility, the temporary bailout fund, reducing the risk of political influences on management.
The third measure is a variant of a proposal advanced last year by the economists Jacques Delpla and Jakob von Weizsaecker: The first 60 percent of each country’s debt would be converted into a “blue” bond, which would be guaranteed by the EU; the rest would float as junior, national debt, or “red” bonds that would be subject to market discipline.
Any variant of eurobonds must address two problems. The first is how to minimize a country’s temptation to free ride on Germany by ending their funding for the blue bond. The second is to make clear who is paying, a transparency that is missing in the standard eurobond proposal. We recommend that the blue bond be funded by a pre-specified fraction of the revenue from the value-added tax. Under this proposal, it is clear from the onset that each country will be required to participate at a level commensurate with its gross domestic product; and all taxpayers will be able to determine exactly how much they are being asked to sacrifice to save a specific nation. This would increase the accountability of all governments involved.
There is no reason why Europe should continue to protect the arsonists who caused this crisis. This plan shows that it is possible to put out the fire, catch those who lit it, avoid free riding, and preserve equity and transparency.
(Robert Perotti is professor of economics at Bocconi University in Milan. Luigi Zingales is professor of finance at the University of Chicago Booth School of Business. The opinions expressed are their own.)
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To contact the writers of this column: Roberto Perotti at firstname.lastname@example.org; Luigi Zingales at Luigi.Zingales@chicagobooth.edu
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