It’s been two years since the European Union’s grand experiment with integration started coming apart at the seams. One plan after another to knit the alliance back together has been tried, and failed. Now comes news that euro-area leaders are considering a tighter fiscal union and the issuance of jointly backed euro bonds.
It’s about time. Setting up a centralized fiscal authority would, in essence, give the euro area a do-over: It would clarify and strengthen the conditions a country must meet to win the collective backing of all the others for its debts.
So how do we begin? As the European Commission, the EU’s administrative arm, wrote in a widely circulated Nov. 23 paper, a fiscal authority must do three things: stabilize and gradually reduce sovereign debt, avoid free-riding by less-disciplined states (the so-called moral hazard), and stop the attacks by investors on euro-area governments. Perhaps most important, fiscal union must benefit all member states.
The last one is especially tricky. In practice, it means that a higher authority in Brussels shouldn’t disenfranchise Greek, Italian and perhaps soon French citizens whose governments and banks need help. But it also means Germany and five other euro-area nations shouldn’t have to give up their AAA credit ratings, and thereby suffer a higher cost of debt financing. It’s a tough puzzle to fit together, but possible.
The way to do it is by simultaneously forming a tighter fiscal union and arranging for the issuance of euro bonds or, to use the EC’s hopeful euphemism, “stability bonds.” This would involve pooling all euro-area sovereign bonds, making each country liable for its own and other euro-area debts.
Here’s the catch: In exchange for guaranteeing their debt, riskier states should pay a premium to the safer ones. A country’s premium would be linked to a risk metric, such as its ratio of debt to gross domestic product. The new European fiscal authority would set premium payments annually, conditioned upon performance targets it would also set. High-debt countries would pay higher premiums to compensate AAA-rated countries (Austria, Finland, France, Germany, Luxembourg and the Netherlands).
Such a system would need strict boundaries, along with penalties and incentives to maintain discipline. First and foremost, any nation’s existing debt should convert into euro bonds only up to a threshold of, say, 85 percent of sovereign debt. That would be high enough to reassure markets but not so high as to let countries completely off the hook. The remaining 15 percent of a country’s debt would continue to be subject to normal market conditions, in which investors impose higher yields on higher-risk countries. Under this arrangement, Greece and Portugal might still need to go through an orderly default for their existing debt.
To maintain its 85 percent allowance, each country would have to meet annual fiscal commitments by keeping its budget deficit, say, below a set amount. If a country meets its targets -- confirmed by an independent fiscal auditing body -- it would be allowed to convert more of its debt into euro bonds. If not, the 85 percent ceiling could be lowered, or a country could be barred from issuing euro bonds until expectations are aligned.
Other measures would be needed, such as the adoption of a common budgetary timeline and close monitoring by Brussels of each country’s fiscal status. Surveillance would grow more intrusive if belt-tightening pledges went unmet.
The euro-bond program would need a thermostat to give a country in recession, or suffering from economic shock, the flexibility to avoid austerity measures that would only shrink the economy, making debt repayment even harder. Likewise, in periods of robust growth, governments would be compelled to cut spending and raise taxes faster. In general, we urge European leaders to make the system as automatic and uniform as possible. This is the only way to keep national resentments from building.
All of this will require the 17 euro-area countries to give up a certain amount of sovereignty. In return, the European Central Bank would be free to embark on the bond-buying program it has long resisted. The central bank is concerned that government-bond buying in large quantities would only give national politicians an escape valve to put off budgetary overhauls. Those worries should finally be erased by the one-two combo of fiscal convergence and conditional euro bonds.
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