German Chancellor Angela Merkel has withstood the pressure from southern Europe: there will be no eurobonds. For the markets, this is a disappointment, but there is no other way for these countries to rebuild themselves than to insist patiently on a phase of debt discipline and an end to lax budget constraints.
Investors in Europe’s troubled economies are already getting enough hand-outs as it is. Eurozone leaders’ decision on July 21 to allow the European Financial Stability Facility to buy back old debts – up to the limitation of the EFSF’s capacity – already amounts to a type of eurobonds. And the European Central Bank will also blithely continue its bailout policy in terms of giving Target loans to the eurozone’s troubled members and purchasing their government bonds.
Southern Europe, however, is pushing hard for a complete changeover to eurobonds to get rid of the interest-rate premiums relative to Germany that markets are demanding of them. This is understandable, given that the hope of interest-rate convergence was a decisive reason for these countries to join the euro in the first place. And, for a little more than a decade, from 1997 to 2007, this hope was realized.
For the Italian state, interest-rate convergence brought a medium-term reduction in debt-service payments of up to 6% of GDP. That would have been sufficient to pay back the entire Italian national debt over about a decade and a half. Italy, however, chose to squander that interest-rate advantage. Italy’s debt-to-GDP ratio today, at 120%, is as high as it was when the country entered the eurozone in the mid-1990s.
Now that interest-rate spreads are increasing again, the pain is considerable, prompting calls for eurobonds. When other countries guarantee repayment, it is hoped, low interest rates will return.
But who is to make these guarantees? The debt-to-GDP ratios of France and Germany are well above 80%, which isn’t all that far below Italy’s and way above Spain’s. Pooling debts, moreover, doesn’t make them go away. Every country has to service its own debts; there is no way around that.
And, incidentally, the current agitation about interest rates is somewhat exaggerated. The interest rates that countries like Italy and Spain have to pay today are only half as high as in 1995, before the conversion rates within the eurozone were set, and interest-rate spreads vis-à-vis Germany today are only two-thirds what they were then. There is no indication that the markets are dysfunctional and are overstating the differences between countries’ creditworthiness.
The spreads are necessary to keep capital flows within the eurozone in check. Before the introduction of the euro, capital flows had been limited by uncertainty about exchange rates. This saved Europe from overly large external imbalances. Now, without exchange-rate risk, interest-rate spreads based on debtor countries’ credit ratings are the only remaining defence against excessive capital movements and the resulting external imbalances. If investors are given unlimited protection, with no risk of bearing their share of possible losses, capital will continue to flow unimpeded from one corner of the eurozone to the other, prolonging these imbalances.
For many years, Italy has disregarded the debt ceilings imposed by the Maastricht Treaty and the Stability and Growth Pact. Only when interest rates recently began to rise a bit did the government finally – and promptly – implement an austerity programme, with the approval of all political parties. The markets, not political debt ceilings, are taken seriously; the introduction of eurobonds would remove that disciplining function.
To a limited extent, the same applies to the EU bailouts and ECB interventions. These could be justified during the recession of 2008–2009, but now they have become counter-productive because they undermine the markets’ controlling function.
By replacing the private credit that is being withdrawn with public credit, the external imbalances within the eurozone are being perpetuated. Even today, four years into the crisis, there are no signs that the overly expensive countries in Europe’s southern periphery have begun a process of real devaluation by cutting wages and prices. That, however, is a precondition for reducing external imbalances and reliance on foreign credit.
The bailouts are prolonging the crisis because they amount to an attempt to keep asset prices at a level above the market equilibrium, creating a unilateral downward risk that is limited only by the deep pockets of the relief funds. This is reminiscent of central banks’ futile efforts, back when fixed exchange-rate regimes were common, to stabilise rates above their market equilibrium. The result, much like today, was merely to exacerbate market turbulence.
It is time for Europe to face reality and initiate the difficult adjustment processes within the real economy that are necessary to rebalance the eurozone. Eurobonds would numb the distressed countries’ current pain, but, by failing to treat the underlying disease, they – and the eurozone as a whole – would end up far sicker than before.
Professor of Economics and Public Finance
President of the Ifo Institute