The tricky path toward greater fiscal integration

By H.G. | LONDON

WAY back in August there seemed to be some momentum behind the idea of a euro bond. Former EU commissioner Mario Monti, investor George Soros, former German finance minister and prominent member of the opposition Peer Steinbrück, amongst many others, have argued in favour. In the European Parliament in September Jose Manuel Barroso announced that the Commission would be putting forward plans for a euro bond. In our poll, 58% of readers backed them as a solution, and Reuters found 41 out of 59 economists support them and 36 out of 60 analysts expected them to be issued as soon as 2012 or 2013.

Staunch opposition from Angela Merkel and Wolfgang Schäuble, her finance minister, reflecting the mood of the German public, quickly ended excitement.This newspaper wasn't too keen either. We worried that proposals like the think-tank Bruegel's blue bond/red bond plan (which was the basis of policy proposals from Giulio Tremonti and Jean-Claude Juncker) would create an unworkable two-tier bond market which left the weakest euro-zone countries in no better a position than they are now.

While markets are cheering the "comprehensive" package announced yesterday, time will tell whether it is enough to stop the rot. Optimism surrounding previous rescue packages has not always lasted. It might yet be worth another look at euro bonds. In a new paper John Muellbauer, of Oxford University, takes a stab.

Paul de Grauwe, of the Catholic University of Leuven, lays out (in a paper Paul Krugman says he wished he'd written) the two main objections to euro bonds. Firstly they suffer from moral hazard. Once underwritten by the euro zone as a whole, wayward countries have no need to tighten their finances and reform themselves. Second, the pooling of debt may lead to countries like Germany, Finland and the Netherlands, which presently benefit from very low rates, paying more.

Mr Muellbauer's solution revolves around conditional euro bonds. He proposes the collective underwriting (though he excludes Greece throughout this proposal) of 85% of outstanding sovereign debt alongside a system of side-payments from sub-AAA-rated countries to the AAA-countries, currently Germany, France, the Netherlands, Austria, Finland and Luxembourg. These payments would be set according to a spread on new borrowing (including refinancing*) determined by annual performance targets, decided by a new European monetary and fiscal authority (EMFA).

To illustrate with a hypothetical example, Portugal's 10-year government bonds currently face a spread of around 8% relative to German 10-years bunds. After receiving a political commitment to structural reform from the Portuguese government, the EMFA might set the spread at 5% for new borrowing in the first year but with the promise that, conditional on satisfactory progress, the spread would be reduced in the following years. This immediately takes off some of the pressure exerted by highly risk averse financial markets on the economy of Portugal and on the holders of its sovereign debt. At the same time it creates a strong reform incentive with early rewards. It also encourages early fiscal discipline: why borrow expensively now when there is a good chance of being able to borrow more cheaply in the future?

Mr Muellbauer argues that this solves the moral hazard problem. On the second problem: A common euro bond would create a large new government bond market with a lot of liquidity. This would attract a lot of investors, particularly China, which is keen to diversify its dollar holdings. This paper estimates that the combined liquidity and reserve currency premium enjoyed by the dollar amounts to approximately 50 basis points. Additionally:

An underlying rationale for Eurobonds is that the public finances of the euro area as a whole look quite respectable…The IMF envisages that general government debt will reach 88% of the single currency zone's GDP this year. This is lower than America's 98% and not much higher than Britain's 83%. The euro area's projected budget deficit will be a bit above 4% of GDP, rather better than America's 10% and Britain's 8.5%

The costs to Germany and the other strong countries, estimated here but much debated, would certainly be reduced by this and the side-payments it would receive.

Mr Muellbauer then goes on to explain how the spreads would be conditioned. He sees the divergence in competitiveness (and in particular unit labour costs) within the euro zone as one of the key sources of internal stress. Much of that is down to the labour market policies of individual countries, which clearly need reforming—though the machinations of the Italian Parliament show how difficult this can be. He suggests a weighted combination of unit labour costs, the sovereign debt-to-GDP ratio and the current-account-to-GDP ratio. In addition he proposes the World Bank's "Doing Business" indicator as a guide for the EMFA on the progress of reforms. The caveat of Goodhart's law, which suggests that if an economic indicator is made a target for conducting policy, it loses the information content that qualifies it to play such a role, should be well observed here.

And yet increasing competitiveness is no easy feat. A common currency rules out depreciation. Mr Muellbauer argues that governments in the peripheral countries must engineer the effects of a currency devaluation through deflationary macroeconomic policies to lower wages and prices in order to improve competitiveness. He points to the wage reductions achieved in Ireland, led by the public sector. Given a nominal wage cut orchestrated by the government, the general price level consumers faced would adjust downwards. Though this depends on how much the country imports (international prices will not be affected by the wage cut) and how much of the wage cut private sector firms choose to pass on. The pain for workers could be quite substantial. Mr Muellbauer thus also proposes a large temporary cut in VAT, which would put pressure on firms to cut their prices.

It strikes me that this "fiscal gamble" as Mr Muellbauer puts it might not quite fly. The idea of Italians or Spaniards receiving a tax cut courtesy of largesse in Brussels seems perverse. This proposal is the best euro-bond pitch I've seen and yet still seems impractical. Mr Muellbauer is not clear on how to deal with the remaining 15% of sovereign debt that is not covered. He says that in the worst case scenario it would all be written down. Uncertainty around the handling of this debt would cause panic.

The questions that Europe needs to answer to end this crisis run through this paper. What faith to put in both new and old collective institutions? How much closer to political union to move? How much will northern Europe eventually pay for a lasting solution? Mr Muellbauer argues that "the policies proposed here provide the right fiscal incentives for each country without draconian central fiscal control". Yet he undermines his own argument when referring to Greece. How much pressure the EMFA would actually be able to exert should be questioned. He writes that "it seems that only by holding a gun to the head of the government has its resolve to reform been achieved". Indeed the neutrality, independence and judgment of the proposed EMFA in the first place should surely be feared for. Decisions would be bitterly contested and it would be unrelentingly lobbied by its charges. Eurostat's dismal performance in originally monitoring the Greek debt position is not encouraging. Ultimately are Europeans prepared to place themselves in the hands of bureaucrats in Brussels in order to protect themselves from the ravages of the market?

*The spreads affect new debt only, but because a substantial fraction of debt is refinanced each year (many of the target countries have a short maturity profile) there is a strong incentive for reform without cripplingly high extra coupon payments on outstanding debt.