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No more "it's not my fault"

Strengthening Eurozone Fiscal Governance

Introduction  |  Adjustments and Restructuring   |  
Fiscal policy governance   |  Reform proposal   |  Conclusions  

Abstract

Progress has been made in overcoming the debt crisis in the euro area, but there is still a need for further adjustments. Efforts to consolidate public finances appear to be flagging and are meeting with political resistance. Fiscal policy governance, or the coordination of fiscal policy and the monitoring and correction of debt policy, is seriously flawed. The European Fiscal Compact stipulates that member states reduce their budget deficits, or deficits adjusted for cyclical effects, towards an upper ceiling of 0.5% of GDP. In reality, however, structural deficits are rising in many countries.

Further reforms to fiscal policy rules are urgently needed as a result. On no account should these reforms include a further loosening of deficit rules. Their aim is to increase the effectiveness of deficit rules. I suggest introducing a new type of government bond called  accountability bond. ¹ Accountability bonds freeze interest payments and their maturity is automatically extended if a country's debt ratio exceeds 120% of its GDP. The bonds lose their value permanently if the issuing country undergoes an ESM Programme. Member states with a current structural budget deficit that exceeds the upper ceiling of 0.5% of GDP have to finance the excess debt via accountability bonds.

Accountability bonds would prevent individual member states from passing on the costs of excessive debt to the community of Eurozone member states via collective liability within the framework of ESM programmes or bond purchases by the ECB. This would reinforce fiscal policy coordination in Europe and supplement it with an element of market discipline.

1. Introduction

The debt crisis in the euro area has preoccupied Europe for almost seven years now. The crisis began in autumn 2009 with the public announcement that the Greek government’s budget deficit was far higher than previously reported. The crisis first came to a head in spring 2010 when Greece was granted bail-out funding; with subsequent bail-out initiatives for Portugal, Ireland and Spain. In the years that followed severe financial the populations of crisis-afflicted states had to deal with recession, unemployment and declining incomes. In the meantime, citizens in the rest of the monetary union saw their countries accept significant liabilities, despite the promise made when monetary union was established that no member state would be held liable for the debts of another. In addition, the ECB increasingly took over responsibility for stabilising the financial situation in crisis-afflicted states; prompting criticisms that it was overstepping its mandate.

Over the course of these crisis years considerable efforts to stabilise the economic development of the Eurozone and to introduce reforms to prevent any repeat of the euro crisis have been seen in European politics. That raises the question of whether the crisis can now be said to have been overcome, with the exception of the special situation in Greece. To answer this question, two aspects need to be taken into account. The first is the development of macroeconomic variables such as growth, employment, debt levels and prices. Have the necessary adjustments happened, is the economy growing in the crisis-stricken states, is unemployment falling, is public debt declining? The other aspect concerns the institutional rules, the "governance" of the monetary union. Will reforms to institutions in the Eurozone provide greater stability in the future?

2. Economic adjustments and the restructuring of banks and public finances

The Eurozone is only gradually recovering from the slump in economic growth caused by the global financial crisis and the debt crisis in the euro area. The Eurozone's economic output did not return to its pre-crisis level of 2008 until 2015. Developments in the member states remain highly heterogeneous. While Germany staged a comparatively swift recovery, with its economic output exceeding the 2008 level as early as in 2011, other member states are still a long way off their pre-crisis performance. Italy's gross domestic product is currently 7 percentage points below the 2008 level and is no higher than it was when the euro was introduced.

Significant adjustments have been made to current account deficits. All of the periphery states are now posting more or less balanced current accounts; or even current account surpluses. In many cases this has been achieved by cutting consumption and reducing imports, but partly with higher exports too. In the area of unit labour costs, an important indicator for economic competition, major adjustments have been seen in Spain, Portugal, Greece and Ireland, largely thanks to a decline in employment. However, no declines in unit wage costs were achieved in Italy and France; where there were fewer job cuts, but no improvement to economic competitiveness. In Germany unit labour costs have been rising faster than before the crisis for several years, which helps to offset differences in competitiveness at a European level.     

In the finance sector developments in different member states are very heterogeneous. The number of high and growing non-performing loans, which account for a good 15% of total credit in Italy and Portugal, remains an unresolved problem.

Efforts to consolidate public finances and reduce budget deficits are flagging. During the crisis the public debt ratio in the euro area rose from a total of 65% of GDP in 2007 to almost 95% in 2014. Current budget deficits, which rose sharply over the course of the crisis, fell significantly in many countries up until 2014. The willingness to pursue reform efforts, however, is waning. In Spain the structural budget deficit is set to rise from 1.7% of GDP in 2014 to 2.5% by 2017. According to estimates by the European Commission, this figure will rise from 1.4% to 3.5% over the same period in Portugal, despite the fact that interest costs have fallen considerably in recent years and are likely to continue to do so, thus reducing their burden on public budgets.

According to the European Fiscal Compact, member states should reduce their budget deficits towards an upper ceiling of 0.5% of GDP. There is, however, growing political resistance to further deficit reductions. Politicians like Italy's Prime Minister Matteo Renzi have repeatedly voiced their support for a return to higher levels of fresh borrowing by the government. Such statements cannot be reconciled with European fiscal rules and raise the question of whether, and how, governance of fiscal policy in the currency union is working at the moment, and whether there is a need for reform.

3. The "governance" of fiscal policy in the Eurozone

The second dimension of the crisis involves the institutional design of the currency union, or its "governance" structures. Fiscal and monetary policy governance in the Eurozone rests on two pillars: the first is the European Central Bank (ECB). The ECB is independent and has a clear mandate, namely to ensure price stability. It is not allowed to finance budgets of member states. The second pillar is the European Stability and Growth Pact, according to which member states pursue a prudent fiscal policy and limit public borrowing. Public budgets should be balanced and the pact stipulates that budget deficits can only amount to a maximum of 3% of GDP. This limit was conceived as an upper ceiling in times of crisis. Under normal conditions, member states are supposed to balance their budgets; only when economic conditions are difficult may they allow their deficits to rise to a maximum of 3%. The Stability and Growth Pact agreed upon in 1997 states that:

"Whereas adherence to the medium-term objective of budgetary positions close to balance or in surplus will allow Member States to deal with normal cyclical fluctuations while keeping the government deficit within the 3% of GDP reference value." ²

The European Fiscal Compact agreed upon in 2012 together with the ESM bail-out fund also stipulates that member states have to strive to balance their budgets in terms of limiting their structural public budget deficit to a maximum of 0.5% of GDP. In the years since the monetary union was established, almost all member states have systematically violated the obligation to balance their budgets and have repeatedly exceeded the 3% of GDP upper ceiling for budget deficits. In the EU as a whole, this ceiling has been exceeded 165 times between 1999 and 2015. Only 51 of these transgressions can be justified by a recession (a drop in gross domestic product); for the remaining 114 cases there was no such justification. And yet no sanctions were ever imposed. Instead, the rules have been increasingly softened, with exceptions made for states that make public investments or implement structural reforms. Individual member states that have failed to abide by the pledges made in their stability programmes have suffered practically no consequences to date.

All of this raises the question of how the institutional framework of the monetary union can be reformed in order to ensure better compliance with the rules agreed upon. Current reform concepts from the European institutions like, for example, the "Four Presidents' Report ³" or the "Five Presidents' Report⁴ " stipulate the deeper coordination of fiscal policy and economic policy overall. At the same time they strive towards more fiscal integration including a) the introduction of fiscal insurance mechanisms like a European unemployment benefit insurance system and b), collective liability for public debt. 

The limited effectiveness of the existing, multiply-reformed coordination and surveillance procedure inevitably casts doubts over whether this procedure can be sufficiently effective without a new, far-reaching reorientation. It certainly couldn't remove the false incentives to raise debt levels that would accompany extended collective liability for public debt.

4. A reform proposal: Accountability bonds

It is urgently necessary to prevent any further fiscal policy dysfunction in the member states and the systematic breaking of the fiscal policy rules that has contributed to the debt crisis. It is therefore necessary to combine components of investor liability, and thus market discipline, with the procedure of fiscal policy coordination. This is precisely what the 'accountability bond' ⁵ concept does.

Accountability bonds are a new form of government bond that are subordinate to outstanding and yet-to-be-issued "normal" bonds. They permanently lose their value in the case of defaults on normal bonds, or if a country undergoes an ESM programme. If a country's debt ratio exceeds 120% of its GDP, an interest payment moratorium kicks in and the accountability bonds' maturity is automatically extended until the debt ratio falls below the 120% mark again. Accountability bonds may not be purchased by the ECB and can only be held by banks with adequate capital buffers.

Under the European Fiscal Compact, the Eurozone member states (as well as all EU states except for the Czech Republic and Britain) committed to limit their structural public budget deficit to 0.5% of GDP. States whose deficit exceeds the mid-term budget target would have to finance their excess debt with accountability bonds. In 2015, for example, Spain posted a structural public budget deficit of 2.5%. According to the reform concept presented here, the country would have financed debts totalling 2% of GDP in the form of accountability bonds. States that abide by the jointly agreed deficit rules would not have to issue any accountability bonds. Accountability bonds would have a maturity of five years that would be rolled over for as long as a country’s debt ratio in conventional bonds exceeds 60% of GDP. This would represent no change to the status quo as far as outstanding government bonds are concerned.

To prevent states from having to issue subordinate bonds in economically difficult times, precautions could be taken in better times via the emission of a 'reserve'. For states currently running high budget deficits, temporary rules could be applied, whereby binding and falling ceilings are agreed for public budget deficits to be financed with conventional bonds.

Compared to the growing number of reform proposals for the Eurozone, some of which are also based on the distinction between primary and subordinate government bonds while others include elements of collective liability for government debt, the concept of Accountability Bonds differs in two key ways: firstly, it is not based on stocks of government debt, but on flows (the current deficit). This avoids the danger that large quantities of government bonds suddenly become subordinate, which might destabilise the financial system. Secondly, the concept of accountability bonds features no new elements of collective liability for government debt.  

The fact that accountability bonds have higher default risks than conventional government bonds begs the question of whether investors may be prepared to buy such bonds. This point is open to speculation, since the bonds do not exist yet. There are, however, other types of bonds with more or less high default risks such as, for example, convertible bank bonds (Cocos) or comparatively risky corporate bonds, some of which are issued by small and medium-sized firms. The saleability of accountability bonds will definitely depend on the country issuing the bond. If Germany or France were to issue such bonds, there would probably be investors ready to purchase them at correspondingly higher yields, which would still be higher for France than for Germany. Countries with higher debts or more vulnerable economies may have difficulties finding investors, but these countries would then be forced to take measures enabling them to once again comply with European fiscal rules. That is precisely the goal of accountability bonds. Alternatively, such countries could apply to an ESM programme, but this programme would presumably also stipulate a very swift return to compliance with the jointly agreed rules.  

What could accountability bonds achieve?

1. The disincentives caused by existing elements of collective liability (the ESM, the ECB's OMT programme), which may lead to excessive debt levels, would be removed, at least partly. The costs of borrowing beyond the jointly agreed fiscal rules would be borne by the respective issuers and investors, and not passed on to the taxpayers of other countries. 

2. Surveillance and compliance with European rules on debts would be strengthened. It would be considerably harder (and more expensive) for members states of the Eurozone to overstep or ignore rules on European fiscal policy coordination.

3. Taxpayers in the Eurozone would be spared having to accept liability for the excessive debts of other countries.

4. Investors would have to bear the costs of fiscal crises, rather than shifting them to taxpayers of other, solvent countries.

5. Fears that the explicit introduction of investor liability will lead to a destabilisation of the entire of market for government bonds would be allayed.

5. Conclusions

Reforms are required to overcome the Eurozone's economic crisis on a sustainable basis in many areas of economic policy, and not just in fiscal policy. But it is of key importance to prevent fiscal governance in the Eurozone from being undermined further, since that would ultimately lead to soft budget constraints and a destructive growth of public debt.  Accountability bonds would support sound fiscal policies by both making political coordination more effective and strengthening market discipline.

Clemens Fuest

Publication forthcoming.