The end-game is debt sustainability

There is one aspect of the euro zone that was little understood when the project was launched and embraced by the member states: countries in a monetary union issue debt in a currency that is foreign to them. As they do not control it, they are unable to use it to soften their own debt burden through devaluation and inflation. In the new scenario, national governments can only restore and secure debt sustainability by means of structural reform and economic growth. Fiscal retrenchment should be just a transitory phase that allows them to move to a stage where structural and growth-enhancing reforms are the name of the game.

Greece has been running undisciplined fiscal policy for years, both before and after the introduction of the Euro. At the beginning markets did not take note of fiscal misbehaviour in Greece (and elsewhere). Government bond yields have been on an astonishing convergence path from 1999 to the outbreak of the crisis. No market pressure and discipline were exercised, which was a mistake. Greek government yields rose dramatically in 2010 just because markets became aware, all of a sudden, of their own misjudgement, and not because of an abrupt deterioration in the country’s fundamentals.

Contagion spread for the very same reason: markets realised that countries with high public debt burdens are unable to deal with them unless they have implemented or will implement structural and growth-enhancing reforms. Italy is a case in point. But a similar reasoning would apply also to countries whose substantial private sector liabilities can easily translate into high public debt burdens (Ireland, Spain, and Portugal).

Furthermore, contagion has been so widespread and extensive because of the facility with which capital flows from one country to the other. In the midst of a crisis, when risk aversion increases, there is indeed a natural “flight to safety” with capital running away from countries that are perceived as risky towards safer countries thanks to full capital mobility and the absence of exchange rate risks.

A two-speed Europe is not a solution to this problem. Indeed a second soft Euro for the South of Europe does not eliminate the fact that a country is still issuing debt in a foreign currency and the same that happened in the euro zone now will occur in a different monetary union constellation.

What makes the euro zone sustainable then? The end-game does not have to be political union, whatever that means. Debt sustainability may be sufficient for the purpose. If all debt levels are set on a sustainable footing, then there should be nothing terribly wrong with issuing debts in a “foreign currency”.

The way to get there is fundamentally a domestic one and includes structural reform (e.g. pension reform) and economic growth, where the latter could be generated, in some cases, through a more efficient and clever use of EU Structural and Cohesion Funds*.

The transition to that end-game however needs strong coordination of policies and fresh resources. It is a welcome development that the new rules for the Stability Pact punish deviation from medium-term fiscal targets and debt reduction. They should have accounted for debt sustainability, and indeed debt sustainability only, since the very beginning. Fiscal policy coordination in the form of stronger ex ante surveillance on debt levels is thus necessary.

Yet, it is not sufficient. In the transition to debt sustainability, financial markets will continue betting against high-debt countries, putting their endeavour at risk. At the margin, it should be said that, if financial markets were truly forward-looking, they would also bet against countries with high implicit public liabilities, which they are probably starting to do just now. Putting controls on capital mobility may not be capable of stopping “flights to safety” and, in any case, it will impact so badly on economic growth that it would endanger debt sustainability even more incisively than rising yields.

By contrast, to support countries that fall under attack, actual resources need to be brought to the table. The ECB can do most of the job if and only if national governments agree to stand behind it and assume the commitment to devoting at least a limited amount of national resources in case of need (i.e. default) (say 1% of their income). This will have to go on until all countries have achieved sustainable debt levels. Further policy integration and common structures are thus the means to get there rather than the end-game.