Blog Post

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 […]

By: Date: November 21, 2011 Topic: Macroeconomic policy

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.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

Read article More by this author
 

Opinion

European governance

Can the EU fiscal rules jump on the green bandwagon?

By and large, setting a new green golden rule would be a useful addition to the existing EU fiscal framework.

By: Guntram B. Wolff Topic: European governance, Green economy, Macroeconomic policy Date: October 22, 2021
Read article
 

Blog Post

European governance

Germany’s post-pandemic current account surplus

The pandemic has increased the net lending position of the German corporate sector. By incentivising private investment, policymakers could trigger a virtuous cycle of increasing wages, decreasing corporate net lending, which would eventually lead to a reduction of the economy-wide current account surplus.

By: Lionel Guetta-Jeanrenaud and Guntram B. Wolff Topic: European governance, Macroeconomic policy Date: October 21, 2021
Read about event
 

Past Event

Past Event

Monetary policy in the time of climate change

How does climate change influence monetary policy in the eurozone? What potential monetary policy measures should be taken up to address climate risks?

Speakers: Cornelia Holthausen, Jean Pisani-Ferry and Guntram B. Wolff Topic: Green economy, Macroeconomic policy Date: October 20, 2021
Read article More by this author
 

Podcast

Podcast

Rethinking fiscal policy

A look at the past, present and future of fiscal policy in the European Union with Chief economist of the European Stability Mechanism, Rolf Strauch.

By: The Sound of Economics Topic: European governance, Macroeconomic policy Date: October 20, 2021
Read about event More on this topic
 

Upcoming Event

Nov
4
14:00

European monetary policy: lessons from the past two decades

This event will feature the presentation of “Monetary Policy in Times of Crisis – A Tale of Two Decades of the European Central Bank."

Speakers: Grégory Claeys and Wolfgang Lemke Topic: Macroeconomic policy Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read article
 

External Publication

European Parliament

Tailoring prudential policy to bank size: the application of proportionality in the US and euro area

In-depth analysis prepared for the European Parliament's Committee on Economic and Monetary Affairs (ECON).

By: Alexander Lehmann and Nicolas Véron Topic: Banking and capital markets, European Parliament, Macroeconomic policy Date: October 14, 2021
Read article More by this author
 

External Publication

Global Economic Resilience: Building Forward Better

A roadmap for systemic economic reform calling for step-change in global economic governance to increase resilience and build forward better from economic shocks, prepared for the G7 Advisory Panel on Economic Resilience.

By: Thomas Wieser Topic: Global economy and trade, Macroeconomic policy Date: October 14, 2021
Read article More on this topic More by this author
 

Opinion

Letter: Declining investment may explain why rates are low

Perhaps an analysis of the causes of the declining investment rate would bring us closer to explaining why real interest rates are so low.

By: Marek Dabrowski Topic: Macroeconomic policy Date: October 1, 2021
Read article More by this author
 

Podcast

Podcast

A green fiscal pact

How can the European Union increase green public investment while consolidating budget deficits?

By: The Sound of Economics Topic: European governance, Macroeconomic policy Date: September 29, 2021
Read article More on this topic More by this author
 

Blog Post

Monetary arithmetic and inflation risk

Between 2007 and 2020, the balance sheets of the European Central Bank, the Bank of Japan, and the Fed have all increased about sevenfold. But inflation stayed low throughout the 2010s. This was possible due to decreasing money velocity and the money multiplier. However, a continuation of asset purchasing programs by central banks involves the risk of higher inflation and fiscal dominance.

By: Marek Dabrowski Topic: Macroeconomic policy Date: September 28, 2021
Read article More on this topic More by this author
 

Opinion

The pandemic’s uncertain impact on productivity

The pandemic has certainly permanently affected our way of working. Whether this is for the better remains to be seen.

By: Maria Demertzis Topic: Macroeconomic policy Date: September 28, 2021
Read about event More on this topic
 

Past Event

Past Event

How to strike the right balance between the three pillars of the pension system?

In this event panelists will discuss the future of European pension schemes.

Speakers: Elsa Fornero, Svend E. Hougaard Jensen and Suvi-Anne Siimes Topic: Macroeconomic policy Date: September 23, 2021
Load more posts