Redemption Fund or Eurobonds?

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Judging from what the media have made of the latest gathering of European leaders in Brussels, it came close to a disaster. No decision about Eurobonds or growth was taken. The big elephant in the room – Greece − was barely mentioned. Chancellor Angela Merkel and the new French President Francois Hollande exchanged the customary pleasantries, but many observers suggested that the Frenchman is looking elsewhere for support for his anti-austerity push. Overall, the prevailing narrative is one of a lost opportunity, or worse, one of growing rifts. Markets expected solutions that never came.  Greece’s exit from the euro zone inches closer, and European partners are still not sure what to do about it. Sounds familiar?

I beg to differ. This meeting was never meant to come up with concrete solutions. Greece has not voted yet, Irish voters still need to decide whether the fiscal compact will be ratified, and Francois Hollande himself is still in campaign mode by getting ready for national assembly elections due in mid June. More importantly, a few positive, yet overlooked elements did indeed emerge during the gathering of European leaders.

Herman von Rompuy, the president of the European Council was given the task of sketching out concrete steps towards closer integration of the euro area, so called “building blocks”. They should be put on the table at the next summit at the end of June. One part of his task is to explore if a cross border deposit insurance could help to stabilize the banking sector, and in particular to avoid a panic driven bank run should Greece leave the euro. A deposit insurance would not only protect most of the euro zone from a destabilizing Greek contagion, it would in effect open the door to a truly integrated European banking system − something Germany and others had resisted vehemently in the wake of the Lehman Brothers collapse in September 2008. The European Central Bank is a strong advocate for a centralized bank resolution.

As to Eurobonds, they are on the way, but with a different nametag. Hollande has never defined what Eurobonds should look like. Merkel has done it for him. What Merkel is rejecting is the idea of mutualizing ALL Eurozone debt. In Merkel’s definition, Eurobonds amount to a full insurance policy that would only benefit profligate euro zone countries. Such a scheme would encourage moral hazard and would never pass the German smell test. According to her, this type of Eurobond could only be introduced if more sovereignty was transferred from member states to central European authorities and a true fiscal union emerged. Whether Hollande and other Eurobond advocates, such as Italian Prime minister Mario Monti, would completely disagree with Merkel on this point is an open question. Probably not. But there are many types of Eurobonds. Ultimately what Italy, Spain and France want more than anything else is not to pool all debt, but to drive interest rates down to a sustainable level and to avoid falling into a debt trap. What they need is a partial insurance policy. That is something Germany’s governing coalition is much more open to. In effect, leading German economists have already submitted a detailed proposal that would more or less work like this: all debt in excess of 60 % of GDP (the famous limit set up in the Maastricht treaty) could be pooled into a Eurozone debt redemption fund that could be paid down over 20 to 25 years. To service this debt the pool would issue common bonds. Interest rates would come down to a more sustainable level and the huge debt stock of euro zone countries, including Germany’s, would gradually shrink. Of course, in order to finance the rest of their debt, member countries would need to continue to issue their own bonds. In order to avoid excessive market pressure member states would have a strong incentive to keep their deficits under control. This solution is gaining traction in Germany, because it addresses both the practical problem of reducing the debt stock and the moral hazard. It reflects the German willingness to show solidarity but only in exchange for good behavior.

Realizing that this approach could carry the day, German Social Democrats and Greens are trying to claim ownership. Those parties are now entering the final stretch of their negotiations with the Government on whether to support the fiscal compact. They are turning these “common redemption bonds” into a bargaining chip. The stakes are high, because unless a deal is struck, the fiscal treaty could fail to muster the required two-thirds majority in the German Parliament and Merkel’s brainchild would be dead. That is an outcome that the German Chancellor wants to avoid at almost all costs. In fact, “redemption bonds” could help everybody to save face, not only Merkel and the German opposition, but also Hollande and Monti.

As always, while all these plans try to prepare the euro zone for a new turn in the Greek crisis, complete inoculation from the virus in Athens is impossible to achieve. We should expect the game of brinkmanship that Greece’s populist left is playing with its main counterpart to the North, Germany, to continue for at the very least another month. Ultimately, rational and reasonable decisions should emerge. However, that is exactly what a lot of people thought when they went home on the Friday before Lehman Brothers collapsed.