By Alistair Milne
Debt is a drug. High levels of debt used for unproductive purposes result in a temporary economic high. But after the high there is the inescapable low. Who should pay the bill when it eventually comes due? Should it be the debt user, for eagerly borrowing more than they can comfortably repay? Should it be the debt provider, for knowingly supplying more debt than they can reasonably expect to be paid back? Or should others rally round to help reduce the burden?
The struggle by Greece to repair its public finances is a big challenge to the European single currency. But the underlying question is no different from other previous debt crises, such as Imperial Spain in the 16th and 17th century, Latin America in the 1980s or most recently in US subprime mortgage lending. Who pays?
This question can no longer be ducked. A new Maastricht treaty is now unavoidable and Europe faces a big political choice. Shall the single currency be supported through closer fiscal and political union (with eurozone governments creating the political arrangements for collective control of individual national fiscal policy); or – and I argue this is a viable alternative – can it be achieved by introducing effective market disciplines on national fiscal policy?
If neither of these courses of action are chosen then the consequences for the eurozone will be damaging indeed – ongoing political bickering and uncertainty at EU level, severe political instability at national level, and the real possibilities of debt repudiation and even withdrawal from the single currency, either by several weaker members or by its single strongest member.
So, can there be an effective market discipline on national fiscal policy within the eurozone? The answer is yes, but this will require three big changes:
• Arrangements for orderly and predictable restructuring of repayments on eurozone national government debt. I suggest this should be through a limit on the primary fiscal balance of 15 per cent of gross domestic product, i.e. taxpayers should have a degree of limited liability. Only then can holders of debt reach a view on the pricing of debt that reflects risk of default on repayment.
• Strict limits on EU bank holding of eurozone public debt. For example around 30 per cent of Greek government debt is held by commercial banks from other European countries and nearly 20 per cent is in the hands of domestic banks. Only by drastically reducing such bank investment can the market price of eurozone national government debt be a clean price that does not reflect the implicit subsidy of the bank safety net.
• In order to cope with the inevitable disruptions in access to debt markets, short-term liquidity arrangements, with national governments having limited facilities for borrowing for the European Central Bank, guaranteed collectively by fellow eurozone governments and senior to any debt in private hands.
Changes of this kind will fundamentally alter the character of the bulk of eurozone government debt. It will become limited liability and held by non-banks (“limited liability non-bank government debt”). But reform of the Maastricht treaty in this or a similar direction is essential, if the European single currency is to be maintained without following the highly controversial path to fiscal union.
This proposal for limited liability non-bank government debt is no easy option. Until they re-establish their fiscal credibility with the market, it will make borrowing by the weaker eurozone countries much more difficult and expensive than in the past. The consequent fiscal squeeze will be just as fierce as anything the International Monetary Fund is likely to impose. Weaker countries will have to face up to their underlying problems of structural uncompetitiveness.
This will be a painful process taking many years, requiring substantial reductions in real wage costs and likely to sharply increase unemployment (although this may be ameliorated by labour market reforms). The stronger countries will have a responsibility to help share these costs, but will need to do so in ways that do not blunt incentives for change. All this will be in the context of the broader global challenge that Martin Wolf has referred to as “Chermany”, i.e. the absence of productive investment opportunities capable of absorbing the high level of savings of countries such as China and Germany, a further structural problem which threatens to undermine the growth of global demand and output in the years ahead.
What about non-eurozone countries? Will such disciplines not discourage the expansion of the single currency to embrace new member states of the EU? Yes, indeed they will. Many in countries currently outside the eurozone will feel that retaining their monetary sovereignty and a freely floating currency is preferable to accepting such market discipline within the single currency.
Most notable is the case of the UK, whose 2010 government deficit is likely to be even larger than that of Greece (as a percentage of GDP) and where government has recently relied entirely on the central bank for financing its borrowing (with the caveat that this is not direct borrowing but a form of unorthodox monetary policy, with open market purchase of government debt from market participants under the Bank of England’s ‘quantitative easing’).
Monetary sovereignty has certainly benefited the UK. The substantial exchange rate depreciation of the past three years has restored competitiveness. The challenge now is how to restore fiscal discipline. Central bank financing of government debt on the scale recently pursued is ultimately incompatible with the pursuit of stable inflation. But the danger is of a disorderly adjustment and a consequent political backlash that undermines monetary discipline and leads to a loss of monetary as well as fiscal credibility. Innocent savers may end up paying the bill for UK profligacy.
The establishment of credible mechanisms for market discipline on fiscal policy within the single European currency – making sure that the debt provider as well as the debt user are exposed to the costs of excessive government borrowing – could be a clinching economic argument, persuading the UK and other non-eurozone EU countries, that they need to join the single currency in order to maintain both fiscal and monetary discipline.
Related reading:
Limited liability non-bank government debt for the eurozone Alistair Milne, Cass Business School site
Alistair Milne is a reader in banking at Cass Business School, City University London.
