the governance of a fragile eurozone

8/7/2019 The Governance of a Fragile Eurozone

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THEGOVERNANCEOFAFRAGILEEUROZONE

PaulDeGrauwe

UniversityofLeuvenandCEPS

Abstract:

Whenenteringamonetaryunion,member-countrieschangethenatureoftheir

sovereign debt ina fundamentalway, i.e. they cease tohave control over thecurrencyinwhich theirdebtisissued.Asaresult, financialmarkets can force

these countries’ sovereigns into default. In this sensemember countries of amonetary union are downgraded to the status of emerging economies. This

makes the monetary union fragile and vulnerable to changing market

sentiments.Italsomakesitpossiblethatself-fulfillingmultipleequilibriaarise.IanalyzetheimplicationsofthisfragilityforthegovernanceoftheEurozone.I

conclude that the new governance structure (ESM) does not sufficientlyrecognizethisfragility.Someofthefeaturesofthenewfinancialassistanceare

likely to increase this fragility. In addition, it is also likely to rip member-

countriesoftheirabilitytousetheautomaticstabilizersduringarecession.Thisis surely a step backward in the long history of social progress in Europe. I

suggestadifferentapproachtodealwiththeseproblems.

April2011



2

1.Introduction

InordertodesigntheappropriategovernanceinstitutionsfortheEurozoneitis

important to make the right diagnosis of the nature of the debt crisis in the

Eurozone.Failuretodoso,canleadtodesigningagovernancestructurethatis

inappropriate for dealingwith the problemsof the Eurozone. In this paper I

arguethatthegovernancestructurethathasemergedafteraseriesofdecisions

ofsuccessiveEuropeanCouncilmeetings,althoughanimportantstepforwards,

failstoaddresssomefundamentalproblemsinamonetaryunion.

2.AParadox

IstartwiththeparadoxthatisimmediatelyvisiblefromacomparisonofFigures

1and2.Figure1showsthedebttoGDPratiosoftheUKandSpain.Itcanbe

seenthatsincethestartofthefinancialcrisisthegovernmentdebtratioofthe

UKhasincreasedmorethanthatofSpain.Asaresult,in2011asapercentof

GDPtheUKgovernmentdebtstood17%higherthantheSpanishGovernment

debt(89%versus72%).YetfromFigure2 itappearsthatthefinancialmarkets

havesingledoutSpainandnottheUKasthecountrythatcouldgetentangledin

agovernmentdebtcrisis.Thiscanbeseen fromthe factthatsincethestartof

2010theyieldonSpanishgovernmentbondshasincreasedstronglyrelativeto

theUK,suggestingthatthemarketspriceinasignificantlyhigherdefaultriskon

SpanishthanonUKgovernmentbonds.Inearly2011thisdifferenceamounted

to200basispoints.Whyisitthatfinancialmarketsattachamuchhigherdefault

risk on Spanish than on UK government bonds government bonds, while it

appearsthattheUKfacesalessfavourablesovereigndebtanddeficitdynamics?

Onepossibleansweristhatitmayhavesomethingtodowiththebankingsector.

Thisisunconvincing,though.ThestateoftheUKbankingsectoriscertainlynot

much better than the one of Spain. I will argue that this difference in the

evaluationofthesovereigndefaultrisksisrelatedtothefactthatSpainbelongs

toamonetaryunion,whiletheUKisnotpartofamonetaryunion,andtherefore

hascontroloverthecurrencyinwhichitissuesitsdebt.



3

Figure1

Source:EuropeanCommission,Ameco

Figure2:

Source:Datastream

0

10

20

30

40

50

60

70

80

90

100

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Grossgovernmentdebt(%ofGDP)

UK

Spain

2

2.5

3

3.5

4

4.5

5

5.5

6

p e r c e n t

10-yeargovernmentbondratesSpainandUK

Spain

UK



4

3.Onthenatureofsovereigndebtinamonetaryunion

Inanutshell the difference inthe nature ofsovereign debtbetweenmembers

andnon-membersofamonetaryunionboilsdowntothefollowing.Membersof

amonetaryunionissuedebt ina currencyoverwhich theyhavenocontrol.It

follows that financial markets acquire the power to force default on these

countries.Thisisnotthecaseincountriesthatarenotpartofamonetaryunion,

and have kept control over the currency in which they issue debt. These

countriescannoteasilybeforcedintodefaultbyfinancialmarkets.

Letmeexpand on this byconsidering indetail what happenswhen investors

starthavingdoubtsaboutthesolvencyofthesetwotypesofcountries.Iwilluse

theUKasaprototypemonetary“stand-alone”countryandSpainasaprototype

member-country of a monetary union (see Kopf(2011) for an insightful

analysis).

TheUKscenario

Let’s first trace what would happen if investors were to fear that the UK

governmentmightbedefaultingonitsdebt.Inthatcase,theywouldselltheirUK

governmentbonds,drivinguptheinterestrate.Aftersellingthesebonds,theseinvestorswouldhavepoundsthatmostprobablytheywouldwanttogetridof

bysellingthemintheforeignexchangemarket.Thepriceofthepoundwould

dropuntilsomebodyelsewouldbewillingtobuythesepounds.Theeffectofthis

mechanismisthatthepoundswouldremainbottledupintheUKmoneymarket

tobeinvestedinUKassets.Putdifferently,theUKmoneystockwouldremain

unchanged. Part of that stockof money wouldprobablybe re-invested inUK

government securities. But even if that were not the case so that the UKgovernment cannot find the funds to roll over its debt at reasonable interest

rates, itwouldcertainly force the BankofEngland tobuy upthe government

securities.Thus the UKgovernment isensured that the liquidity isaround to

funditsdebt.Thismeansthatinvestorscannotprecipitatealiquiditycrisisinthe

UKthatcouldforcetheUKgovernmentintodefault.Thereisasuperiorforceof

lastresort,theBankofEngland.



5

TheSpanishscenario

Thingsaredramaticallydifferentforamemberofamonetaryunion,likeSpain.

Suppose that investors fear a default by the Spanishgovernment.Asa result,

theysellSpanishgovernmentbonds,raisingtheinterestrate.Sofar,wehavethe

sameeffectsasinthecaseoftheUK.Therestisverydifferent.Theinvestorswho

haveacquiredeurosarelikelytodecidetoinvesttheseeuroselsewhere,sayin

German government bonds. As a result, the euros leave the Spanish banking

system.Thereisnoforeignexchangemarket,noraflexibleexchangeratetostop

this.Thus the total amount of liquidity (money supply) in Spain shrinks. The

Spanishgovernmentexperiencesaliquiditycrisis,i.e.itcannotobtainfundsto

roll over its debt at reasonable interest rates. In addition, the Spanish

governmentcannot force theBankofSpain tobuygovernmentdebt.TheECB

canprovidealltheliquidityoftheworld,buttheSpanishgovernmentdoesnot

control that institution. The liquidity crisis, if strong enough, can force the

Spanishgovernmentintodefault.Financialmarketsknowthisandwilltestthe

Spanish government when budget deficits deteriorate. Thus, in a monetary

union,financialmarketsacquiretremendouspowerandcanforceanymember

countryonitsknees.

ThesituationofSpainisreminiscentofthesituationofemergingeconomiesthat

havetoborrowinaforeigncurrency.Theseemergingeconomiesfacethesame

problem,i.e.theycansuddenlybeconfrontedwitha“suddenstop”whencapital

inflowssuddenlystopleadingtoaliquiditycrisis(seeCalvo,etal.(2006)).

There is an additional difference in the debt dynamics imposed by financial

marketsonmemberandnon-membercountriesofamonetaryunion.IntheUK

scenariowehaveseenthatasinvestorsselltheproceedsoftheirbondsalesin

theforeignexchangemarket,thenationalcurrencydepreciates.Thismeansthat

theUKeconomyisgivenaboostandthatUKinflationincreases.Thismechanism

isabsentintheSpanishscenario.TheproceedsofthebondsalesinSpainleave

theSpanishmoneymarketwithoutchanginganyrelativeprice.

InFigure3and4IshowhowthisdifferencehasprobablyaffectedGDPgrowth

andinflationintheUKandSpainsincethestartofthesovereigndebtcrisisin

theEurozone.Itcanbeseenthatsince2010inflationisalmosttwiceashighin



6

theUKthaninSpain(2.9%versus1.6%).InadditiontheyearlygrowthofGDPin

theUKaverages2%since2010againstonly0.2%inSpain.Thisiscertainlynot

unrelated to the fact that since the startof the financial crisis the pound has

depreciatedbyapproximately25%againsttheeuro.


Thisdifference ininflationandgrowth canhaveaprofoundeffectonhowthe

solvency of the governments of these two countries is perceived. It will berememberedthatanecessaryconditionforsolvencyisthattheprimarybudget

-0.5%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

2009 2010 2011

Figure3:InlationinUKandSpain

UK

Spain

-6.0%

-5.0%

-4.0%

-3.0%

-2.0%

-1.0%

0.0%

1.0%

2.0%

3.0%

2009 2010 2011

Figure4:GrowthGDPinUKandSpain

UK

Spain



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surplusshouldbeatleastashighasthedifferencebetweenthenominalinterest

rateandthenominalgrowthratetimesthedebtratio1.Iapplythisconditionand

showthenumbersintable1.IassumethatSpainandtheUKwillcontinuetoface

the long-term interest rates that the markets have imposed since the last 6months (on average 3.5% in the UK and 5% in Spain). Applying the average

nominalgrowthratessince2010(4.9%intheUKand1.8%inSpain)wecansee

thatintheUKthereisnoneedtogenerateaprimarysurplusinordertostabilize

thedebttoGDPratio(andassumingthesegrowthrateswillbemaintained).In

Spaintheprimarysurplusmustbemorethan2%toachieve thisresult.Thus,

SpainisforcedtoapplymuchmoreausteritythantheUKtosatisfythesolvency

condition.Putdifferently,SpaincouldnotgetawaywiththeUKbudgetarypolicy

withoutbeingbrandedas insolvent despite the fact that ithas a substantially

lowerdebtlevel.

Table1:Primarysurplusneededtostabilizedebtat2011level

(percentGDP)

UK

-1,21

Spain

2,30

Thepreviousanalysisillustratesan importantpotentiallydestructivedynamics

in a monetary union. Members of a monetary union are very susceptible to

liquiditymovements.Wheninvestorsfearsomepaymentdifficulty(e.g.triggered

by a recession that leads to an increase in the government budget deficit),

liquidityiswithdrawnfromthenationalmarket(a“suddenstop”).Thiscanset

inmotion adevilish interactionbetween liquidity and solvencycrises.Once a

membercountrygetsentangledinaliquiditycrisis,interestratesarepushedup.

Thus the liquidity crisis turns intoasolvencycrisis. Investors can thenclaim

thatitwasrighttopulloutthemoneyfromaparticularnationalmarket. Itisa

self-fulfillingprophecy:thecountryhasbecomeinsolventbecauseinvestorsfear

insolvency.

1TheformulaisS≥ (r–g)D,whereS istheprimarybudgetsurplus,r isthenominalinterestrateonthegovernmentdebt, gisthenominalgrowthrateof

theeconomyandDisthegovernmentdebttoGDPratio.



8

NotethatIamnotarguingthatallsolvencyproblemsintheEurozoneareofthis

nature. In the case of Greece, for example, one can argue that the Greek

governmentwas insolvent before investorsmade theirmovesand triggered a

liquidity crisis in May 2010.What I am arguing is that in amonetary unioncountriesbecomevulnerabletoself-fulfillingmovementsofdistrustthatsetin

motionadevilishinteractionbetweenliquidityandsolvencycrises.

Thisinteractionbetweenliquidityandsolvencyisavoidedinthe“stand-alone”

country,wheretheliquidityisbottledupinthenationalmoneymarkets(thereis

no “sudden stop”), andwhere attempts to export it to othermarkets sets in

motion an equilibrating mechanism, produced by the depreciation of the

currency.Thus,paradoxically,distrustleadstoandequilibratingmechanismin

theUK,andtoapotentiallydisequilibratingmechanisminSpain.

From the preceding analysis, it follows that financial markets acquire great

powerinamonetaryunion.Willthispowerbebeneficialfortheunion?

Believersinmarketefficiencyhavebeentellingusthatthispowerissalutary,as

itwillactasadiscipliningforceonbadgovernments.Ihavelostmuchofmy

faithintheideathatfinancialmarketsareadiscipliningforce.Thefinancialcrisis

hasmade abundantlyclear that financialmarketsareoftendrivenbyextreme

sentiments of either euphoriaorpanic. During periods of euphoria investors,

cheeredbyratingagencies,collectivelyfailtoseetherisksandtakeontoomuch

of it. After the crash, fear dominates, leading investors, prodded by rating

agencies,todetectriskseverywheretriggeringpanicsalesmuchofthetime.

4.Multipleequilibria

The inherent volatility of financial markets leads to another fundamental

problem.Itcangiverisetomultipleequilibria,someofthemgoodones;others

bad ones.This arises from the self-fulfilling nature ofmarket expectations. In

appendix, I present a simple theoretical model showing more formally how

multipleequilibriacanarise.

SupposemarketstrustgovernmentA. Investorsthenwillshowawillingnessto

buy government bondsata low interest rate.A low interest rate embodies a



9

belief that the default risk is low.But the same low interestrate alsohas the

effect of producing a low risk of default. This is made very clear from our

solvencycalculationsintable1.MarketstrustthattheUKgovernmentwillnot

default (despite its having a high debt ratio).Asa result, the UK governmentenjoysalowinterestrate.Oursolvencycalculationthenshowsthatindeedthe

UKgovernmentisverysolvent.FinancialmarketsgentlyguidetheUKtowardsa

goodequilibrium.

Suppose market distrusts government B. As a result, investors sell the

governmentbonds.Theensuingincreaseintheinterestrateembedsthebelief

thatthereisadefaultrisk.Atthesametimethishighinterestrateactuallymakes

default more likely. Thus in our calculation from table 1 it appears that the

market’s distrust in the Spanish government ina self-fulfilling way hasmade

defaultmorelikely.FinancialmarketspushSpaintowardsabadequilibrium.

The occurrence of bad equilibria ismore likely withmembers of amonetary

union,whichhavenocontrolofthecurrencyinwhichtheyissuetheirdebt,than

withstand-alonecountriesthathaveissueddebtinacurrencyoverwhichthey

havefullcontrol.Asmentionedearlier,themembersofamonetaryunionface

the same problem as emerging countries that because of underdeveloped

domesticfinancialmarkets,areforcedtoissuetheirdebtinaforeigncurrency

(Calvo,etal.(2006),seeEichengreen,atal.(2005)).InthewordsofEichengreen

etal.(2005)thisworksasthe“originalsin”thatleadsthesecountriesintoabad

equilibriumfullofpainandmisery.

Thereisanadditionalcomplicationinamonetaryunion.Thisisthatinsucha

union financial markets become highly integrated. This also implies that

government bonds of member countries are held throughout the union.

AccordingtotheBISdata,formanyEurozonemembercountriesmorethanhalf

ofgovernmentbondsare heldoutside the countryof issue. Thuswhen abad

equilibriumisforcedonsomemembercountries,financialmarketsandbanking

sectors in other countries enjoying a good equilibrium are also affected (see

Azerki,etal.(2011)whofindstrongspillovereffectsintheEurozone).



10

Theseexternalitiesareastrongforceofinstabilitythatcanonlybeovercomeby

government action. I will return to this issuewhen I analyze the governance

questionoftheEurozone.

Towrapupthepreviousdiscussion:membersofmonetaryunionaresensitiveto

movementsofdistrustthathaveself-fulfillingpropertiesandthatcanleadthem

tobepushedintoabadequilibrium.Thelatterarisesbecausedistrustcansetin

motionadevilishinteractionbetweenliquidityandsolvencycrises.

Onceinabadequilibrium,membersofmonetaryunionfinditverydifficultto

useautomaticbudgetstabilizers:Arecessionleadstohighergovernmentbudget

deficits;thisinturnleadstodistrustofmarketsinthecapacityofgovernments

toservicetheirfuturedebt,triggeringaliquidityandsolvencycrisis;thelatter

thenforcesthemtoinstituteausterityprogramsinthemidstofarecession.In

the stand-alone country (UK) this does not happen because the distrust

generatedbyhigherbudgetdeficittriggersastabilizingmechanism.

Thus,membercountriesofamonetaryunionaredowngradedto the statusof

emergingeconomies,which find itdifficult ifnot impossible touse budgetary

policiestostabilizethebusinesscycle.Thisfeaturehasbeenshowntoproduce

pronounced booms and busts in emerging economies (see Eichengreen, et al.

(2005)).

Thisfeatureofamonetaryunionmakesitpotentiallyverycostly.Theautomatic

stabilizersinthegovernmentbudgetconstituteanimportantsocialachievement

inthedevelopedworldastheysoftenthepainformanypeoplecreatedbythe

boomsandbustsincapitalistsocieties.Ifamonetaryunionhastheimplicationof

destroying these automatic stabilizers, it is unclear whether the social andpolitical basisforsuchaunioncanbemaintained. Itis therefore important to

designagovernancestructurethatmaintainstheseautomaticstabilizers.

5.Competitivenessandsovereigndebt

The previous analysis allows us to connect sovereign debt dynamics and

competitivenessproblems.



11

It is now widely recognized that one of the fundamental imbalances in the

Eurozoneistheincreaseddivergenceincompetitivepositionsofthemembersof

the Eurozone since 2000. The phenomenon is shown in figure 5, which I am

confidentmostreadersmusthaveseensomewhere.Onemaycriticizethisfigurebecauseofthechoiceof2000asthebaseyear.Indeed,thischoiceassumesthat

in 2000 there were no imbalances in competitive positions, so that any

movementawayfromthe2000-levelisadeparturefromequilibriumandthus

problematic.Thisissurelynotthecase(seeAlcidiandGros(2010).Anumberof

countries may have been far from equilibrium in 2000 so that movements

observedsincethatdatecouldconceivablybemovementstowardsequilibrium.

InordertotakethiscriticismintoaccountIpresentrelativeunitlabourcostsof

themembercountriesusingthelong-termaverageovertheperiod1970-2010as

thebase.Theresultsareshowninfigure6.Thedivergenceislessspectacular,

but stillvery significant. Figure 7 confirms this: the standarddeviation of the

yearlyindicesincreasedsignificantlysince1999.


85

90

95

100

105

110

115

120

125

20002001200220032004200520062007200820092010

Figure5:RelativeunitlaborcostsEurozone(2000=100)

Italy

Greece

Portugal

Spain

Ireland

Netherlands

Finland

Belgium

France

Austria

Germany



12


Note:ComputedusingdataofFigure6.

The countries that lost competitiveness from1999 to2008 (Greece,Portugal,

Spain, Ireland) have to start improving it. Given the impossibility of using a

devaluation of the currency, an internal devaluationmust be engineered, i.e.

wagesand pricesmustbebrought downrelative tothoseof the competitors.

This can only be achieved by deflationary macroeconomic policies (mainly

budgetary policies). Inevitably, this will first lead to a recession and thus

(through the operation of the automatic stabilizers) to increases in budgetdeficits.

80

85

90

95

100

105

110

115

120

125

199920002001200220032004200520062007200820092010

Greece

Portugal

Spain

Italy

Belgium

Netherlands

Austria

Ireland

France

Finland

Germany

Figure6:RelativeunitlaborcostsinEurozone(average1970-2010=100)

4

5

6

7

8

9

10

11

199920002001200220032004200520062007200820092010

p e r c e n t

Figure7:Standarddeviationrelativeunitlabour

costsinEurozone(inpercent)



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Most of the analyses in textbooks nowstop by noting that this is a slow and

painfulprocess.Theanalysisoftheprevioussections,however,allowsustogoa

littlefurtherandtolinkitwiththedebtdynamicsdescribedearlier.Ascountries

experience increasing budget deficits while they attempt to improve theircompetitiveness,financialmarketsarelikelytogetnervous.Distrustmayinstall

itself. If strong enough, the latter may lead to a liquidity crisis as described

before.Thistheninevitablytriggersasolvencycrisis.

Thustheperiodduringwhichcountriestrytoimprovetheircompetitivenessis

likely to be painful and turbulent: Painful, because of the recession and the

ensuing increase in unemployment; turbulent, because during the adjustment

period,thecountycanbehitbyasovereigndebtcrisis.Ifthelatteroccurs,the

deflationaryspiralisboundtobeintensified.Forinthatcasethedomesticlong

terminterestrateincreasesdramatically,forcingtheauthoritiestoapplyeven

morebudgetaryausterity,whichinturnleadstoanevenmoreintenserecession.

Thecountrycanfinditselfstuckinabadequilibrium,characterizedbyausterity

programsthat fail toreducebudget deficitsbecausethey lead toadownward

economic spiralandpunishing interestrate levels.Thepath towardsrecovery

formembersofamonetaryunionislikelytobecrisis-prone.

Thecontrastwithstand-alonecountriesthathavethecapacitytoissuedebtin

their own currency is stark. When these countries have lost competitiveness,

theywilltypicallytrytorestoreitbyallowingthecurrencytodropintheforeign

exchangemarket.Thismakesitpossiblenotonlytoavoiddeflation,butalsoto

avoid a sovereign debt crisis. As we have seen earlier, these countries’

governmentscannotbeforcedintodefaultbytriggeringaliquiditycrisis.Whatis

morethewholeadjustmentprocessinvolvingcurrencydepreciationislikelyto

boostoutputandinflation,therebyimprovingthesolvencyofthesovereign.

6.Governanceissues

ThedebtcrisishasforcedEuropeanleaderstosetupnewinstitutionscapableof

dealingwiththecrisis.Themostspectacularresponsehasbeenthecreationof

the European Financial Stability Mechanism (EFSF) in May 2010 to be



14

transformed into a permanent European rescue fund, the European Stability

Mechanism(ESM)from2013on.Surelythesewereimportantstepsthatwere

necessarytomaintainthestabilityoftheEurozone.

Yet the opposition against these decisions continues to be high especially in

NorthernEuropean countries. Opposition is also strong among economists of

these countries (see the statement of 189 German economistswarning about

futurecalamitiesiftheEFSFweretobemadepermanent,Plenumderökonomen,

(2011)).

This opposition is based on an incomplete diagnosis of the sovereign debt

problemintheEurozone.For the189Germaneconomists the storyissimple:

some countries (Greece, Ireland, Portugal, Spain) have misbehaved. Their

governmentshave irresponsiblyspenttoomuch,producingunsustainabledebt

levels.Theyarenowinsolventthroughtheirownmistakes.Thereisnopointin

providingfinancialassistancebecausethisdoesnotmakethemsolvent.Itonly

gives them incentives to persevere in irresponsible behavior (moral hazard).

Thus in this diagnostics, the problem is a debt crisis of a limited number of

individual countries, that can only be solved by an orderly debt default

mechanism.ThelatteriscrucialtoavoidthatGermantaxpayershavetofootthe

bill.

WhilethisanalysismaybecorrectinthecaseofGreece,itfailstounderstandthe

natureofthedebtcrisisinotherEurozonecountries,becauseittreatsthedebt

problem asa series of individual problems; not as the outcomeofa systemic

problemintheEurozone, that Ihavedescribedearlier.Thissystemicproblem

hasseveralingredients.First,byacquiringthestatusofemergingcountries,the

sovereigns of the member states in a monetary union are fragilized, as

unfavorablemarketsentimentscanforcethemintodefault.Thishastheeffectof

pushingthecountryinto abadequilibrium, characterizedbypunishinglyhigh

interest rates, chronically high budget deficits and low growth. Second, the

degree of financial integrationinthemonetaryunionissuch thatwhensome

sovereignsarepushedinabadequilibrium,thisaffectstheothercountries.In

particularitfragilizesthebankingsystemsintheseothercountries.Thus,strong

externalitiesarecreated,makingitimpossibletoisolateafinancialproblemof



15

one country from the rest of the Eurozone. Put differently,when one country

experiencesadebtproblem thisbecomesaproblemofthe Eurozone. It ismy

contention that the governancestructure that isnowbeingdesigneddoesnot

sufficientlytakeintoaccountthesystemicnatureofthedebtproblem.

7.Whatkindofgovernance?

Likewithallexternalities,governmentactionmustconsistininternalizingthese.

ThisisalsothecasewiththeexternalitiescreatedintheEurozone.Ideally,this

internalization can be achieved by a budgetary union. By consolidating

(centralizing)nationalgovernmentbudgetsintoonecentralbudgetamechanism

of automatic transfers can be organized. Such a mechanism works as an

insurancemechanism transferring resources to the country hit by a negative

economic shock. In addition, such a consolidation creates a common fiscal

authoritythatcanissuedebtinacurrencyunderthecontrolofthatauthority.In

so doing, it protects the member states from being forced into default by

financialmarkets.

Thissolution of thesystemicproblemof theEurozone requires a far-reachingdegreeofpolitical union.Economistshave stressedthat such apolitical union

willbenecessarytosustainthemonetaryunioninthelongrun(seeEuropean

Commission(1977)andDeGrauwe(1992)).It isclear,however,thatthereisno

willingnessinEuropetodaytosignificantlyincreasethedegreeofpoliticalunion.

Thisunwillingnesstogointhedirectionofmorepoliticalunionwillcontinueto

maketheEurozoneafragileconstruction.

Thisdoesnotmean,however,thatoneshoulddespair.Wecanmoveforwardby

takingsmallsteps.Suchastrategyofsmallstepsnotonlyallowsustosolvethe

most immediate problems. It also signals the seriousness of European

policymakersinmovingforwardinthedirectionofmorepoliticalunion.



16

8.AStrategyofsmallsteps

Idistinguishbetweenthreestepsthateachrequiresinstitutionalchanges.Some

ofthesestepshavealreadybeentaken.Unfortunately,asIwillarguetheyhave

beenloadedwithfeaturesthatthreatentounderminetheireffectiveness

8.1:AEuropeanMonetaryFund

AnimportantstepwastakeninMay2010whentheEuropeanFinancialStability

Facility(EFSF)wasinstituted.Thelatterwillbetransformedintoapermanent

fund, theEuropean StabilizationMechanism (ESM),whichwill obtain funding

from the participating countries and will provide loans to countries indifficulties.Thus,aEuropeanMonetary Fundwillbe inexistence, aswas first

proposedbyGrosandMaier(2010).

It is essential that the ESM take a more intelligent approach to lending to

distressedcountriesthantheEFSFhasbeendoinguptonow.Theinterestrate

appliedbytheEFSFintheIrishrescueporgramamountstoalmost6%.Thishigh

interestratehasaveryunfortunateeffect.First,bychargingthishighinterest

rate it makes it more difficult for the Irish government to reduce its budget

deficitandtoslowdowndebtaccumulation.Second,bychargingariskpremium

of about 3% above the risk free rate that the German, Dutch and Austrian

governmentsenjoy,theEFSFsignalstothemarketthatthereisasignificantrisk

ofdefault, and thus that the Irish governmentmay not succeed inputting its

budgetary house in order. No wonder that financial markets maintain their

distrust and also charge a high-risk premium.All this, in a self-fulfilling way,

increasestheriskofdefault.

Theintelligentapproachinfinancialassistanceconsistsinusingapolicyofthe

carrot and the stick. The stick is the conditionality, i.e. an austerity package

spelledoutoverasufficientlylongperiodoftime,sothateconomicgrowthgetsa

chance.Withouteconomicgrowthdebtburdenscannotdecline.Thecarrotisa

concessionalinterestratethatmakesiteasierforthecountryconcernedtostop

debtaccumulation.A lowinterestratealsoexpressestrustinthesuccessofthe

package;trustthat financialmarketsneed inordertoinduce themtobuy the



17

governmentdebtata reasonable interestrate. Unfortunately, the futureESM

willapplyaninterestratethatis200basispointsaboveitsfundingrate.Thereis

nogoodreasonfortheESMtodothis.Byapplyingsuchariskpremium,theESM

willsignaltothemarketthatisdoesnottrulybelieveinthesuccessofitsownlendingprogram.

ThereareotherfeaturesoftheESMthatwillundermineitscapacitytostabilize

thesovereignbondmarketsintheEurozone.From2013on,allmembersofthe

Eurozone will be obliged to introduce “collective actions clauses” when they

issuenewgovernmentbonds.Thepracticalimplicationofthisisthefollowing.

Wheninthefuture,agovernmentoftheEurozoneturns totheESMtoobtain

funding,privatebondholdersmaybeaskedtoshareintherestructuringofthe

debt.Put differently, theymay beaskedto take someof the losses. Thismay

seemtobeagooddecision.Bondholderswillbeforcedtothinktwicewhenthey

invest in government bonds, as these bonds may not be as secure as they

thought.

Theintentionmaybegood;theeffectwillbenegative(seeDeGrauwe(2010)).In

factwehavealreadyseentheeffects.WhentheGermangovernmentmadethe

first proposal to introduce collective action clauses at the European Council

meetingofOctober2010,theimmediateeffectwastointensifythecrisisinthe

Eurozonesovereignbondmarkets.IshowevidenceforthisinFigure8,which

presentsthegovernmentbondspreadsofanumberofEurozonecountries.Itcan

beseenthatimmediatelyaftertheEuropeanCouncilmeetingofOctober28-29,

when the first announcement was made to attach collective action clauses

(CACs) to future government bond issues, the government bond spreads of

Ireland, Portugal and Spain shot up almost immediately. Since then these

spreadshaveremainedhigh.ThiscontrastswiththepreviousEuropeanCouncil

meetings,whicheitherdidnotseemtoaffectthespreads,orasinthecaseofthe

May2010meetingwasfollowedbya(temporary)declineinthespreads.

ThereactionofthemarketstotheannouncementoffutureCACsshouldnothave

beensurprising.Whenprivatebondholdersknowthatinthefuturetheirbonds

willautomaticallyloosevaluewhenacountryturnstotheESM,theywillwantto

becompensatedfortheaddedriskwithahigherinterestrate.Inaddition,and



18

evenmore importantly,eachtime theysuspectthatacountrymayturntothe

ESMforfundingtheywillimmediatelyselltheirbonds,soastoavoidapotential

loss.Butthissellingactivitywillraisetheinterestrateonthesebonds,andwill

makeitmore likely thatthegovernmentwillhavetoask forsupportfromtheESM.

Figure8

Source:Datastream

Thusthecollectiveactionclauseswillmakethegovernmentbondmarketsmore

fragileandmoresensitivetospeculativefears.Iarguedearlierthatthesystemic

problemof theEurozoneliesin the factthat inamonetaryunionthenational

governmentsaremorevulnerabletoliquiditycrisestriggeredbymovementsin

confidenceinfinancialmarkets.Insteadofalleviatingthisproblemthecollective

action clauses will intensify it, because with each decline in confidence

bondholderswill“runforcover”toavoidlosses,therebytriggeringacrisis.

CACsdowngradethemembersofthemonetaryuniontothestatusofemerging

marketsforwhichtheseclauseswereinvented.Inawayitisquiteextraordinary



19

thattheEuropean leadershave designed a “solution”to thesystemicproblem

thatwillturnouttomakethatproblemmoresevere.

There is another feature of the ESM that instead of solving a problem may

actually make it more pronounced. I argued earlier that when the member

countries of amonetary unionare pushed into a bad equilibrium, they loose

muchoftheirability toapplythe automatic stabilizers inthe budget during a

recession.CountriesthatapplyforfinancingfromtheESMwillbesubjectedtoa

tough budgetary austerity programas a condition forobtaining finance. Thus,

witheachrecession,whenanumberofEurozonecountriesmaybeforcedtoturn

totheESMtheywillbeobligedtofollowpro-cyclicalbudgetarypolicies,i.e.to

reducespendingandincreasetaxes.Asurewaytomaketherecessionworse.

Thepro-cyclicalityofgovernment budgets isan important achievement in the

developed world. It has led to greater business cycle stability and to greater

social welfare, shielding people from the harshness of booms and busts in

capitalist systems. The way the ESM has been set up, however, risks

underminingthisachievement.

All this is quite unfortunate. Especially because the existence of a financial

support mechanism in the Eurozone is a great idea and a significant step

forwardsinthebuildingofan integratedEurope.Unfortunately,byintroducing

allkindsofrestrictionsandconditions,theESMhasbeentransformedintoan

institutionthatisunlikelytoproducemorestabilityintheEurozone.

8.2:JointissueofEurobonds

A second step towards political union and thus towards strengthening the

EurozoneconsistsinthejointissueofEurobonds.AjointissueofEurobondsis

animportantmechanismofinternalizingtheexternalitiesintheEurozonethatI

identifiedearlier.

ByjointlyissuingEurobonds,theparticipatingcountriesbecomejointlyliablefor

the debt they have issued together. This is a very visible and constraining

commitmentthatwillconvincethemarketsthatmembercountriesareserious

about the future of the euro (see Verhofstadt(2009), Juncker and



20

Tremonti(2010)). In addition, by pooling the issue of government bonds, the

member countries protect themselves against thedestabilizing liquidity crises

that arise form their inability to control the currency in which their debt is

issued.Acommonbondissuedoesnotsufferfromthisproblem.

TheproposalofissuingcommonEurobondshasmetstiffresistanceinanumber

of countries (see Issing(2010)). This resistance is understandable. A common

Eurobondcreatesanumberofseriousproblemsthathavetobeaddressed.

A first problem is moral hazard. The common Eurobond issue contains an

implicitinsurancefortheparticipatingcountries.Sincecountriesarecollectively

responsibleforthejointdebtissue,anincentiveiscreatedforcountriestorely

on this implicit insurance and to issue too much debt. This creates a lot of

resistanceintheothercountriesthatbehaveresponsibly.Itisunlikelythatthese

countrieswillbewillingtostepintoacommonEurobondissueunlessthismoral

hazardriskisresolved.

A second problem (not unrelated to the previous one) arises because some

countrieslikeGermany,FinlandandtheNetherlandstodayprofitfromtripleA

ratings allowing them to obtain the best possible borrowing conditions. The

questionarisesofwhatthebenefitscanbeforthesecountries.Indeed,itisnot

inconceivablethatbyjoiningacommonbondmechanismthatwillincludeother

countriesenjoyinglessfavourablecreditratings,countrieslikeGermany,Finland

andtheNetherlandsmayactuallyhavetopayahigherinterestrateontheirdebt.

Theseobjectionsareserious.Theycanbeaddressedbyacarefuldesignofthe

commonEurobondmechanism.ThedesignofthecommonEurobondsmustbe

such as to eliminate the moral hazard risk and must produce sufficientattractiveness for the countries with favourable credit ratings. This can be

achievedbyworkingbothonthequantitiesandthepricingoftheEurobonds.

Thus,myproposalwould betoseek a combinationof the Eurobond proposal

madebyBruegel (Delpla and vonWeizsäcker(2010) and the onemadebyDe

GrauweandMoesen(2009).Itwouldworkasfollows.Countrieswouldbeable

toparticipateinthejointEurobondissueupto60%oftheirGDP,thuscreating

“bluebonds”.Anythingabove60%wouldhavetobeissuedinthenationalbond



21

markets (“red bonds”). This would create a senior (blue) tranche that would

enjoythebestpossiblerating.Thejunior(red)tranchewouldfaceahigherrisk

premium.Thisexistenceofthisriskpremiumwouldcreateapowerfulincentive

for the governments to reduce their debt levels. In fact, it is likely that theinterest rate that countries would have to pay on their red bonds would be

higherthantheinterestratetheypaytodayontheirtotaloutstandingdebt(see

Gros(2010) on this). The reason is that by creating a senior tranche, the

probabilityofdefaultonthejuniortranchemayactuallyincrease.Thisshould

increase the incentive for countries to limit the red component of their bond

issues.

TheBruegelproposalcanbecriticizedonthefollowinggrounds.Totheextent

that the underlying riskof the government bonds isunchanged, restructuring

thesebondsintodifferenttranchesdoesnotaffectitsrisk.Thus,ifthebluebond

carriesalowerinterestrate,theredbondwillhaveahigherinterestratesuch

thattheaverageborrowingcostwillbeexactlythesameaswhenthereisonly

onetypeofbond(seeGros(2011)).ThisisanapplicationoftheModigliani-Miller

theorem which says that the value of a firm is unaffected by the way the

liabilitiesofthatfirmarestructured.

All this is true tothe extent that the underlying risk isunchanged.The point,

however, is that the commonbond issue isan instrument to shield countries

frombeingpushedintoabadequilibrium.Ifthecommonbondissuesucceedsin

doingso,theunderlyingriskofthebondsofthesecountriesdoesindeeddecline.

Inthatcasethesecountriesareabletoenjoyaloweraverageborrowingcost.At

the same time the marginal borrowing cost is likely to be higher than the

average.Thisis exactlywhatonewantstohave:adeclineoftheaveragedebt

cost,andanincreaseinthemarginalcostofthedebt.Theformermakesiteasier

toservicethedebt;thelatterprovidesstrongincentivestowardsreducingthe

levelofthedebt.Thisfeatureisimportanttoreducethemoralhazardrisk.

ThesecondfeatureofourproposalworksonthepricingoftheEurobondsandit

follows theproposalmadebyDeGrauweandMoesen(2009). Thisconsists in

usingdifferentfeesforthecountriesparticipatinginthebluebondissue.These

feeswouldberelatedtothefiscalpositionoftheparticipatingcountries.Thus,



22

countries with high government debt levels would face a higher fee, and

countrieswithlowerdebtlevelswouldpayalowerfee.Inpracticaltermsthis

meansthattheinterestratepaidbyeachcountryinthebluebondtranchewould

bedifferent. Fiscallyprudent countrieswould have topay a somewhat lowerinterestratethanfiscallylessprudentcountries.Thiswouldensurethattheblue

bondissuewouldremainattractiveforthecountrieswiththebestcreditrating,

therebygivingthemanincentivetojointtheEurobondmechanism.

It should be noted that if successful, such a common Eurobond issue would

createalargenewgovernmentbondmarketwithalotofliquidity.Thisinturn

wouldattractoutsideinvestorsmakingtheeuroareservecurrency.Asaresult

theeurowouldprofitfromanadditionalpremium.Ithasbeenestimatedthatthe

combined liquidity and reserve currency premium enjoyed by the dollar

amounts to approximately 50 basis points (Gourinchas and Rey(2007)). A

similarpremiumcouldbeenjoyedbytheeuro.Thiswouldmakeitpossiblefor

theeurozonecountriestolowertheaveragecostofborrowing,verymuchlike

theUShasbeenabletodo.

8.3:Coordinationofeconomicpolicies

A third important step in the process towards political union is to set some

constraints on the national economic policies of the member states of the

Eurozone. The fact that while monetary policy is fully centralized, the other

instruments of economic policies have remained firmly in the hands of the

national governments is a serious design failure of the Eurozone. Ideally,

countries should hand over sovereignty over the use of these instruments toEuropean institutions. However, the willingness to take such a drastic step

towards political union is completelyabsent. Here also small steps should be

taken.

The European Commission has proposed a scoreboard of macroeconomic

variables(privateandpublicdebt,currentaccountimbalances,competitiveness

measures,houseprices)thatshouldbemonitored,andthatshouldbeusedto

pushcountriestowardsusingtheireconomicpolicyinstrumentssoastocreate



23

greaterconvergenceinthesemacroeconomicvariables.Failuretotakeactionto

eliminatetheseimbalancescouldtriggerasanctioningmechanismverymuchin

the spirit of the sanctioning mechanism of the Stability and Growth Pact

(EuropeanCommission(2010)).

While an important step forward, this approach is incomplete. National

governments have relatively little control over many of the macroeconomic

variablestargetedbytheEuropeanCommission.Infacttheevidencewehaveof

thepre-crisisdivergencedynamicsisthatmuchofitwasproducedbymonetary

andfinancialdevelopmentsoverwhichnationalgovernmentshadlittlecontrol.

Localboomsand bubblesdeveloped inthe periphery ofthe Eurozone. These

weredrivenmainlybybankcreditexpansion.ThisisvividlyshowninFigure9.It

is the combination of bubbles (especially in the housingmarkets) and credit

expansion that makes bubbles potentially lethal (see Borio(2003)). This has

beenmadevaryclearbytheexperienceofSpainandIreland.

Thus,anypolicyaimedatstabilizinglocaleconomicactivitymustalsobeableto

control localcredit creation. It isclear that because themember states of the

Eurozonehaveenteredamonetaryuniontheylacktheinstrumentstodealwith

this.Putdifferently,ifthemovementsofeconomicactivityaredrivenbycredit-

fueledanimalspiritstheonlyinstrumentsthatcaneffectivelydealwiththisare

monetary instruments. Members of a monetary union, however, have

relinquishedtheseinstrumentstotheEuropeanmonetaryauthorities.

The next question then becomes: can the European monetary authorities, in

particulartheECB,helpoutnationalgovernments?Wehavebeentoldthatthisis

impossible because the ECB should only be concerned by system-wide

aggregates.Itcannotbemaderesponsiblefornationaleconomicconditions.The

reasonisthatithasoneobjectivewhichisthemaintenancesofpricestabilityin

theEurozoneasawhole,andbecauseithasonlyoneinstrumenttoachievethis

goal.

ThisIbelieveistoocheapananswer.TheECBisnotonlyresponsibleforprice

stability but also for financial stability.The financial crisis that eruptedinthe

Eurozonein2010haditsorigininalimitednumberofcountries.Itistherefore

importantthattheECBfocusesnotonlyonsystem-wideaggregatesbutalsoon



24

what happens in individual countries. Excessive bank credit creation in a

numberofmembercountriesshouldalsoappearontheradarscreenoftheECB

inFrankfurtuponwhichtheECBshouldact.

Figure9

Source:Kannan,etal.(2009)

One may object that the ECB does not have the instruments to deal with

excessive bank credit inpartsof the Eurozone. This,however, isnot so. The

Eurosystemhas the technical ability torestrictbank credit in some countries

morethaninothersbyapplyingdifferentialminimumreserverequirements,orby imposing anti-cyclical capital ratios. These can and should be used as

stabilizinginstrumentsatthenationallevel.

Anotherobjection is that it is theresponsibilityof thefinancial supervisors to

dealwithexcessive risk taking bybanks.Whenbanksextend toomuchcredit

andtherebyincreasetheriskoftheirbalancesheets,nationalsupervisorsshould

intervene. This is undoubtedly so. At the same time it does not absolve the

Eurosystem from its responsibility in maintaining financial stability. When a



25

credit-fueledboomemergesinsomememberstates,it isalsotheresponsibility

oftheEurosystemtoact.TheEurosystemalsohasthemostpowerfultoolkitin

controllingthemacroeconomicconsequencesofboomsandbusts.

Therecentreformsinthesupervisory landscape in theEurozone increase the

scopeforactionbytheEurosystem.TheEuropeanSystemicRiskBoard(ESRB)

whichwascreatedin2010isofparticularimportancehere.Verypointedly,the

presidentof theECBwillalsopresideovertheESRB.Thus the creatorsof the

ESRBhaveclearlyunderstoodthattheECBisatthecenterofthemonitoringof

emergingsystemicrisksintheEurozone.Itwouldbequiteparadoxicalthatthe

presidentoftheESRB(ECB)wouldemitwarningsignalsaboutsystemicriskand

wouldthennotfollow-upthiswarningbyactiontoreducetherisks,leavingitto

thenationalsupervisorstoactalone.

The steps described in this and the previous sections, involving both the

responsibilities of national governments, the European institutions and the

Eurosystemare important tomove towards political union. They also give an

important signal in the financial markets that the member countries of the

EurozoneareseriousintheirdesiretoguaranteethesurvivaloftheEurozone.

These steps are also to be seen as commitment devices that enhance the

credibility of the monetaryunion. They are crucial in stabilizing the financial

marketsintheEurozone.

9.Conclusion

Amonetaryunionismorethanonemoneyandonecentralbank.Countriesthat

join a monetary union loose more than an instrument of economic policy

(interestrateorexchangerate).Whenenteringthemonetaryunion,theyloose

theircapacitytoissuedebtinacurrencyoverwhichtheyhavefullcontrol.Asa

result, a loss of confidence of investors can in a self-fulfilling way drive the

countryintodefault.Thisisnotsoforcountriescapableofissuingdebtintheir

own currency. In these countries the central bank can always provide the

liquiditytothesovereigntoavoiddefault.Thismayleadtofutureinflation,butit

shieldsthesovereignfromadefaultforcedbythemarket.



26

Thus, member-countries of a monetary union become more vulnerable.

Changingmarket sentiments can lead to “sudden stops” in the funding of the

governmentdebt,settinginmotionadevilishinteractionbetweenliquidityand

solvency crises. There is an important further implication of this increasedvulnerability.Thisisthatmember-countriesofamonetaryunionloosemuchof

their capacity to apply counter-cyclical budgetary policies. When during a

recessionthebudgetdeficitsincrease,thisriskscreatinga lossofconfidenceof

investorsinthecapacityofthesovereigntoservicethedebt.Thishastheeffect

of raising the interest rate,making the recessionworse, and leading to even

higherbudgetdeficits.Asaresult,countriesinamonetaryunioncanbeforced

intoabadequilibrium,characterizedbydeflation,highinterestratesandhigh

budgetdeficits.

Thesesystemicfeaturesofamonetaryunionhavenot sufficiently been taken

intoaccountinthenewdesignoftheeconomicgovernanceoftheEurozone.Too

much of this new design has been influenced by the notion (based on moral

hazardthinking)thatwhenacountryexperiencesbudgetdeficitsandincreasing

debts,itshouldbepunishedbyhighinterestratesandtoughausterityprograms.

I have argued that this approach isusuallynot helpful inrestoring budgetary

balance.

In addition, a number of features of the design of financial assistance in the

EurozoneasembodiedintheESM,willhavetheeffectofmakingcountrieseven

moresensitivetoshiftingmarketsentiments.Inparticular,the“collectiveaction

clauses”whichwillbeimposedonthe future issue of governmentdebt inthe

Eurozone, will increase the nervousness of financial markets. With each

recessiongovernmentbondholders,fearinghaircuts,willrunforcover,thereby

making a default crisis more likely. All this is likely to increase the risk that

countriesintheEurozoneloosetheircapacitytolettheautomaticstabilizersin

thebudgetplaytheirnecessaryroleofstabilizingtheeconomy.

Amonetaryunioncreates collective problems.Whenone government faces a

debtcrisisthisislikelytoleadtomajorfinancialrepercussionsinothermember

countries. This is so because a monetary union leads to intense financial

integration.Whetherone likes itornot,member countries are forced tohelp



27

each other out. Surely, it is important to provide the right incentives for

governmentssoastoavoidprofligacythatcouldleadtoadebtcrisis.Discipline

bythethreatofpunishmentispartofsuchanincentivescheme.Ihaveargued,

however, that too much importance has been given to punishment and notenoughtoassistanceinthenewdesignoffinancialassistanceintheEurozone.

This excessive emphasis on punishment is also responsible for a refusal to

introducenewinstitutionsthatwillprotectmembercountriesfromthevagaries

of financial markets that can trap countries into a debt crisis and a bad

equilibrium.Onesuchaninstitutionisthecollectiveissueofgovernmentbonds.

Iarguedthatsuchacommonbondissuemakesitpossibletohaveacollective

defense system against the vagariesof euphoria and fears that regularly grip

financialmarkets.

Amonetaryunioncanonlyfunctionifthereisacollectivemechanismofmutual

supportandcontrol.Suchacollectivemechanismexistsinapoliticalunion.In

the absence of a political union, the member countries of the Eurozone are

condemned tofill inthe necessary pieces ofsucha collectivemechanism.The

debtcrisishasmadeitpossibletofillinafewofthesepieces.Whathasbeen

achieved, however, is still far from sufficient to guarantee the survival of the

Eurozone.



28

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Adjustments,CEPSPolicyBrief,http://www.ceps.eu/book/european-experience-large-fiscal-adjustments

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MarketsSpillovers:EvidencefromtheEuropeanDebtCrisis,IMFWorkingPaper,11/69,March.

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Eichengreen,B.,Hausmann,R.,Panizza,U.,(2005),“ThePainofOriginalSin”,in

Eichengreen,B.,andHausmann,R.,Otherpeople’smoney:Debtdenominationandfinancialinstabilityinemergingmarketeconomies,ChicagoUniversity

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Gourinchas,P.-O.,andRey,H.,(2007),FromworldBankertoWorldVentureCapitalis:theUSExternalAdjustmentandtheExorbitantPrivilege,in

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Gros,D.,(2010),TheSeniorityConundrum:Bailoutcountriesbutbailinprivateshort-termcreditors,CEPSCommentary ,10November.

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Issing,O.,(2009),WhyacommonEurozonebondisn’tsuchagoodidea,Europe’sWorld ,Summer,77-79.

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30

APPENDIX:AMODELOFGOODANDBADEQUILIBRIA

InthissectionIpresentaverysimplemodelillustratinghowmultipleequilibria

canarise.Thestartingpointisthatthereisacostandabenefitofdefaultingon

thedebt,andthatinvestorstakethiscalculusofthesovereignintoaccount.Iwill

assumethatthecountryinvolvedissubjecttoashock,whichtakestheformofa

declineingovernmentrevenues.Thelattermaybecausedbyarecession,ora

lossofcompetitiveness.I’llcallthisasolvencyshock.Iconcentratefirstonthe

benefitside.ThisisrepresentedinFigureA1.OnthehorizontalaxisIshowthe

solvencyshock.OntheverticalaxisIrepresentthebenefitofdefaulting.There

aremanyways and degreesofdefaulting. Tosimplify I assume this takes the

formofahaircutofa fixedpercentage.Thebenefitofdefaultingin thisway is

thatthegovernmentcanreducetheinterestburdenontheoutstandingdebt.As

aresult,afterthedefault itwill havetoapply lessausterity, i.e. itwill haveto

reducespendingand/or increasetaxesby less thanwithoutthe default. Since

austerityispoliticallycostly,thegovernmentprofitsfromthedefault.

Amajorinsightofthemodelisthatthebenefitofadefaultdependsonwhether

thisdefaultisexpectedornot.Ishowtwocurvesrepresentingthebenefitofa

default. BU is the benefit of adefault that investors do not expect tohappen,

whileBEisthebenefitofadefaultthatinvestorsexpecttohappen.Letmefirst

concentrateon theBU curve. It isupwardslopingbecausewhen the solvency

shockincreases,thebenefitofadefaultforthesovereigngoesup.Thereasonis

thatwhenthesolvencyshockislarge,i.e.thedeclineintaxincomeislarge,the

cost of austerity is substantial. Default then becomes more attractive for the

sovereign.Ihavedrawnthiscurvetobenon-linear,butthisisnotessentialfor

the argument. I distinguish three factors that affect the position and the

steepnessoftheBUcurve:

• Theinitialdebtlevel .Thehigher is this level, thehigher is thebenefitof a

default.ThuswithahigherinitialdebtleveltheBUcurvewillrotateupwards.

• Theefficiencyofthetaxsystem.Inacountrywithaninefficienttaxsystem,the

government cannot easily increase taxation. Thus in such a country the

optionofdefaultingbecomesmoreattractive.TheBUcurverotatesupwards.



31

• Thesizeoftheexternaldebt. Whenexternaldebttakesalargeproportionof

total debt there will be less domestic political resistance against default,

makingthelattermoreattractive(theBUcurverotatesupwards).

FigureA1:Thebenefitsofdefaultafterasolvencyshock

B

Inow concentrate ontheBE curve. This showsthe benefitofadefaultwhen

investors anticipate such a default. It is located above theBU curve for the

following reason. When investors expect a default, they will sell government

bonds.Asaresult,theinterestrateongovernmentbondsincreases.Thisraises

the government budget deficit requiring amore intense austerity program of

spendingcuts andtaxhikes.Thus,defaultbecomesmore attractive.Forevery

solvencyshock,thebenefitsofdefaultwillnowbehigherthantheywerewhen

thedefaultwasnotanticipated.

Inowintroducethecostsideofthedefault.Thecostofadefaultarisesfromthe

factthat,whendefaulting,thegovernmentsuffersalossofreputation.Thisloss

ofreputationwillmakeitdifficultforthegovernmenttoborrowinthefuture.I

BU

Solvencyshock

BE



32

willmakethesimplifyingassumptionthatthisisafixedcost.InowobtainFigure

A2whereIpresentthefixedcost(C)withthebenefitcurves.

FigureA2:Costandbenefitsofdefaultafterasolvencyshock

B

Inowhavethetoolstoanalyzetheequilibriumofthemodel.Iwilldistinguish

betweenthreetypesofsolvencyshocks,asmallone,anintermediateone,anda

largeone.Takeasmallsolvencyshock:thisisashockS<S1Forthissmallshock

thecostofadefaultisalwayslargerthanthebenefits(bothofanexpectedand

an unexpected default). Thus the government will not want todefault. When

expectationsare rationalinvestorswillnotexpectadefault.Asa result, ano-

defaultequilibriumcanbesustained.

Letusnowanalyzealargesolvencyshock.Thisisoneforwhich S>S2.Forall

theselargeshocksweobservethatthecostofadefaultisalwayssmallerthan

the benefits (both of an expected and an unexpected default). Thus the

governmentwillwanttodefault.Inarationalexpectationsframework,investors

willanticipatethis.Asaresult,adefaultisinevitable.

BUBE

C

S1 S2



33

Inowturntotheintermediatecase:S1<S<S2.FortheseintermediateshocksI

obtainanindeterminacy,i.e.twoequilibriaarepossible.Whichonewillprevail

onlydependsonwhatisexpected.Toseethis,supposethesolvencyshockisS’

(seeFigureA3). Inthiscasethereare twopotentialequilibria,D andN.TakepointD.Inthiscaseinvestorsexpectadefault(DislocatedontheBEline).This

hastheeffectofmakingthebenefitofadefaultlargerthanthecostC.Thus,the

governmentwilldefault.Disanequilibriumthatisconsistentwithexpectations.

ButpointNisanequalcandidatetobeanequilibriumpoint.InN,investorsdo

notexpectadefault(NisontheBUline).Asaresult,thebenefitofadefaultis

lowerthanthecost.Thusthegovernmentwillnotdefault.ItfollowsthatNisalso

anequilibriumpointthatisconsistentwithexpectations.

FigureA3:Goodandbadequilibria

B

Thusweobtain two possibleequilibria,a bad one (D) that leads todefault, a

good one (N ) that does not lead to default. Both are equally possible. The

selectionofoneofthesetwopointsonlydependsonwhatinvestorsexpect.Ifthe

latterexpectadefault,therewillbeone;iftheydonotexpectadefaulttherewill

BU

BE

C

S1 S2

D

S’

N



be none. This remarkable result is due to the self-fulfilling nature of

expectations.

Thepossibilityofmultipleequilibriaisunlikelytooccurwhenthecountryisa

stand-alone country, i.e. when it can iissue its debt in its own currency. This

makesitpossibleforthecountrytoalwaysavoidoutrightdefaultbecausethe

centralbankcanbeforcedtoprovidealltheliquiditythatisnecessarytoavoid

suchanoutcome.Thishastheeffectthatthereisonlyonebenefitcurve.Inthis

case the government can stilldecide todefault (if the solvencyshock is large

enough). But the country cannot be forced to do so by thewhim of market

expectations

the governance of a fragile eurozone

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