A Take on Eurozone Debt Crisis

Orderly Debt Reduction Rather Than Permanent Mutualisation Is The Way To Go

by Vesa Vihriala and Beatrice Weder di Mauro, Voxeu.org

The EZ debt overhang needs to be fixed. This column argues that making market discipline credible requires an orderly debt restructuring mechanism combined with a strictly regulated temporary mutualisation scheme or a well-designed debt conversion scheme. This combination could reduce the current debt overhang in an orderly fashion and cement strong incentives against over-borrowing in the future.

Follow up:

High levels of public debt have been at the centre of the euro crisis. Perceived unsustainability of individual member states’ public debt resulted in high interest rates and the threat of exclusion from the bond market. This prompted emergency financial assistance, the establishment of institutions for assistance, and ultimately the Outright Monetary Transactions (OMT) promise by the ECB. The effective partial mutualisation of sovereign risk has been important in calming down market turbulence and allowing a modest recovery to take hold.

At the same time, debt mutualisation has been a very controversial issue.

  • One camp argues that for the monetary union to function, a large part if not all of sovereign debt should be permanently mutualised, and fiscal policymaking should be moved from the national level to the Eurozone level.
  • Another camp claims that mutualisation is a blatant violation of an important foundation of the Treaties, namely the no-bailout clause, and should be kept at the bare minimum in the form of conditional, ‘ultima ratio’ financial assistance. Instead of mutualisation, fiscal rules should be tightened and enforced with more determination, be it by a budget tsar or by the European Court of Justice.

A new report

The fresh report of an expert group appointed by the EU Commission, in which we took part, discusses extensively the pros and cons of two specific types of debt mutualisation: eurobills and the debt redemption fund/pact. In the carefully worded conclusions, debt mutualisation is considered to have merits in stabilising government debt markets, supporting monetary policy transmission, and promoting financial stability and integration. At the same time, all the schemes considered are associated with economic, financial, and moral hazard risks. Strong economic governance is one way of containing these risks, and the report suggests that it would be prudent to first collect evidence on the reformed governance mechanisms before any decisions on new schemes of joint issuance are taken.

We subscribe to these conclusions. However, it was considered outside the expert group’s mandate to examine more broadly how the Eurozone could overcome the current debt overhang problem and how to reduce the likelihood of something similar happening again going forward. In our view, this is the central policy issue at hand, and a discussion of debt mutualisation without this perspective remains abstract.

The Eurozone’s debt overhang problem

We have five points to make:

  • First, the current debt overhang is unlikely to be solved smoothly and without excessive risks by fiscal consolidation alone, as foreseen in the Stability and Growth Pact (SGP) and the Treaty on Stability, Coordination and Governance (TSCG). Exceptional measures are needed.
  • Second, permanent debt mutualisation arrangements beyond what is implied by the European Stability Mechanism (ESM) are not economically sensible or politically feasible in the foreseeable future.
  • Third, the promise of OMT has eliminated tail risks but should not become the main instrument to reduce debt burdens.
  • Fourth, the two main alternatives to facilitate smooth and orderly debt reduction are: (1) a flow operation like the debt redemption pact, or (2) a stock operation, e.g. using ECB seigniorage.
  • Fifth, a statutory sovereign debt restructuring mechanism is a necessary part of a stable regime that keeps moral hazard in check, and can be introduced sooner than often thought.

Consolidation alone is a risky strategy

While fiscal consolidation cannot and should not be avoided, there are well-known problems in relying on it alone. Attaining the required primary balances for the debt to go down to, say, 60% even in 25 years requires significant further consolidation in countries like Spain, Italy, Belgium, and France. This would dampen the already low growth for several years.

More importantly, maintaining the necessary primary balances for at least two decades will be very difficult. Any major shock, cyclical or otherwise, could easily wipe out the primary surplus, calling into question the sustainability of the debt paths of the highly indebted counties. Reinhart and Rogoff (2013) demonstrate that working down debt overhangs in the past has not really succeeded with fiscal consolidation, forbearance, and growth alone. Given the European growth prospects, this is a risky strategy for the high-debt Eurozone countries.

Inflation surprises and financial repression have often been used to reduce excessive debts. Their feasibility and attractiveness can nevertheless be questioned. Interest rates are likely to react strongly to any attempts to inflate debts away. Forcing private investors to hold government debt at low yields may not be easy in the sophisticated and integrated global financial system either. Moreover, both mechanisms would be bad for long-term growth through their impacts on uncertainty and resource allocation. Something else is needed.

Mutualisation attractive but fraught with problems

Mutualising debt is obviously an attractive solution for the highly indebted countries. The required primary surplus would be reduced as interest expenses would decline, the degree of course depending on the scheme and the prevailing spreads.

However, economic logic suggests, and experience proves, that shifting risk away from the decision-maker induces more risk taking. Moral hazard can take many forms, but most likely it means reduced effort to implement painful reforms.

To guard against such disincentives, the EU level should be able to control very effectively fiscal policymaking in the member states. While we don’t know for sure how well the current governance mechanism is going to function, we know that it does not allow the EU level to take binding decisions on member states’ fiscal or structural policies. There is no political will among the EU member states to give up so much fiscal sovereignty through a Treaty change in the foreseeable future.

An alternative is a financial incentive system that penalises bad behaviour with high interest rates and rewards good behaviour with low rates. The problem with this is that such penalties, be they administered by some EU body or by markets, would increase the debt service burden, and could ultimately lead to default. Unless the Eurozone is capable of sustaining such a failure without overwhelming financial stability consequences, the penalties are not credible.

The difficulty of relying on OMT

The OMT is a de facto extension of the ESM promise of conditional financial assistance. Although the OMT promise has been a very effective and cheap way of eliminating tail risk, it should not be the main instrument to bring down debt burdens. One difficulty is reconciling the promise with the non-monetary financing rule, and associated with that the weak political acceptability in Germany, should it need to be activated. For these reasons and because any potential beneficiary would be reluctant to accept strong conditionality, the facility might be activated only under extreme stress. Therefore, the highly indebted countries will most likely not benefit more than has happened so far, and the spreads could widen quite a bit from the current level. In addition, there is still some uncertainty about the legality of OMT.

Thus, the Eurozone should look for a fiscal solution, which could either be a flow operation (i.e. help that eases the debt service burden on an ongoing basis) or a stock operation (i.e. a debt conversion scheme using future seigniorage revenues).

Debt redemption pact as a flow solution

One attempt to square the circle of helping out highly indebted countries while preventing bad behaviour is the debt redemption pact proposed originally by the German Council of Economic Experts (GCEE 2010 and 2013).

  • Its basic idea is to mutualise all new borrowing of high-debt countries in a jointly guaranteed fund until the national debt is down to 60% of GDP and to redeem the debt over a period of some 25 years, after which no mutual debt would exist anymore.
  • To ensure that the member states would pursue prudent fiscal policies and would be able to redeem the debt, strict debt rules would be introduced in national legislation, the participating countries would be required to post collateral, interest mark-ups would be used as incentives, and during the roll-in phase any non-compliant member state would be excluded.

Two safeguards would help ensure that the operation would be a one-off and mutualisation would remain temporary: (1) any renewal or extension would have to be approved by popular referendum in Germany, and (2) a sovereign debt restructuring regime would be an integral part of the package (see below).

While the precautions against moral hazard are stronger than in many other mutualisation schemes, the basic problem remains. As long as the EU level does not have binding powers over member states’ policies, and as long as the Eurozone cannot sustain the consequences of a failure of a member state to honour its commitments, moral hazard is difficult to contain. The problem would be particularly serious immediately after the roll-in phase is over, and in some cases more than half of a member state’s debt is mutualised.

Solutions involving a one-time stock operation

One way to quickly get rid of a large part of the debt overhang would be a debt conversion scheme based on the idea of using future seigniorage revenues to redeem debt (Pâris and Wyplosz 2014).

  • The highly indebted countries would not reduce their debt service burden though mutualisation; they would do so through borrowing from their own future generations.

Some of the more ambitious schemes could immediately wipe out the entire debt overhang.

  • The ECB would buy sovereign debt in shares equal to its profit sharing rule (sterilising this operation to keep its monetary policy stance unchanged) and convert them into a perpetual bond – essentially cancelling the national debt.

However, some of the smaller variants avoid any direct involvement of the ECB. In such a variant, governments could forego future seigniorage revenues and pre-commit them to debt redemption. The ESM would convert outstanding national debt into bonds backed by the seigniorage stream. The stock operation could be designed without any transfer or mutualisation, though some redistribution might be helpful to make the scheme acceptable to all.

While there is not necessarily any mutualisation (with the associated transfer risk) in these conversion schemes, there are strong incentives to overestimate the degree to which future seigniorage streams could be used to service debt, and to repeat the conversion exercise in the future, thus endangering both fiscal and – in the end – monetary stability. To counter these incentives, Pâris and Wyplosz propose a market penalty scheme and strengthened debt brakes. That may go some way to addressing the issue, but the question remains whether such mechanisms would be effective enough to prevent misusing the scheme when the interests of policymakers in different countries coincide better than in any mutualisation scheme. It would seem necessary that the size of the scheme is set small enough to be safely within the capacity of the estimated seignorage flows, and that the system is kept ‘fiscal’ i.e. not involving the ECB directly to reduce the conflict with ECB’s independence in setting monetary policy and with the non-monetary financing rule. Furthermore, strict debt brakes would need to be supported by strong market incentives to keep fiscal policymaking prudent and discourage resorting to conversion repeatedly.

The importance of a debt restructuring mechanism

In both solutions described above, the introduction of a statutory sovereign debt restructuring regime could be the way to ensure that the operation is not repeatable and to guard against renewed over-borrowing. Of course, the design of the restructuring regime needs to be intelligent in order to fulfil these tasks credibly.

A credible restructuring regime needs to have enough flexibility to accommodate some shocks and not induce ‘too much’ restructuring, but it also needs to be clear and stringent to discourage both over-borrowing and the temptation of official creditors to procrastinate and to do ‘too little, too late’ (as recently diagnosed in IMF 2013).

The original proposal of the German Council of Economic Experts (2010) describes a restructuring regime that attempts to balance these trade-offs. The CIEPR (2013) further refines this proposal and explains the links to other EU-level instruments such as the banking union.

The idea is to condition ESM lending to two debt thresholds:

  • A lower threshold derived from the EU fiscal framework, and
  • An upper threshold suggested originally at 90% of GDP.

Below the lower threshold, countries would be able to access the ESM without fiscal conditionality, providing protection from creditor runs and an additional incentive to remain below the threshold. Between the lower and the upper threshold, a country faced with a refinancing crisis could access ESM lending but only under strict conditionality. Above the upper threshold ESM lending would only be possible with an immediate debt restructuring.

Obviously, this scheme sets strong incentives against accumulating public debt as well as against taking on the debts of the banking system. It thus presents a strong second line of defence should the new economic governance of the EU prove to be insufficient.

When could such a regime be introduced? Clearly, it could be highly destabilising if it were introduced while debt levels were still above the higher threshold. Conversely, it would become a stabilising device as soon as countries’ debt levels have fallen below the upper threshold. Moreover, the upper threshold could be set somewhat higher initially (say 100%). Under a debt redemption pact this aim could be achieved in less than 10 years, and under the PADRE scheme (Pâris and Wyplosz 2014) it could be achieved almost instantly. Thus, the second line of defence could be activated sooner than often claimed.

The principle of bailing in private creditors has been accepted in the case of banks and an orderly mechanism will be introduced in few years’ time in the EU. It should not be impossible to start applying the same principle to the de facto risky sovereign debt as well.

The way to go

The debt overhang is a drag and risk on growth in Europe. Given the different debt levels and debt service capacities, mutualisation of public debt has been proposed as an attractive way to overcome the problem. The associated moral hazard is nevertheless a serious economic and political hurdle. We do not believe that there is going to be political will in the foreseeable future to transfer sufficient fiscal and economic policy-making powers from sovereign states to the EU level to eliminate this risk. In our view, a much more promising alternative to contain moral hazard is to make market discipline credible through an orderly debt restructuring mechanism. By combining such a mechanism with a strictly regulated temporary mutualisation scheme or perhaps even a well-designed debt conversion scheme, one might both reduce the current debt overhang in an orderly fashion and cement strong incentives against over-borrowing in the future. Without a debt restructuring mechanism, the proposed ideas to ease the burden of consolidation would be far too risky.


Committee on International Economic Policy and Reform (2013), “Revisiting Sovereign Bankruptcy”, Washington DC: Brookings Institution.

Expert Group on Debt Redemption Fund and Eurobills (2014), “Final Report”, European Commission, 31 March.

German Council of Economic Experts (2010), “Annual Report 2010/11”, Chapters 3 and 4, Wiesbaden.

German Council of Economic Experts (2012), “Special Report”, Wiesbaden.

IMF (2013), “Sovereign Debt Restructuring – Recent Developments and Implications for the Fund's Legal and Policy Framework”, 26 April.

Reinhart, C and K Rogoff (2013), “Financial and sovereign debt crises: Some lessons learned and those forgotten”, IMF Working Paper 13/266.

Pâris, P and C Wyplosz (2014), “PADRE: Politically Acceptable Debt Restructuring in the Eurozone”, Geneva Special Report on the World Economy 3, ICMB and CEPR.

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