Euro bonds are not the answer to the region’s raging financial crisis. The euro countries aren’t going to agree to guarantee each others’ debts in time to solve it. And, once it is over, neither euro bonds nor fiscal union is desirable. Market discipline is a better way of dealing with the current crisis as well as running monetary union in the long run.
One can understand why fiscally-challenged governments such as Italy’s and Greece’s are in favor of euro bonds. If they could issue debt which was guaranteed by all their partners in the euro zone, they wouldn’t find it so hard to borrow money. They would then no longer be under such pressure to do unpopular things like tighten their belts and reform their economies. One can also understand why investors are clamoring for the introduction of euro bonds. They would recoup the losses on their investments in fiscally-weak countries’ bonds.
But there’s precious little chance of these bonds being approved any time soon by fiscally-strong countries — led by Germany, the Netherlands and Finland. The politicians and public in these nations are worried about being drowned by other countries’ debt. Such debt collectivization would also blunt the incentive for governments, which have borrowed too much money and whose economies are uncompetitive, to put their own houses in order.
Germany may be prepared to consider green-lighting euro bonds once current debts are under control. But that, by definition, wouldn’t be a solution to the crisis. What’s more, Berlin would only agree to the issue of euro bonds if other governments accepted strict rules on how much they could borrow. Mark Rutte, the Dutch prime minister, has even suggested that a budget tsar should be appointed to ensure that countries don’t break the rules in future. He or she would have the power to fine miscreants and, in extremis, force them to raise taxes or quit the euro zone. Once the crisis is over, other euro countries may not find such a loss of sovereignty so appealing.
Conventional wisdom, of course, is that fiscal union -– of which euro bonds would be a key element -– is needed to make monetary union a success. Both euro-enthusiasts and euro-skeptics tend to share this view, although the latter group thinks of such union as hell rather than heaven and would prefer the single currency to be dismantled. Both camps often argue that the main reason the euro zone is in crisis is because monetary union was launched without fiscal union.
But this conventional wisdom is flawed. Governments didn’t rack up excessive debts because of the lack of fiscal union. Rather it was because they flouted the rules designed to limit borrowing and bond investors kept lending them money. There was a failure of discipline, both by the bureaucrats and the market.
The least bad way forward is to make the discipline of the market more effective while giving struggling governments some help to make a transition to healthier economies. Allowing controlled default, which inflict losses on investors, would be a valuable lesson that foolish lending has consequences. So far this has only happened in a clumsy manner causing unnecessary suffering. In the case of Greece, the “pretend and extend” approach has meant that the country hasn’t been allowed to go bust despite debts that could reach 167 percent of GDP this year, according to Citigroup.
Despite the chaotic policy-making, the current approach has had one big success: Greece, Ireland, Portugal, Italy and Spain have finally started embracing reforms they have shirked for years. Labour markets are being liberalized, pension ages pushed up, corruption rooted out and tax evasion combatted. More reform is required. Ultimately these changes will result in fitter economies, although there’s no denying that the short-term outlook is bleak.
A combination of such supply-side reforms with the option of controlled default in extreme cases isn’t just the best way of handling the current difficulties. It is a better long-term model for the region than euro bonds and fiscal union.