How to Save the Euro? Lessons from the US

by Jacques Melitz © VoxEU.org

Earlier this year, the fiscal situation in Greece caused turmoil across Europe. This column examines why the financial difficulties of several state governments in the US are not having similar impacts on its economy.

The problems of the Eurozone this year brought to light some failures of the system. Nevertheless, the resulting drop in confidence in the system has gone further than we might have expected. Questions have even arisen about the survival of the system (see Baldwin 2010 and Blejer and Levy-Yeyati 2010 for discussions). Yet monetary systems do not tend to dissolve simply because of faulty performance. On the contrary, as a rule they endure even when they function very badly. It takes a political force majeure to bring about the break-up of a single currency area, typically without connection to monetary performance. Why, then, has the possible default of a country engaged in irresponsible fiscal policy and accounting for only 3% of the Eurozone’s GDP raised questions about ‘saving the euro’ and the survival of the Eurozone?

The issue has not received the attention it deserves. It is often simply taken for granted that the departures from the Stability and Growth Pact provide a sufficient reason for the earthquake that has shaken the whole currency area. Yet if we look around the world past and present, the mismanagement of finances by regional governments has no particular tendency to bring down entire monetary systems, far from it. In line with the usual – I think superficial – diagnosis of the ailment, proposed remedies for the Eurozone centre on strengthening the Pact, increasing joint political control over fiscal policy, and providing joint insurance against government default, or some mixture of the three. But what if a vital element of the problem is really the official doctrine that sovereign default is incompatible with the euro? What if the scale of the crisis that took place this year has resulted from financial markets’ conviction, based on this doctrine, that the future of the euro was at stake? What if assuring the long-run sustainability of the euro means convincing those markets, quite differently, that nothing as manageable as a Greek default can upset the Eurozone?

Lessons from the US

That is precisely what the US example would suggest and what I will defend. With this idea governing beliefs, the right road ahead looks quite different. It means shifting the emphasis away from avoiding government defaults toward assuring the stability and the solvency of the banking system at all times, regardless of the financial difficulties of some member governments.

In the US, default on state and municipal contractual obligations is very much a possibility whenever lower-level governments are in financial trouble; bailout cannot be taken for granted. New York City defaulted in 1975, the biggest default of all by a lower-level government unit since World War II took place in 1983 when the Washington Public Power Supply System went into bankruptcy, and Orange County defaulted in 1995. Various municipal governments have been on the verge of default at times in the last few decades, including Philadelphia and Cleveland. There is also no Stability and Growth Pact in the US. Yet financial discipline is considerably higher in the US at the state government level than in the Eurozone at the national level. All states except Vermont have balanced-budget rules; but these rules are self-imposed. It is easy to argue that this difference in fiscal discipline on the two sides of the Atlantic is related to the fact that when push comes to shove in the US and a lower-level government unit cannot or will not meet its debt obligations, the lenders can expect to take a big part of the hit.

Some rudimentary analysis is relevant. Consider any government unit unable to print money and without any prospect of a bailout. Theory tells us that credit rationing is very much a possibility. As the interest rate that such a government offers on its debt goes up, extra lending dries up completely at some point as the expected rate of return on the government debt falls. This must happen because higher nominal interest rates impair the government’s solvability and bring default nearer. Risk aversion simply lowers the interest rate at which credit rationing begins.

Suppose we compare the situation in the US and the Eurozone since the 2007-2009 financial crisis in this light. The crisis brought about dire financing problems for many lower-level government units in the US and some national governments in the Eurozone. According to the spreads on credit default swaps, California and Illinois now have a higher probability of non-performance on public debt than Portugal and Spain. This has been true for months. Consider next the difference in response in the States and Europe. Recently Illinois simply stopped paying $5 billion of bills. In June of last year California issued vouchers for wage payments. In addition, savage cuts in public services have begun and are now threatened in various states in difficulty, not only these two. Nevada has made startling reductions in spending on higher education and welfare. In the case of Portugal and Spain, nothing so drastic has happened thus far. There have been occasional spikes in interest rate spreads over German bunds of 100 to 200 percentage-points above usual levels. Both Spanish and Portuguese governments have also been forced to plan greater austerity and reduced government deficit spending. Meanwhile, they have been able and willing to keep borrowing.

Why the difference between the Eurozone and the US?

Part of the explanation may be that Portugal and Spain are more able to raise tax revenues than US states. But another part is the higher probability of a bailout in Europe. The example of Greece is to the point. Greece has been able to continue borrowing this year at interest rates typically around 200 percentage-points above Portugal and Spain on 10-year government bonds (and since May more than 500 percentage-points higher than German bunds). If you do the math, it is clear that this could never have happened without a high probability of a bailout. In fact, you do not need to do the math: there have been occasions in February/March and particularly May when some Greek issues would clearly have failed without the assurance of public lending and ECB support. If Greece can borrow on the probability of a bailout, so could Portugal and Spain.

Based on this evidence, the current Eurozone strategy of treating government default as anathema permits member governments to sink into deeper waters, weakens the forces that would otherwise exist toward self-imposed budget restraints, and thereby raises the probability of a bailout. But an actual bailout is perhaps the most likely setting for the breakdown of the Eurozone. If taxes ever need to rise all over the Eurozone in order to bail out a member government, one can easily imagine a pullout by Germany, followed by the Netherlands and Austria (if no others), in order to form a separate monetary union.[1]

What are the dangers of the opposite strategy of mimicking the US instead and moving toward heavier reliance on markets to discipline member governments and to price sovereign risk? The answer lies in the external effects of government default on the payment system and the banks, and this problem would be aggravated by contagion. But those dangers exist in the US as well. If the US federal government were to allow Illinois or California to default on state government debt in today’s circumstances of widespread financial difficulties across the states, there is a serious threat that interest premia would go up on the debt of most state governments and a wave of state defaults would follow. For this reason, the federal government might well step in. But if we look at the institutional manner in which the US deals with the problem, we find the answer to lie in country-wide prudential rules for banks and central bank powers of lender of last resort. There is no general announcement that state government default is incompatible with the dollar. Instead there is a strict separation of the issue of joint support of the financial system and joint support of financing by the sub-government units in the country. Would Europe not be wise to adopt the same strategy and to cease to conflate the two issues?

Tweaking the Pact

What this would mean, of course, is adopting Eurozone-wide prudential rules on banks, providing the ECB full powers of lender of last resort, and, very significantly, dismissing the idea that the Stability and Growth Pact is the pillar on which the whole Eurozone project stands. This idea is highly perilous.[2] Markets believe it, and at times of financial precariousness, what markets believe is extremely important. According to my proposal, the Pact could still be upheld as a code of good behaviour which improves public finances in Europe and facilitates the task of the ECB. But the basic philosophy would be that if any individual member government in the Eurozone engages in irresponsible fiscal conduct, contrary to the Pact, the creditors and its taxpayers would bear the brunt of the consequences. Everything would be done to assure the stability of the financial sector in the Eurozone and the lack of repercussions on the risk premiums that the more financially responsible member governments need to pay. Banks might be bailed out but not governments. Any aid to member governments, if it came, would not concern the euro system but the IMF or if any aid did come from the EU it would be part of a programme that could as well have existed had the euro never appeared and would be clearly sealed off.

VoxEU Editors' note: This article will appear as a roundtable discussion in Miroslav Beblavy, David Cobham and Ludovit Odor, eds., The euro area and the financial crisis, Cambridge University Press, forthcoming.

References:

Baldwin, R (2010), A re-cap of Vox columns on the Eurozone crisis” VoxEU.org, 13 May.

Blejer, M and Levy-Yeyati, E (2010), Leaving the euro: What’s in the box, VoxEU.org, 21 July.

Economist (2010), Can pay, won’t pay, June 19.

Poterba, J (1996), Do budget rules work? NBER Working Paper 5550, April.

Public Bonds (2010), Municipal bonds and defaults, downloaded 23 August.

Reinhart, C M and Rogoff, K (2009), This time is different: eight centuries of financial folly, Princeton: Princeton University Press.

Sinn, H-W (2010), Rescuing Europe, CESifo Forum, special issue, August.

Notes:

[1] Many would say that Greece has already been bailed out. But so far no holder of Greek debt has yet suffered a credit event. Further, no one outside of Greece has yet paid any taxes to fulfil a claim on Greek debt. Thus, according to my usage, no bailout has happened. However, none of the argument hinges on this choice of words.

[2] If we really think that a government default would bring the euro under, we must conclude that the euro has no long-run future ahead – that it is doomed. A reading of Reinhart and Rogoff (2009) should convince anyone.

Republished with permission of VoxEU.org