Workshop Discussion Material European Public Debt: A Solution to Fragility 1. Moral Hazard within EUM The establishment of an economic and monetary union generates benefits in terms of microeconomic efficiencies, macroeconomic stability and increased regional equity. Several of the most significant benefits of the European monetary unification are macroeconomic stability and economic growth. Such benefits can be achieved through low inflation and low interest rates, which are factors that facilitate steady growth over time. Moreover, a greater coordination of economic policies combined with the medium term goal of a balanced budget, favoring a reduction of asymmetric shocks among member countries, contributes to a monetary policy that can absorb symmetric shocks and avoid distortions. EMU thus achieves its maximum effectiveness if all member countries share its mechanisms and adopt domestic policies that are consistent with the common objectives of monetary policy. In addition to macroeconomic stability, benefits in terms of increased efficiency, greater regional equity, and external benefits should represent a strong incentive for member countries to coordinate their fiscal policies as well as comply with fiscal rules. Nevertheless, there still are dynamics that lead to selfish and shortsighted behavior on the part of the member countries. Indeed, one of the problems in the economic unions is the fact that the costs of an excessive unbalanced budget policy are not likely to be borne exclusively by the country that adopted that risky policy. Strong financial interconnections and possible contagion effects among member countries are a threat to someone else bears the costs when things go badly. The moral hazard phenomenon exists therefore in monetary unions and occurs despite the presence of monetary and fiscal constraints. In the Euro zone, we can distinguish between two types of moral hazard: one related to weak countries (Italy, Spain, Greece, Portugal) and another related to the strong countries (Germany, Netherlands, Finland, Austria). Week countries We can identify two cases. 1) The introduction of the euro led to a convergence of spreads on government bonds, lowering the interest expenses of the weak countries, which benefited from significant savings in terms of debt costs. In addition, the stability within the euro zone especially in the early years of the introduction of the euro - generated favorable conditions for the implementation of major structural reforms. In many cases, however, the reforms, along with public debt reduction programs, were postponed. The lesser cost of debt was utilized to
increase mostly government (unproductive) spending in order to obtain electoral gains, regardless of the possible negative effect on credit conditions in the financial markets. 2) Within economic unions, the lack of appropriate fiscal surveillance determines the conditions under which some member countries are tempted to implement non- transparent fiscal policies. Alt, Lassen and Wehner (2011) show that, within economic unions, the transparency of the budget process affects the use of fiscal gimmicks and creative accounting. The lower the transparency, the greater the incentive to "beautify" national accounts. In addition, the imposition of fiscal constraints such as those of the Stability and Growth Pact combined with political pressure from the electoral cycle and negative shocks of the economic cycle reinforce the incentive. This is more likely to occur when member countries need to cut government spending in order to comply with fiscal rules. In particular, when elections are close, governments rarely adopt unpopular choices to respect budgetary constraints. In case of low transparency of the budget process, policy makers are more inclined to use fiscal gimmicks or creative accounting to avoid sharp losses of votes. Emblematic is what occurred in Greece in 2009, when a 3% deficit was subsequently revised to 15%. The IMF in 2011 warned that, with the onset of global economic crisis, some countries would be tempted to replace spending cuts with accounting tricks. The recent facts underline that the adoption of budget constraints within economic unions - if not accompanied by fiscal discipline - does not generate by itself compliance with fiscal rules of all member countries. Strong countries The evidence of moral hazard of strong countries is closely related to the flight to safety effect. In crisis times, investors' choices are more oriented towards safe investments lowering the relative returns of such assets. Dany, Gropp, Littke and von Schweinitz (Halle Institute) show that from October 2014 to July 2015 bad news about the possibility of a resolution of the Greek debt crisis determined the lowering of yields on German government bonds. Increased uncertainty within the euro zone shifts portfolios towards investments considered safer (German bonds) while good news about the sustainability of the Greek debt has the opposite effect. Therefore, good news for Greece is bad news for Germany and vice versa. Through different approaches, the study simulates the yields on German government bonds, assuming the absence of the crisis of European sovereign debt, comparing the results with actual yields. The econometric application highlights that Germany, thanks to the panic generated by the European sovereign debt crisis, benefits from a remarkable reduction of the interest payments from 2010 to 2015. Since within the European Monetary Union, the German bonds are considered a safe haven by investors, their yields decreased much more than they would have done in the absence of the crisis. This trend is amplified by the need for highly accommodative European monetary policy, too accommodating if only compared with the fundamentals of the German economy. The study result is around 100 billion euro savings in terms of interest payments, through the new bond issues from 2010 to 2015. Other countries, especially weak economies, suffered from financial panic that generated a sharp rise of the spreads as well as an increasing cost of the public debt. It triggered a spiral in which the weak countries paid very high interests while strong countries benefited from huge savings in interest expense, with remarkable distortions among EMU economies.
2. Debt burden and interest expense Data from public sector show that there is a strong correlation between the annual interest expense on the outstanding debt paid by a government and the debt accumulated in the past. If the money borrowed by the government in the past does not generate enough economic growth, in a way that the GDP (at the denominator) increases at the same pace of the debt (at the numerator), the debt/gdp ratio rises. Furthermore, the interest expenses paid on the new issues increases together with the debt accumulated in the past. This is due to the risk that the government is not able to repay its debt. Such risk becomes larger as long as the debt continues to grow. In fact, the yearly interest expense/gdp is likely to be higher for countries that have high level of public debt, since the factors that contribute to this result are huge stock of debt and higher interest rates. The chart shows on the x- axis the ratio debt/gdp and on the y- axis, the ratio interest expense/gdp. It is clear the positive relationship 1 between the two variables (Fig. 1). Italy, Portugal, Ireland and Greece (even after the default) pay much more in interest than the other member countries, since they have a greater stock of debt, but the European sovereign debt crisis also increases the spreads. Fig. 1 The sustainability of the ratio debt/gdp is reached only under some circumstances: in presence of positive annual deficits, the real growth must be greater than the real interest rate. If it is not verified, to avoid the explosion of the ratio debt/gdp, the governments must achieve an adequate level of annual surplus of primary balance to offset the negative difference. In a dynamic context, this policy target can be very challenging: in a scenario of low or negative growth and low inflation or deflation, in order to maintain a sustainable ratio debt/gdp, an annual surplus of primary balance is needed. The primary balance can be obtained reducing the public expenditure or increasing the taxation or by a combination of the two. In any case, this kind of policy, so- called austerity, reduces the 1 The equation, using a linear regression, is Interests/GDP = 0,00286*Debt/GDP+0,1386. The R 2 is 0,77
aggregate demand, which in turn lowers the potential growth. The conclusion is that the austerity could trigger a vicious circle through the reduction of the potential growth as well as lowering inflation. The vicious circle generates a sharp increase of public debt, a loss of government credibility, higher credit risk, and consequently higher rates. On the other hand, higher real interest rate imply negative effect on the aggregate demand. In order to not to compromise the sustainability of the debt/gdp ratio, it is important to prevent the interest rates spikes during debt crises. 3. European Monetary Policy: a limited medicine In crisis time, Europe experienced a sort of dualism, between countries that can issue new debt at lower rates and countries that face an increase of financing rates because of the credit risk. In fact, a negative difference between the real growth rate and the real interest rate affected the policy choices of many member countries. Those with low debt/gdp ratio could use the deficit spending as a strategy to support and sustain the growth; others with high debt/gdp ratio needed to reduce the deficit in order to restore credibility. In the Euro- zone, considering that the economies of the countries are strictly related, two countries should observe the same trends in the bond market. The 10 years yield on government bonds is an indicator of the investor confidence. When confidence is high, the ten- year Treasury bond s price drops and yields go higher because investors feel they can obtain higher returns in other riskier assets. By contrast, when confidence is low, the price goes up as demand for safe investments increases while yields fall. To better understand this dynamic, it is useful to isolate all the situations in which two countries, for example Germany and Italy, have the yield on the 10 years benchmark bond that move in the opposite direction. The blue histogram of the chart represents the difference between the 10 years yield of Italy and the 10 years yield of Germany only in the cases in which the two rates observe opposite directions (rise/decrease). When they move in the same direction, the difference is set to zero. The aim is to focus on divergences between two variables. The chart shows clearly that at the beginning of the monetary union the Italian and the German yields used to move in the same direction (Fig. 2). During the turmoil provoked by the Lehman Brothers bankruptcy, the two yields started to decouple slightly, while during the sovereign crisis from 2011 to 2013 the divergence became much more significant. This means that when the Italian government yield bonds augments, the German bonds yield declines. Fig.2
An expansionary monetary policy can only partially offset the divergences. The green line (Fig. 3) shows the policy rate of the ECB. Despite its strong reduction, yield differences between German and Italian bonds remain considerably high. Only thanks to non- conventional monetary policy operations (direct purchase of government bonds) that affect the quantity of money in circulation (M3, in chart the green line) the effect of diversion decreases. Fig.3 Credit and liquidity risks still affect Euro Zone countries. In fact, nominal interest rates on currently issued government bonds affect the interest expense calculated in nominal terms; if the growth is low or even negative, and the inflation is low or even negative, the real interest rate can be too high even if the nominal interest rates are very low. Beyond the difficulties for the governments to keep the debt/gdp ratio under control, an increase in the interest rates due to credit risks of the government affect the aggregate demand and they both contribute to deflating the GDP, making it even harder to avoid the explosion of debt.
Since private banks usually hold government bonds and private loans, an increase in the interest rates undermines the robustness of the banking system, and the whole system becomes more fragile. Factors that contribute remarkably to this fragility are: Fall in the market value of government bonds. Increased volatility and consequently higher risk related to government bonds. Necessity to maintain adequate capital requirements. Fund- raising difficulties. Credit crunch. 4. European debt imbalances among member countries In the Euro- zone, the debt burden across the countries is diversified. The ring chart (Fig. 4) shows the stock of the debt in the external ring while in the internal ring shows the GDP. If each country had the same proportion of debt, the two rings would be aligned. On the contrary, discrepancies are visible: for some countries the external ring is bigger than the internal, while for other countries it is the opposite. Fig. 4 Figure 5 represents another way of looking at discrepancies among EMU member countries. By calculating the difference between the stock of public debt and GDP, it is straightforward to verify two major couples of imbalances: Italy and Germany, Greece and Netherlands. Fig. 5
5. European Public Debt The existence of different domestic policy strategies, a remarkable difference in macroeconomic fundamentals, and a moral hazard phenomenon suggest that European integration process is not yet completed. Since the moral hazard for member countries is identical to the moral hazard in the financial market, one way to overcome is risk- limiting regulation through increasing transparency and a greater coordination of fiscal policies of all member countries. The creation of European Public Debt, based on a system of rewards and penalties can certainly facilitate to achieve the goal. Here below we summarize some features for a first step to analyse its implementation. Rewards Possibility to issue additional debt under some circumstances. Creation of the European Federal Budget. Possibility for struggling member countries to have access to the Federal Budget, under some conditions. Fiscal Surveillance and Penalties Government budget ceilings. Maastricht criteria still valid. Application of a spread ( penalty rate payable to ECB ) on the issues of additional debt. Utilization of the federal budget subject to strict conditions (economic downturn, external factors, structural reforms). Implementation: Governance, and Democratic Legitimacy Problem Implementation of the European Public Debt is subject to a numerous complications that need to be evaluated. Generally, it could not be considered a problem that not all EU countries adopted the euro, but for the purposes of a European treasury and European debt, it can be a crucial complication. ECB is currently the only euro area institution; all others (Commission, Parliament etc.) are at the EU level.
Hence, a treasury at the EU level cannot really be justified, as the main justification precisely consists of having a common currency. The establishment of European monetary policy has been accompanied with the creation of one independent authority. Similarly, the creation of the European Public Debt could hardly be successful without considering an appropriate independent institution, with its rules and policies : an area euro treasury governed by an independent institution that for reasons of simplicity we define as Ministry of Treasury. European Public Debt could certainly build a wide mechanism for offsetting idiosyncratic shocks to individual member countries, but the main obstacle is how to implement it in a way that solves the commitment problem. Here below, the followings could represent a first proposal to start investigating the issue: Establishment of the Ministry of Treasury with its Board of Directors. The European Parliament appoints the Board of Directors after each European election. Implementation, within European Parliament, of some euro area member specific sessions with the aim to nominate the new members of BoD. Possibility to assign some Board of Directors candidates to the European Commission. To guarantee an efficient coordination between budget and monetary policy, the Ministry of Treasury could adopt a dual system with a Surveillance Organism controlled by the ECB and a Board of Directors that governs. Other instruments related to European Public Debt Issuing Eurobonds to finance a number of EU projects in terms of infrastructure, research and development, education, integration. European wide unemployment insurance: it would be a specific business cycle related expenditure that would automatically allocate more funds to countries in recession. The utilization of these instruments should be subordinated to the adoption of a common legal framework related to the specific instruments. Trinità dei Monti Think Tank: Pierluigi Testa, Filippo Perazzoli Special thanks to Prof. Reimt E. Gropp