Germany and the Eurozone: Clutching disaster from the jaws of victory?

by John Muellbauer

Vox
November 25, 2011

For months economists have been arguing that Germany holds the key to ending the Eurozone crisis. Should it relax its anti-inflation stance and allow the ECB to inflate away sovereign debt? Or should it write a cheque of its own to the EFSF? Neither, says this column. There is a simple solution, if only Eurozone leaders can see it. Eurobonds are the answer – but with conditions.

Aided by market panic and confusion, it could be said that German toughness has transformed the reform prospects for Europe. Italy, Spain, and Greece now have credible, reform-committed governments. Ireland, bailed out under tough conditions, has cut its unit labour cost by 17% over 2 years and is showing growth. Portugal is strenuously reforming its public sector and labour markets. However, market panic has been costly for the European banking system and for short-run economic prospects.

All this would be a price worth paying, however, if Angela Merkel now completes the final stage of what would be seen as a remarkable moral, political, and economic triumph. A few years ago, a sleazy and ineffective Italian government could borrow on the markets at a cost scarcely higher than that of Germany. Last week, it cost the new Italian government over 6 percentage points more to borrow for two years than it cost the Germans. (see for example Manasse and Trigilia 2011). There is a way to put an instant stop to this absurdity without the European Central Bank and the European Stability Fund.

The German Ministry of Finance could offer a two-year loan to the Italian government at 3% above what it pays, and promise that next year, if the Italian reform programme is showing visible signs of success, the spread could fall to 2.5% and then to 2% if progress continues. With backsliding, the cost would rise. This solidarity gesture would be highly profitable for the German taxpayer. The conditionality of the offer would keep the new Italian government committed to reform, aiding Italy’s credibility as a Eurozone member. Conventional Eurobonds, meanwhile, with the same funding costs for every country but with risk collectively underwritten, would likely be a recipe for disaster. They would encourage lax fiscal policy, backsliding on reform, and moral hazard. But conditional lending as illustrated above could be institutionalised in conditional Eurobonds as explained in my CEPR Policy Insight 59 (Muellbauer 2011).

For the investor, conditional Eurobonds trade at the same price for all issuing countries, but the riskier countries pay a premium, or ‘spread’, to the safer countries for underwriting their common debt issuance. Conditional Eurobonds, with spreads linked to the ratios to GDP of government debt and deficits, were first proposed by Wim Boonstra, chief economist of Rabobank, even before monetary union (Boonstra 1991). Had they been part of Eurozone architecture, the current crisis could largely have been avoided, and even without fiscal centralisation.

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