Eighty-one years after Gustav Stresemann raised his voice in front of the League of Nations to call for a European currency, the object of his wish is in a devastating state. When the European Currency Unit was introduced 50 years after Stresemann’s speech, it took about a decade for Europe to find itself in choppy waters, with Italy deciding to devalue the Lira and the UK to leave the exchange rate mechanism. When the euro superseded the currency unit in 1999, again it has taken about a decade for Europe to find itself in choppy waters. The plot of the current crisis resembles that of 1992; markets spotted potentially unsustainable developments in some member countries and put their finger on the weak spots. As in 1992, the countries in trouble face twin deficits, and like those days, reactions by other EU members and the European Commission did not give the impression of being in control of the situation – perhaps until 9 May. Yet steps towards a persuasive handling of the situation are still hopelessly disconnected.
A new framework for fiscal policy consolidation: A European Consolidation Pact
To deal both with the ongoing as well as future fiscal crises, we propose a new framework for fiscal policy consolidation in Europe. At its centre is a European Consolidation Pact that supplements the Stability and Growth Pact in times of crisis. The Consolidation Pact is based on ideas first published in the German Council of Economic Experts’ Annual Report 2009/10 and spelled out more thoroughly in our paper (Bofinger and Ried 2010). It has five distinguishing elements.
Element 1: An expenditure path to balancing the budget
Participating countries are obliged to detail a path to balancing their budgets, including a concrete course to cutting non-cyclical government expenditure and a binding roadmap for planned changes to tax legislation. All Consolidation Pact members coordinate and decide about their national efforts together. Decisions should be in line with those of the excessive deficit procedure of the Stability and Growth Pact, but possibly going beyond them.
Why would a country be willing to participate in such a pact? There are two perspectives. For a low-deficit, low-debt country, the Consolidation Pact offers strict consolidation rules for all members. Given the European economies' interdependence, it would be highly beneficial if fiscal consolidation were organised as a disciplined march of the whole troop rather than a courageous foray by the vanguard. At the same time the other EU member countries should have an incentive to gain the confidence of market players through a credible commitment to budgetary discipline as an essential prerequisite for low long-term interest rates.
Element 2: A debt surcharge
Countries willing to participate in the European Consolidation Pact are obliged to implement an automatic tax increase law in their national legislation. This states that the tax rate of a specific Consolidation Pact member country will automatically rise by a certain amount in case that country is straying from the defined path ("debt surcharge"). The resulting tax receipts completely remain with the straying country to enable it to improve its fiscal stance. This element makes it clear to the voters of a country that it is in their hands to deal with excessive deficits. This should give incentives to both voters – to carefully decide about which fiscal policy proposal to vote for – and governments – to make sure every fruitful opportunity other than the automatic tax increase is used.
Element 3: Guarantees
Every country participating in the pact would be able to apply for European Consolidation Pact guarantees for each newly issued government debt that is in line with the specified path to balancing its budget. This implies that the soundness of fiscal policies has to be monitored before and after each new government bond issue that applies for the guarantee. The monitoring should be carried out by the European Commission or by designated staff members of the Consolidation Pact. While consolidation path and automatic tax increase law belong to the stick principle, guarantees serve as a carrot that makes the European Consolidation Pact attractive to the country in difficulties. The increased credibility of a lasting consolidation effort that is to be expected for Consolidation Pact members serves as another “carrot”.
Element 4: A fee for the guarantee
Each guarantee issued would be paid for with a percentage fee to the European Consolidation Pact, as compensation for the risk taken and to confine moral hazard. The fee would then be distributed among the pact members. The size of the fee would be such that there are gains for both sides. The European Consolidation Pact would have to be compensated for bearing the default risk of that specific tranche of government debt, the beneficiary of the guarantee should have a positive effect in terms of credit costs. This implies that the percentage fee should have a positive size, bounded from above by the interest rate spread that the markets (currently) demand for a government bond without guarantee relative to a benchmark bond like the 10-year Bund.
Element 5: How to deal with non-compliance
Non-compliance with the automatic tax increase law or voluntary exit from the Consolidation Pact leaves future government bond issues without Consolidation Pact guarantees. Either the country is in good health and does not need the guarantee any longer, or it is willing to default. As argued before, the monitoring could be done by either the European Commission or Consolidation Pact staff or finance ministers of the Pact members. Our preference is for a strong and independent organisation, be it the Commission or a European Consolidation Pact that turned into a kind of fiscal mirror image of the European Central Bank.
Given the outline of the European Consolidation Pact, it is clear that the case of a default has nothing to do with illiquidity, but is freely chosen after a government has done all necessary pondering of the immediate and permanent pros and cons of either servicing high levels of debt or declaring insolvency. As this decision is and remains in the hands of the sovereign country, the Consolidation Pact must respect this decision. Nonetheless, an orderly government default can be of high value to both the debtor and the creditors. The role of the Consolidation Pact should be that of a mediator between creditors and debtor, with three main tasks. It should increase the efficiency of renegotiations, improve information on both sides, and work as a commitment device, as it is much more influential on the debtor country than any particular creditor (Panizza et al. 2009).
Finally, the European Consolidation Pact works as a coordination device for the consolidation efforts of the pact members and therefore within the EU. As the pact members decide together about the path to balancing their budgets, the overall applicability and the spill-over effects can be taken into account and taken care of. For example, it might be to the benefit of all pact members to allow some of them to postpone a full-speed consolidation if the resulting relative growth effect is positive for the sum of the pact members.
On 12 May 2010 the European Commission demanded “reinforcing economic policy coordination” in the Eurozone (European Commission, 2010). It proposed important measures to improve on the existing Stability and Growth Pact. This is exactly what the German Council of Economic Experts had in mind when it published its idea of a European Consolidation Pact in November 2009. But as things have dramatically changed in the past months, there is a need for a new, broader framework for fiscal policy coordination in Europe that includes measures for stricter consolidation and its control, for mutual support, and for government insolvency. We hope that like the choppy waters of the European Monetary System crisis of 1992/93, the choppy waters of the European Economic and Monetary Union crisis of 2009/10 give rise to policies that make Europe stronger and more stable. We presume that a European Consolidation Pact may be a valuable measure in the process towards the next stage of the European development.
Bofinger, P and S Ried (2010), “A New Framework for Fiscal Policy Consolidation in Europe”, German Council of Economic Experts Discussion Paper 03/2010.
Dabán Sánchez, T, E Detragiache, G di Bella, GM Milesi-Ferretti, and S Symansky (2003), “Rules-Based Fiscal Policy in France, Germany, Italy and Spain”, IMF Occasional Paper, 225.
Panizza, U, F Sturzenegger, and J Zettelmeyer (2009), “The Economics and Law of Sovereign Debt and Default”, Journal of Economic Literature, 47(3):651-698.
Savage, JD and A Verdun (2009), “Reforming Europe’s Stability and Growth Pact: Lessons from the American Experience in Macrobudgeting”.