A way out for the Euro zone

Dimitri Papadimitriou | September 1, 2010

Suggestions a few months back by Germany’s chancellor that countries running consistently high deficits be expelled from the Euro zone evidently haven’t fallen on deaf ears. Even though almost everyone thinks of expulsion as a remote possibility, the notion does get factored into the thinking of bankers and investors in a way that may ultimately become a self-fulfilling prophesy. Fears of sovereign-debt debt default are not about to go away anytime soon.

But there is an alternative for dealing with public debt that may help achieve a more perfect union. The European Central Bank should create a large sum of money—say, a trillion Euros—and distribute it across the Euro zone on a per capita basis. Each country could use this emergency relief as it sees fit. Greece might purchase some of its outstanding public debt; others might spend it on fiscal stimulus.

If you think this idea will force every European household to purchase a wheelbarrow with which to transport its soon-to-be-worthless currency, consider the case of Japan. With a 227 percent sovereign debt to GDP ratio, Japan is the world’s most indebted nation. But close to half of this debt is held by the country’s central bank, and interest payments on this half are returned to the Japanese government, making it in effect interest-free. Basically, the central bank printed the money to acquire this debt. To inflation hawks, the creation of trillions of yen to finance government deficits raises the terrifying specter of runaway inflation. Yet prices in Japan over the last two decades have risen by a mere 6 percent—not annually, but for the entire period. The only problem with the yen, meanwhile, is that it’s too strong.

The ECB should do the same thing. It holds sovereign bonds, and it should refund the interest payments on this debt to the issuing countries just as the Japanese central bank has done. The Federal Reserve does the same thing when it returns all net earnings from its securities holdings to the U.S. Treasury.

Modern money economists would argue that over the longer term for the Euro zone countries it may be necessary to put in place a permanent fiscal arrangement through which the central authorities distribute funds to be used by member nations. Ideally this should be in the hands of the equivalent to a national treasury responsible to an elected body of representatives—in this case, the European Parliament. This would parallel the U.S. Treasury’s relationship with the American states. Perhaps an amount equal to 10 percent of Euro zone GDP would be distributed each year on a per capita basis to member nations. This would relieve pressure to adopt austerity and reduce the need to keep borrowing from financial markets. To be sure, the European Parliament has long engaged in transfers to its poorer nations—but its total budget has been below 1 percent of GDP, which is clearly too small to allow economies to operate near full employment even in the best of times. In a deep recession, even 10% of GDP might not be enough, in which case the EU can provide more funding.

A second option for over-indebted Euro zone states that has been put forward is to include a covenant in their debt instruments stating that in the event of default the bearer can use those securities to pay taxes. This would make it obvious to investors that these new securities are as good as cash, and would allow countries to finance deficits at low interest rates. This option may suffer from a “moral hazard” problem—it could lead governments to continue with business as usual, spending too much and generating inflation. And it does not resolve the fundamental problem with the euro—the absence of a supra-national fiscal authority that can generate an alternative to the “beggar thy neighbor” export-led growth strategy that the current arrangement promotes.


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