The eurozone has been in crisis since 2008. By the end of 2015 domestic demand was still 3 percent below its pre-crisis peak. Throughout, the European Central Bank (ECB) has acted as the eurozone’s prime crisis manager.  As capital flows reversed and inter-bank lending seized up, the ECB provided emergency liquidity to keep banking systems afloat.

However, for legal and political reasons, the ECB was restrained in supporting sovereign debt. But, given that there are close linkages between banks and sovereigns, supporting only one party in the duo proved insufficient. From 2011–2012, interest rate differentials between eurozone members soared and credit dried up, as the risk of default on national debt and currency redenomination became investors’ foremost concern. In the end, Mario Draghi’s famous promise to “do what it takes” calmed the markets – at least for now.

The ECB’s monetary policy course was rather less helpful. The ECB is legendary for its reluctance to ease interest rates in the face of downside risks, and it even prematurely hiked rates in 2011. And so it took the ECB until the summer of 2014 to finally contemplate unconventional monetary policy measures to counter deflation risks, which were by then acute. Meanwhile, the ECB has indeed adopted a negative interest rate policy, pushing short-term money market rates below zero. It has also embarked on quantitative easing, including the large-scale purchase of national sovereign debts, as part of monetary policy rather than for government financing reasons.

Falling Interest Rates Reduce Incomes

The ECB’s more aggressive monetary policies are working, to some extent. Credit and the economy are growing again – albeit sluggishly – after years of shrinkage. Overall, however, the eurozone’s recovery remains fragile and uneven, while the ECB is falling short of its primary price stability mandate by a wide margin.

Arguably, the ECB’s negative interest rate policy even risks self-defeat: as a means to weaken the euro, the ECB’s global competition is getting fiercer; as a means to boost lending, it may not help to undermine bank profitability by effectively taxing them as the negative deposit rate amounts to taxing banks. Quantitative easing has at least successfully diminished interest differentials and reduced borrowers’ interest burden, opening up some fiscal space, among other things.

However, there is a downside, as falling interest rates actually reduce incomes. In the end all may come to nothing unless someone boosts spending. Neither exports nor private spending are a promising proposition here. Government spending is the last resort. Halting the brutal austerity policies that were imposed from 2010 until 2012 was an important first step towards ending the two-year decline in domestic demand. Today it is time to take the next step: governments must step in and boost infrastructure investment spending.

The Euro Treasury Plan

Eurozone investment, both public and private, remains stuck at severely depressed levels. Public infrastructure investment has fallen victim to austerity, irresponsibly harming the economy, both in the short and the long term. The Euro Treasury Plan (ETP) is not unique in calling for a return to normalcy in this regard. The super-low interest rates, stagnation and critical public infrastructure needed for Europe’s future make this an easy appeal to justify.

But the ETP is more than a mere recovery programme. It is by combining the much warranted public investment initiative with a joint funding facility that the ETP also constitutes a small step towards a fiscal union, an opportunity to back the stateless common currency with an embryonic common fiscal authority.

The Euro Treasury would act as a vehicle to pool future eurozone public investment spending and have it funded by proper eurozone treasury securities. The Euro Treasury would allocate investment grants to member states based on their GDP shares. It would collect taxes to service the interest on the common debt, also exactly in line with member states’ GDP shares.

The Euro Treasury would function on the basis of a strict rule, the so-called golden rule of public finance, which foresees that public investment should be debt financed. The arrangement amounts to a rudimentary fiscal union that is, by design, not a transfer union. Nor would there be any mutualization of existing national debt. Instead, the debts issued by the Euro Treasury would fund the joint infrastructure spending, which would be the basis for the union’s joint future.

Public Debt Ratios Would Decline with the Euro Treasury

The ETP has many advantages that go beyond the timely short-term stimulus. With a capital budget separately funded at the centre, member-states would henceforth have to balance their current budgets. Over time, national public debt ratios would decline to low and safe levels, while the common Euro Treasury debt would build up. The latter would provide the eurozone with a common safe asset and the basis for a common term structure of risk-free interest rates – a vital ingredient in finally fulfilling the promises of the common market and common currency. Only in times of crisis would the ECB intervene in the common debt, thereby ending the challenges associated with purchasing national public debt.

The Euro Treasury is a small step entailing a joint budget of, say, 3 percent of GDP. But it would be a significant step in the right direction. Partnering the ECB with a Euro Treasury is essential for the survival of the euro and the prosperity of the eurozone.

For more information, read:

Bibow, J. (2015) The Euro’s Savior? Assessing the ECB’s Crisis Management Performance and Potential for Crisis Resolution. Levy Economics Institute of Bard College, Working Paper No. 845.

Bibow, J (2015) Making the Euro Viable: the Euro Treasury Plan. Levy Economics Institute of Bard College, Working Paper No. 842.

Cross-posted from The Broker.