• A fiscal union in the Eurozone (EZ) – whether in the form of additional financing or debt mutualization – is not only politically unrealistic but also counter-productive in dealing with the issues at hand. Transfers or grants would work, but would need to be open-ended to be credible, which is both unacceptable and unaffordable.
• Calls for ‘growth-promoting’ policies reflect the ideals of 40+ years of Keynesian folly. To a large extent, these tried and failed policies are the source of today’s debt mountain in many countries. Even if successful, such policies can only have a marginal near-term impact on debt dynamics.
• The only viable and politically acceptable solution is a Sovereign Debt Reduction Mechanism (SDRM) for the eurozone. This has the advantage of offering both stock-and flow adjustments, while not calling for an open-ended commitment like a fiscal union. The flipside is that it requires significant support for the financial sector in order to prevent a systemic collapse.

As the Eurozone crisis continues to rattle on in never-ending stops and starts, a broad consensus that it’s either going to be a fiscal union or a break-up has begun to set in. A third option of ‘muddling through’ through a mixture of delay, half-hearted financial support and austerity is seen as increasingly unsustainable as it simply allows unresolved problems to fester and mount. Markets for their part, seem to regard the eventuality of a fiscal union as an increasingly likely outcome as the recent combination of relative stability of the euro and rising German long-end yields illustrates.

Fiscal Union: What Exactly Are We Talking About?

Yet, even as the debate advances at the policy level, it is becoming increasingly muddled with the proliferation of multiple proposals. Indeed, the concept of fiscal union comes in many shapes, from the roundabout implicit to the outright explicit. In ascending order of integration:

• A fiscal union by stealth already exists in the form of the ECB’s selective government debt purchases through the Securities Markets Program. If the ECB were ever to suffer capital losses on these holdings (or indeed those part of its liquidity operations), it would most likely seek a capital increase from its shareholders according to its capital key.
• The same is true for selective bond purchases via the EFSF/ESM on the market, either in direct form or in indirect form if it were to operate under a bank license and open-ended ECB financing. Losses on holdings would require additional capital transfers.
• Similarly, the rescheduling of official loans at a reduced interest rate to Greece represents an implicit subsidy and thus a form of transfer. This forms the next-stronger variant of a ‘fiscal union’.
• Further up the integration-ladder is the mutualization of debt, which itself has varying degrees: (1) a one-off collective assumption of the stock of outstanding debt, (2) the introduction of ‘Eurobonds’ for part of future issuance (e.g. proposals for ‘red’ and ‘blue’ bonds) and (3) the introduction of such bonds for the entire financing needs of all member states.
• Purists might insist that this goes not far enough though: after all, loans are discretionary and guarantees contingent and so do not reflect strong enough a commitment to stand by an ailing member. Only a central fiscal authority that distributes resources in the form of unrequited transfers could be seen as a sufficiently deep fiscal union and thus remedy one of the EZ’s original design flaws.
• The most ardent supporters of fiscal centralization will go yet further and argue that it is not enough that member states transfer resources from their Treasuries, but the central authority itself must be allowed to collect revenues. In other words, not only ought the EZ’s liabilities to be shared but its revenues and assets as well.

Fiscal Union Not Necessary… and Even Counter-Productive

But whatever the proposed shape of a fiscal union, it is mistaken to think that monetary union cannot function without it. A fiscal union is neither a necessary, nor a sufficient condition to make a monetary union work effectively (although it can do so). In principle, a monetary union can function perfectly well with constituents of differential credit quality. The creditworthiness problem is an issue that can be treated and priced separately in the market. The lack of sovereign backing for individual states, municipalities and cities in the US clearly illustrates this. Similarly, the Eurozone would be better served if it implemented its “no bail-out” clause more strictly. Indeed, the idea of a fiscal union combines several disadvantages:

1. Political constraint: The creation of a fiscal union is politically completely unrealistic at this juncture, witness only the debate in Germany over its Deutschland Bonds or the fierce resistance to the abdication of sovereignty even the Troika programs already in operation imply for debtor countries;
2. Capacity constraint: To credibly stand behind the public – let alone the financial sector – liabilities of the periphery is beyond the financial means of the creditor countries;
3. Incentive constraint: The open-ended provision of funds a fiscal union implies – whether in loan or in grant form – promotes moral hazard by letting large deficit/debtor countries ‘off the hook’ even if the assistance carries stringent conditions;
4. Implementation constraint: A fiscal union is impossible to implement: what credibility could the threat of EZ sanctions have, ever since France and Germany flaunted the provisions of the Stability and Growth Pact?
5. Solvency constraint: If a ‘transfer union’ is unaffordable and/or unacceptable, any arrangement can only take the form of a ‘financing union’: yet, further loans will not solve the excessive debt problem (only in net present value terms, if that) but rather add to it;
6. Cost/benefit constraint: In the current situation, a fiscal union would distribute the costs and benefits it bestows asymmetrically across the EZ. The immediate financial costs would be disproportionately large for the creditor countries, whereas the benefits would primarily be enjoyed by the debtor countries.
7. Complexity constraint: Even if all the above could be overcome, the mere existence of such a fiscal union could not address the competitiveness, balance of payments and banking capitalization issues within the EZ.

Indeed, those viewing a fiscal union as the solution to the EZ’s problems must implicitly regard the issue as one of liquidity or as a temporary market disturbance rather than the deep-seated, fundamental solvency problem several peripheral countries are in fact facing. Where debt levels are already excessive, additional debt – even if provided at more favorable levels – cannot restore solvency. Yet, promises of further financing can never be fully credible given their ultimately limited amplitude. They are merely instruments aimed at short term market pacification.

In her reluctance to countenance moves towards deeper integration before fiscal adjustment has worked it’s way, Chancellor Merkel is thus right: A fiscal union can only make sense if the set of countries under its umbrella are sufficiently homogenous. If differences are too large or too persistent, a system of nationally-elected governments cannot allow sustained ‘free-riding’.

The Fallacy of ‘Growth-Promoting’ Policies: There Are No ‘Debt-Reducing Fiscal Expansions’

Critics of the EZ’s austerity programs are no doubt correct in their skepticism regarding so-called ‘expansionary fiscal contractions’ (an idea the IMF firmly put to rest with its recent review of 173 adjustment cases). But while valid, this point is misplaced: it simply ignores the fact that growth is not the eurozone’s primary objective at this stage. As the EZ struggles for its survival, its priority is to reduce internal imbalances, and in particular restore private capital flows. This in turn requires a reduction of the amount of liabilities outstanding, both public and private.

Proponents of ‘growth promoting’ policies are seemingly oblivious to the fact that this is the path  governments in many industrialised nations and emerging markets have pursued for the last 40+ years. And it is these very policies which are the reason for the build-up of today’s vast stock of public debt in many cases. In almost no case has the bet that fiscal spending would spur growth to such an extent that the associated increase in revenue outpaces the additional outlays – thus leading to narrower fiscal deficits and a reduction of debt – worked out.

But even assuming that growth could suddenly be boosted by, say, 1% point across the EZ (with perhaps a multiplier effect of 1.5 on the fiscal balance) the impact on countries with debt-to-GDP ratios well over 100% and primary deficits of 4-6% of GDP would be minimal and have a material effect only through the power of compounding over many years. Indeed, such a strategy would only aggravate the problem in the near term as a delay in fiscal adjustment or, worse, a widening of the deficit would further increase the public debt, all else equal. In other words, there is no such thing as ‘debt-reducing fiscal expansions’ either.

Towards a Realistic Solution

If fiscal union is not only unlikely but also undesirable, what is to be done? A key (though not sole) element of the crisis is the overhang of public debt which has become unsustainable. This could have happened for any of the following reasons:

–        Growth is too low (to stabilize public debt at a given level);

–        Interest rates are too high (perhaps because of a contagion effect);

–        Policy is paralysed (inhibiting fiscal adjustment);

–        Large private sector liabilities are regarded as merely contingent public sector debt by markets.

In these cases, additional loans won’t help. Transfers or grants would, but would need to be open-ended to be credible, which is both unacceptable and unaffordable. As a result, the only way out of the impasse is a stock adjustment, in the form of a reduction of the outstanding amount of public debt. Critically, this has to involve both official and private sector debt holders.

It is true that the official sector has already participated in debt reductions such as the repeated reschedulings and softening of terms for Greece. But these arrangements only affected the net present value of debt and have not reduced the nominal amount outstanding. What is worse, the ECB’s purchases of market debt (through the SMP) have complicated the issue as it behaved as a hold-out investor in the restructuring. This implied that the required haircut on privately held debt had to be all the larger to achieve a given targeted overall debt reduction, and stood in the way of a more meaningful write-down.

They key ingredient that can lead the way out of the current debacle is thus the establishment of an EZ Sovereign Debt Reduction Mechanism (SDRM). This would allow overindebted economies to restore their creditworthiness and regain access to capital markets at affordable interest rates. At the same time, a meaningful stock reduction would also have a benign impact on both the fiscal and the external accounts as the interest service burden would ease considerably.

A further advantage of this approach is that it solves today’s debt problem without requiring treaty changes, politically impalpable moves toward greater integration or drawing creditor nations into open-ended commitments for ongoing funding as a true fiscal union would. It would be a one-off event that deals with the excesses of the past and allows countries to have a fresh start. After this, they will be on their own again and markets will price the now-revealed probability of default more accurately than in the run-up to the crisis (no more ‘convergence trades’).

Naturally, this approach comes at a cost. It comes in the form of a hit to the sovereign’s creditors, primarily banks and insurers. This will have to be dealt with and is the reason why the proposed ‘banking union’ (comprising a trinity of a common supervisor, deposit insurance and capital fund) represents a necessary condition to ensure the survival of the Eurozone.

This approach will of course not cure all the EZ’s ills. But the revenues freed by debt forgiveness could be redeployed to finance the cost of structural reforms, notably efforts to improve competitiveness and reduce external imbalances. It also offers the fastest way to restore growth in the Eurozone.