Digest of Our Key Views on the Reform of The Eurozone – November 2018

This post was written in November 2018 in a pre-COVID situation characterized by a German economy near full-employement and Italy struggling to reduce its debt. Our analysis of the shortcomings of the Stability and Growth Pact has not changed, but we have updated here – unfortunately in French – our proposals.  

Macroeconomic policies have failed in the Eurozone since the creation of the common currency. Nothing prevented the building of huge imbalances in some countries (loss of competitiveness, massive current account deficits and/or real estate bubbles) and, in the aftermath of the 2007-2009 financial crisis, we watched helplessly the marked divergence in economic performance (in terms of economic growth, unemployment and public deficits).

A pessimistic viewpoint might be that the continent is in fact not ready for a common monetary policy. Critics of the Maastricht treaty may have been proved right. Far too often, there is no “one-size-fits-all” level of interest rates: for some countries, monetary policy is too loose and, as a result, imbalances are gradually widening (inflation and its various painful consequences) and for others monetary policy is too tight and these countries are condemned to years of low growth and high unemployment (and sometimes political crisis). The loss at national level of a key instrument of economic policy is at the heart of the difficulties of the Eurozone. Thus, one could expect this issue to be at the very center of the discussions on the future of the Eurozone: with the benefits of now almost 20 years of experience, what does it really mean to be unable to use interest rates at the national level to stabilize the economy? Is it possible to compensate for this loss by smartly using other policy instruments, including fiscal policy? We think so, and we will highlight in particular a key idea that unfortunately does not appear on the radar screen of policy makers: economic policy could be made much more efficient in the Eurozone if member countries decided to significanlty lengthen the maturity of their public debts in order to make their economies more resilient to shocks.      

Curiously, the fundamental issues related to macroeconomic policies are not the main topics of the ongoing discussions. The key problem seems to be “risk-sharing”: that is, when things go very badly, with banks or even states becoming insolvent, who should bear the costs? Is it possible to share them among members of the Eurozone, thanks to more fiscal transfers or a common insurance of bank deposits? And rightly so, Northern countries object that “risk-sharing” is not only difficult to swallow by their taxpayers, but can also increase the risk of disasters as it will reduce incentives in all countries for the proper management of the economy. All these “risk-sharing” discussions are indeed a little distracting when the priority should be to prevent future catastrophic losses, rather than trying desperately to share them. However, the German position has also its weaknesses as it is very narrowly focused on the idea of fiscal discipline and structural reforms to avoid catastrophic outcomes. Yet fiscal discipline and structural reforms are not in themselves answers to the loss of national monetary policies and, if applied too strictly, tend for a while to worsen divergences between countries (much more on that later). Ineffective economic policies undermine citizens’ confidence in the euro project and no “risk-sharing” mechanisms can save a country governed by populists who want to leave the union! Thus, the current discussions largely ignore the key issue and may lead to the types of poor compromises we have seen in the past (based on a lot of Northern fiscal rigidity backing a small bit of badly thought Latin risk sharing…).

As a starting point, let us dig a little more into the weaknesses of the German position which nevertheless has the advantage of getting right the priorities, i.e. the need to limit the risks before trying to share them. Yet, Germany seems to underestimate the political and economic challenges to limit risks and make the Eurozone work better. Perhaps unsurprisingly, the German position does not recognize the importance of a proactive monetary policy and is based on the dubious assumption that well-managed economies (with flexible labour markets, sound fiscal policies, etc.) are automatically able to withstand the various shocks in a satisfactory manner and return to equilibrium. But one of the main painful discoveries of the last twenty years is that when the common monetary policy is not adapted to the specific situation of a diverging country, there are few mechanisms left to ensure a smooth convergence process in the future. And this is not only a question of time and (German) patience: at the end of the road, new divergences, not convergence, seem to result from an initial phase of divergence. The case of Germany is a good example: Germany enjoyed a boom in the early 1990s in the aftermath of the East-West reunification and was at the time the high growth, low unemployment, relatively high inflation country of the European Union. The country lost its competitiveness and was then for ten years of painful adjustment the sick man of Europe (with low growth and a relatively high unemployment rate). Why has the adjustment been so painful, as Greece, Italy or Spain by now have also discovered? The answer is that without the help of monetary policy, the adjustment process tends for many years to artificially increase the initial divergence: countries with high unemployment struggle. Wages are slowing due to the high unemployment rate and the need to restore the country’s competitiveness without the help of a lower exchange rate. As a result consumption is weak and investments are picking up modestly as companies face weak domestic despite soaring corporate profits. Lower inflation than in other countries also means higher real interest rates that weigh on the large real estate sector. Last but not least, lower growth may lead to higher taxes or lower public spending in order to control fiscal deficits despite disappointing tax revenues. Despite the rise in exports, all these mechanisms played against Germany from the mid-1990s until the years 2006-2007. They played against Greece, Spain or Italy, and sometimes France as well, over the last ten years. Yet, at the end of this multi-year painful adjustment process, what we got, and probably will get again in the future, was NOT convergence. We got a very competitive Germany and a new group of “sick men” of Europe. And the story is not over: with an extremely low unemployment rate, Germany is now raising the wages of its workers and reducing taxes, while most other countries continue to fight against a high unemployment rate and small wage increases. Are we sure that this process is under control and will come to an end with the dreamed convergence, rather than Germany becoming again in a few years the new sick man of Europe, confronted with the ultra-competitiveness of Spain, Portugal and France (and maybe some others)?

No, we are not sure given the experience of the last twenty years. Indeed it is easy to understand why the convergence of unemployment rates does not happen miraculously and why, with the loss of national monetary policies, the “sick man” badge tends to rotate between European countries. This is mainly due to the complex dynamics of competitiveness and the role played by the “natural rate of unemployment” or NAIRU. As long as the unemployment rate is higher than the NAIRU, i.e. during the so-called adjustment phase, inflation in the so-called “converging” country is likely to decline year after year. Why is inflation not only weak, but likely to continue falling until the very last moment of the convergence process? The reason is that as long as the labour market is highly unbalanced, real wages are likely to increase less than productivity. And as a result there is a continuous downward spiral in prices and wages. Thus when the adjusting country finally reaches full employment, it has not converged smoothly according to most other metrics: it still has a lower inflation rate than other countries and the gap can be quite large (remember again that the inflation rate is supposed to decline as long as the unemployment rate is higher than the NAIRU). This is why initial divergences tends to be followed by a new sort of divergences: the former sick man of Europe will continue to benefit from many years of rising competitiveness and improved markets shares, while households consumption is picking up again since real wages at last move in line with productivity. All the engines of growth are now playing favorably, and the former sick man does not smoothly catch up with other countries, it tends to overtake them at high speed! This is schematically the history of Germany after 2007.

In a nutshell, this is the key problem of the Eurozone that is not recognized by Germany: with a common monetary policy, even with a flexible labour market, inflation differentials do NOT effectively reduce divergences between countries. They tend to exacerbate divergences in a first stage (in particular booming high inflation countries have lower real interest rates and a high degree of consumer confidence!) and they tend to lead to overreaction and new divergences in the medium term. Obviously, adjustment in relative prices is often a necessary part of the convergence process. But, it cannot be the only instrument: it needs help to work efficiently.

Thus, in the forthcoming discussions about the reform of the Eurozone, the question of “monetary policy divergences” should have priority over that of “risk sharing”. We must stress once again that when the common monetary policy does not meet the needs of a specific country, problems (economic AND political) will emerge sooner or later. When it is too tight, the problems quickly become obvious (rising unemployment, banking sector weakened by credit losses, rise of the euro-sceptic populist parties and frightening possibility of hung parliaments…). When it is too loose, the short-term euphoria may be paid much later at a very high price: inflation is a poison that kills effectively in a monetary zone, but rather slowly (see Ireland or Spain before the 2008-2009 crisis). We must therefore address this issue of “monetary policy divergences”. How can we identify them early enough? How do we reduce them?

Of course, we do not intend to give a complete answer to these two difficult questions, but only to provide some elements which, in our opinion, must be taken into account.

First, important “monetary policy divergences” are not too difficult to detect. Sure enough, there is always a lively debate going on at the margin about the appropriate level of interest rates in a specific country. And the “minutes” published by many central banks testify discussions between “hawks” and “doves”. However, disagreements are often about 25 or 50 basis points on official refinancing rates. The appropriate broad stance of monetary policy is generally not too difficult to assess. For example, there are little doubt that the ECB’s policy is currently too loose for Germany which is at full employment and too restrictive for countries like Greece and Italy. It would be very useful to have a systemic evaluation of this sort of monetary policy divergences (from the European Commission, the ECB, the national central banks, think tanks working on public grants?). Some policy makers would probably be reluctant to institutionalize such an explicit monitoring process, fearing to provoke some rather undesirable hostility towards Europe in countries that do not seem well served by the common monetary policy. Yet there is no point trying to hide the truth. Italian voters did not need an official report to believe that the policy mix was not optimal and that Italy probably could not afford a very restrictive fiscal policy in the short term. Recognizing the monetary policy divergences and opening a wide debate about them are necessary steps to find efficient solutions.

Second, in principle, fiscal policies can help facilitate the convergence process. As we have already pointed out, initially, inflation differentials do not lead to convergence, but unfortunately aggravate existing divergences (the low unemployment country benefits from a more dynamic internal demand for quite a while, until the loss of competitiveness eventually takes its huge toll). It is only in a second phase that inflation differentials produce the expected strong impact. Indeed, at one time or another, the impact becomes so strong that countries do not converge and that the “sick man” badge turns between countries. Thus, in principle, fiscal policies could help mitigate this chaotic process. Countries with high inflation need a restrictive fiscal policy to slow down the economy and avoid the euphoria phase. This restrictive policy will later offer some leeway to support the economy when competiveness losses will actually start to beat. Symmetrically, the country with high unemployment and low inflation can support economic activity during the first phase of adjustment and later adopt a more restrictive fiscal stance when the economy becomes robust enough. thanks to accumulated competitiveness gains.

Third, with regard to national economic policies, there is no obvious conflict of interest between the diverging country and the rest of the Eurozone. Both suffer from existing monetary policy divergences. The ECB has to take into account, to a certain extent, the needs of the diverging country and the Eurozone monetary policy may therefore be biased against that required by other countries. There is therefore a common interest in limiting the monetary policy divergences and in organizing a smooth convergence process, rather than a chaotic scenario in which the “sick man” badge rotates from one country to another. However, this point of view may seem counterintuitive if we consider the current German situation. Low-unemployment Germany fears the chaotic process already described, for which the country has paid a rather high price as a result of the West-East reunification. Thus, until the mid-2018 economic slowdonw, many German politicians prefered to build fiscal surplus rather than cut taxes or boost spending. In some respects, this is in line with what has been explained: the rise in wages and inflation in Germany may pose a risk to the future competitiveness of the country and it makes sense, from the German point of view, to be very cautious on the fiscal front as long as the economy is strong. But, most other Eurozone countries seem to see the situation differently and would like Germany to boost its economy by all the available instruments even when it is already strong. In our view, these countries, including France, have sometimes a rather partial view of their own interest, which does not take into account the feedback loop created by the common monetary policy. The diverging German situation is already causing headaches, both economically and politically, for the ECB. An overheating of the German economy would accelerate the future tightening of the ECB’s policy (rising interest rates after the end of Quantitative Easing). Thus, other European countries should better balance the apparent short-term benefits of a fiscal stimulus in Germany with the many disadvantages of a more restricitve monetary policy, especially for indebted countries1. Yet, in this discussion, we must admit that the European economy is still not in a normal situation: the ECB relies on unconventional monetary tools (negative interest rates, Quantitative Easing) which may present certain risks. Moreover, the European economy has suffered a significant slowdown in the course of 2018 (Brexit fears, trade wars…). It is therefore (perhaps…) not totally unreasonable today to encourage Germany to boost its economy despite the potential consequences for the common monetary policy. But this exceptional situation, stigmata of the recent crisis, should not overshadow the fact that, in a normal situation, countries should prize a lot the fact that the ECB is acting in their own interest. In normal times, Eurozone countries have no interest in aggravating existing divergences. This is a very important point:  as long as countries are solvent, there is no reason to believe that fiscal policies should be in some way centralized because of the so-called “externalities” that they seem to produce. A low inflation/high unemployment country has the appropriate incentives to temporarily relax, if possible, its fiscal policy while a high inflation/low unemployment country should tighten. And, once their impacts on the common monetary policy are taken into account, there are no negative externalities: these reactions are in the best interests of the other countries which belong to the monetary union. This does not mean that there is no need for some kind of collective surveillance. Of course, economic policies may suffer from many bias, especially in the run-up to the next general elections… The real interest of a country may not be fully recognized by its government (see the recent example of the unfunded US tax cuts…). Thus, in addition to the key mechanisms needed to ensure that medium term solvency is 100% protected (more on that shortly), extensive joint discussions on economic policies, and some kind of peer pressure are needed. Howeve, a balance needs to be struck: there is absolutely no reason to believe that countries should completely lose control of their fiscal policies in order to participate in a monetary union. As long as fiscal policies are sustainable, elected governments should have some degrees of liberty to tackle situations in which the common monetary policy does not fit well the country’s interests. This is both economically useful and politically necessary to stop the irresistible rise of eurosceptic parties.

Fourth, the key problem of “sustainability” that we have mentioned several times needs to be addressed more effectively. Obviously, a failing country creates huge negative externalities for other countries. If they agree to bail out the country that loses access to capital markets, they bear a mix of potential economic and political costs. If they decide to let the country fail, there is a risk of contagion and even an existential risk for the Eurozone.

Despite its importance, this issue has been treated with a kind of empirical and pragmatic approach which has clearly failed. In the Maastricht treaty, certain ad hoc criteria for fiscal sustainability were introduced without any theoretical or empirical basis (the 3% limit for the deficit and the 60% ceiling for the public debt). At that time, they seemed tough enough and indeed the first time they became really constraining (2005), the Eurozone decided to weaken the Growth and Stability Pact and to be quite flexible in how to enforce these theoretical limits. Everything has changed as a result of the 2007-2009 financial crisis and the realization that the sustainability of public debt in many countries was surprisingly a real problem.

The Eurozone crisis after 2010 had three fundamental causes that had not been correctly anticipated:

  • One country, Greece, was cheating! And when the true state of its public finances became evident, it was too late to implement the necessary corrective actions. Debt relief has become unavoidable.
  • Even forgetting for a moment the very specific case of Greece, the divergences between countries following the financial crisis have become much larger than everyone expected. The shortcomings of the supposedly “one-size-fits-all” monetary policy became apparent. This should not have been surprising, but some countries (Spain, Ireland, Portugal…) paid a heavy price for the previous monetary policy divergences (i.e. interest rates too low for these countries between 2000 and 2007, which led to real estate bubbles and losses of competitiveness). In these countries, unemployment rates skyrocketed and the public deficits, starting from a low base, exploded.
  • Last but not least, it should not have been a surprise either, but these struggling countries faced a kind of powerful vicious circle (or what economists call “multiple equilibrium situation”) that reminded us what had happened during the EMS currency crisis in the 1990s. Large “credit risk premia” appeared and those countries most in need of low interest rates were severely punished by a higher cost of debt. And, because of the worsening of their situation, investors were rightly asking for even higher risk premia … This vicious circle only stopped in the summer of 2012, when Mr Draghi broke it by stressing that “the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough”.

While the unforeseen vulnerability of the Eurozone became evident after 2010, Northern countries led by Germany imposed a severe tightening of the Stability and Growth Pact, a price to be paid for new risk-sharing instruments designed to help countries in difficulty. The various new regulations put in place in the years 2010-2012 (“six pack”, “two pack” and the Treaty on Stability, Coordination and Governance) have made it clear that Eurozone countries should credibly target a balanced budget throughout the business cycle. With a balanced budget, public debt is by definition stable. As nominal GDPs increase, public debts should gradually disappear as a percentage of GDP. In the very long term, we can not imagine a more radical and pragmatic way to guarantee the solvency of the countries belonging to the Eurozone!

Yet, this radical a-theoretical new approach is not without costs. It totally negates the role of fiscal policies as useful tools to help smooth the convergence process in situation of monetary policy divergences. Fiscal policies are supposed to be on some sort of autopilot mode: as long as the structural deficit has not been suppressed, governments are required to reduce it (by 0,5% per year). And a country with a balanced structural budget is not supposed to use its room of manoeuvre to cope with the specific shocks it may encounter: it is supposed to maintain this structural equilibrium. As a result, no progress is being made to better address monetary policy divergences and avoid the chaotic convergence progress that we have described. Moreover, this lack of policy flexibility at the national level and the austerity it will impose in most countries in the foreseeable future can only strengthen populist Eurosceptic political parties2.

However, according to their proponents, these new stringent solvency rules will have a positive side effect: the disappearance of public debts as a share of GDP will ensure the well-being of future generations. Interests paid on public debts will cease to crowd out more useful public spending, such as for health and education. Thus, thanks to balanced budgets, a bright future made of lower taxes or higher useful public spending is waiting for us… To evaluate the power of this key argument, it is useful to calculate precisely the gains that can be obtained in the very long term from a disappearing public debt. Let’s compare two countries with the same “useful” public spending (i.e. excluding interest payments) and public debts stabilized at 100% and 0% of GDP, respectively. How much more taxes will citizens of the indebted country have to pay to service their high public debt? If the interest rate on government bonds is r, they will have to pay r% of the GDP annually to the creditors. However, this is not the end of the story: if the debt is stabilized at 100% of GDP, the indebted country can issue a bit of new debt every year. If the nominal growth rate of the economy is g, it can issue g% of GDP in new debt while keeping at the same time the debt ratio at 100%. Thus, compared to the country without debt, taxes in the indebted country will not be r% of GDP higher, but only r%-g% of GDP higher. In particular, when interest rates are lower than the nominal growth rate of the economy, citizens in the indebted country will pay eternally less tax than the citizens in the country without debt! Indeed, this is well known in the academic literature: interest rates stabilized below the nominal growth rate of the economy represents a kind of anomaly (the situation of “overaccumulation”) and provides a rather rare free lunch to governments which can increase public debts without penalizing future generations (assuming interest rates stay low! More on this later). When interest rates are lower than the nominal GDP growth rate, countries that try to balance their budget rather than simply stabilize the Debt-to-GDP ratio pay a large short term cost with no long-term benefit. Let’s take a typical Eurozone country with a potential nominal growth rate of 3,5% (1,5% in real terms plus 2% inflation). If this country wants to stabilize its public debt at 80% of its GDP, it can maintain a budget deficit at 2,8% of GDP (2,8%/80% = 3,5%). Thus, balancing the budget rather than stabilizing the Debt-to-GDP ratio needs for many years 2,8% of GDP of tax increases or spending cuts. It’s a huge amount of money! What about the long term? Imagine that interest rates remain at the current French level, that si to say 0,7%. In the very long term, the country will save 0,7%x80%=0,56% of GDP of interest payments on its public debt. Balancing the budget still costs in the very long term more than 2,2% of GDP in tax increases or spending cuts… It is only if interest rates rise above 3,5% that some very long term benefits begin to emerge from the “balanced budget” policy.

This small calculation shows that the issue of debt sustainability is extremely dependent on the level of interest rates. When interest rates are very low, it is very easy to service a high public debt. Indeed, when interest rates are lower than the nominal growth rate of the economy, citizens of indebted countries can, years after years, pay lower taxes than citizens of countries free of debt. Thus, they have no reason to repudiate their debts, and creditors have no reason to worry.

Curiously, this decisive element of debt sustainability has never been taken into account in the successive approaches of the last twenty years (the “Maastricht criteria” versus the “balanced budget” rule). And perhaps the moment has come to do a little more economic analysis and base the rule of the euro area on an in-depth understanding of what determines the solvency of various countries!

There are three aspects to consider:

  • As we have just said, the level of interest rates, or more exactly the difference between the level of interest rates and the nominal growth rate of the economy.
  • The size of the public debt. Once interest rates are above the nominal growth rate, public debt becomes costly in the long run. However, when the difference between the interest rates and the economy’s growth rate is small, the cost of debt is not very high and it seems extremely unlikely that a country may decide to bear all the short term costs of a default to save a small amount of money in the long run. For example, with interest rates at 4,5%, a country growing at an average of 3,5% per annum and stabilizing its public debt at 80% of GDP, will only have to increase taxes in the long term by 0,8% of GDP above the level prevailing in a country free of public debt (3,6% of GDP of interest paid to creditors minus 2,8% of GDP of new debts). It can be argued that such a situation would be perfectly sustainable.
  • Last but not least, the maturity of the public debt. The current public debt can be considered as perpetual: no country intends to actually repay the debt incurred in the past. The most ambitious countries, such as Germany, are aiming for a gradual reduction of the debt-to-GDP ratio and not of the debt expressed in euros. Yet, in most countries, debt is financed on average by medium-term bonds rather than by ultra-long or even perpetual bonds. For example, in France the average maturity of the existing public debt is currently slightly less than 8 years (see http://www.aft.gouv.fr/en/debt-key-figures). Consequently, before financing the current fiscal deficit, the French Treasury must, in 2018, refinance €130 billion of short-term debt and issue close to €120 billion of bonds to replace the existing debt that comes due. There are two risks with this mismatch between the true maturity of the public debt (perpetual!) and how it is financed. First, most countries are highly exposed to an increase in the general level of interest rates. It becomes vain to try to identify, as in the Maastricht treaty, the level of public debt that fully guarantees the solvency of a country. A viable debt with a low interest rate can become unbearable if interest rates rise sharply. Second, countries become vulnerable to the self-fulfilling crisis we have already described. When investors fear a default in the future, they demand a higher credit risk premium, making debt more difficult to finance. As we have seen in the Eurozone in the years 2010-2012, the negative circle may be very difficult to break. Of course, the risk of such a self-fulfilling crisis depends heavily on the maturity of the public debt: with very long maturities, the short-term cost of increasing risk premia is moderate and will not trigger a vicious circle, nor panic.

Thus, a serious economic analysis of the question of “sustainability” would probably lead to the following conclusions:

  • Countries belonging to the Eurozone should have a public debt with an extremely long maturity. The need to protect the integrity of the zone means that the risk of default must be close to zero and not be sensitive to the vagaries of interest rates and risk premia. Curiously, the UK, outside the Eurozone, has a public debt with a maturity much higher than that of most other European countries (around 15 years).
  • Once the stock of debt is financed in a stable and sustainable way, it becomes possible to introduce some economic rationality in how new public deficits are regulated at the European level. There is a close link, illustrated by some earlier calculations, between a stabilized public deficit and the ratio of public debt to GDP in the long term. If the economy grows in nominal terms by 3,5% a year, the debt is stabilized if the debt also increases by 3,5%. So, if the public deficit is x% of GDP, and the debt-to-GDP ratio is d%, we have the long-term key relationship x/d=3,5%, i.e. d=x/3,5%. We can also calculate the real long-term cost, as a percentage of GDP, of a stabilized public deficit, according to the level of interest rates r. The taxes needed to service the stabilized debt will be rd-x, i.e. x(r/3,5%-1). As noted above, a net visible cost exists only when the interest rate is higher than the long-run equilibrium growth rate. A rational constraint is to ensure that the current policy, if maintained, will not lead in the long run to a net cost of debt to tax payers that could be considered excessive. For example, we could ambitiously target a cap of only 0,5% of GDP for the net cost of debt. This constraint would be respected if x(r/3,5% – 1)<0,5%. The order of magnitude for a reasonable set of rules, a little more hawkish that the mechanical application of the preceding formula, would be the following. As long as very long-term interest rates (50 years maturity?) stay below the potential growth rate of the economy, the Maastricht treaty criteria would be applied even if the public debt is in some sense “free” in this special case: the public deficit must be kept below 3% (via the “excessive deficit” procedure). When the cost of new debts reaches the potential growth rate plus 0.5%, the ceiling of the structural deficit is lowered to 2,5% of GDP. For a cost of new debt equal to g+1.5%, the new medium-term ceiling is 1%.  And at a certain level to be identified, the balanced-budget rule is reestablished.

In the case where the public debt is made up of bonds with a very long maturity, such a set of rules would have the right dynamic properties and would fully guarantee the solvency of Eurozone countries. Once solvency is protected, countries may be given more flexibility to deal effectively with situations where a case of monetary policy divergence has been diagnosed.

Financing public debts with very long maturities would be a game changer. Why has this key question never been addressed in the “constitution” of the Eurozone? The obvious reason is the fear that the very long-term financing of public debt will lead to a much higher cost of this debt for the taxpayer. Thus, Eurozone countries have kept full control over the maturity of their debt, knowing that common fiscal rules would require them to raise taxes or reduce spending if they chose to resort to short-term debt and interest rates rose sharply in the future. Yet this freedom left to governments introduces a significant solvency risk and in a way justifies Germany’s hard position on the “balanced budget” approach. In this context, we believe that the costs (if any!) of a long-term financing of public debts deserve to be borne. Specifically, in this key discussion, three elements should be taken into account:

  • It is far from certain that extending the maturity of public debts will significantly increase their long-term costs. For sure, the current yield curve has a positive slope: long-term rates are higher than short-term rates, and issuing short-term instruments has an immediate advantage. Governments under pressure to comply with the strict European fiscal rules are very tempted to maximize this immediate advantage. Yet, short-term interest rates are exceptionally low, thanks to the unconventional European monetary policy, and will rise in the future, penalizing countries with short-term debts. In the long run, the key question is how will the risk premium required by investors to hold long-term rather than short-term bonds evolve? Since the 1930s, it is common sense to assume the existence of a positive duration risk premium.  Yet, there are many signs that the duration risk premium has become negative over the last ten or even twenty years. This key question is discussed at length here on this website. This structural change is due to three main reasons: the high level of long-term pension saving seeking safe assets, the credibility of central banks with regard to inflation (long-term bonds of the 70s had to pay a risk premium particularly high to compensate investors exposed to volatile inflation rates) and, last but not least, the recurrence of financial crisis (bonds have a negative “beta” relative to the stock markets: their prices rise when equities fall. As such, they provide some kind of insurance and can remain attractive despite a negative risk premium, a bit like gold). In such an economic environment, long-term bonds may have a negative risk premium relative to short term bills. Indeed, in a similar context (low inflation risk thanks to the gold standard, many very rich people looking for safe assets in a long-term perspective, deep and recurrent financial crisis), the yield curve was in general inverted in the late 19th and early 20th Andrew Ang (2014) dates from the mid-30s an apparent structural shift between negative and positive bonds risk premia3. We are maybe living the reversal of this old and largely forgotten movement.
  • Furthermore, if the lengthening of the maturity of the public debt has a significant cost, it will appear rather slowly. Assuming that Eurozone countries negotiate a common framework for the management of public debts, the implementation would not be immediate and the actual maturity of public debts would rise only slowly over many years, if not decades. Thus the cost would be smoothed over time and a country would have time to reduce its public debt as a percentage of GDP if it felt that the cost was becoming excessive. In some ways, the “balanced budget” approach may in some countries become a rational national choice rather than a purely European constraint.
  • In any case, the mere notion of “cost” (or “gain” if indeed the risk premium has become negative again!) can be quite misleading and needs to be relativised. The way the government finances itself can not change the national income in a closed economy! The impact is only redistributive: tax payers pay more with long-term debts if the risk premium is positive, but debt holders get more. When, in a homogeneous society, they are the same people (tax payers also holds life insurance contracts), the net impact is zero! However, in a segmented society (to caricature, with “workers” as taxpayers and “capitalists” as holders of bonds), a redistributive impact may remain. In addtion, the structure of the public debt influences the distribution of risks between social groups. This is therefore a rather complex issue that we will not discuss further4. Especially since we are actually quite convinced that duration risk premia are currently significantly negative!

Let’s conclude.

The aim of this document was obviously not to provide a complete picture of what could be a reform of the Eurozone, taking full account of the shortcomings that have emerged over the last twenty years. However, we believe that three key topics should be discussed:

  • The importance of gradually consolidating existing public debts to protect countries against the vagaries of interest rates and credit risk premia. Curiously, the current discussions do not address this key issue, but focus on the “risk-sharing” mechanisms and the consolidation of European Lenders of Last Resorts (the ECB and the European Stability Mechanism). How to make things more complicated than they are… Lenders of Last Resorts can protect countries against market instability, but they introduce insoluble questions of moral hazard and governance. The issuance of very long-term debts is probably a much better first-line defense.
  • Making the structural public deficit ceiling conditional on the level of interest rates. The original 3% Maastricht criteria is more than fine when interest rates are below the nominal growth rate of the economy. This constraint may become a little loose if interest rates in the future return to more natural levels (4%, 5% or even 6%).
  • Allowing more flexibility for countries suffering from “monetary policy divergences”. Common and credible medium-term convergence plans should be developped to avoid a chaotic convergence process where the “sick man” badge rotates between countries.

Until this point, we deliberately avoided adressing the other suggestions on the table (the well-defined proposals of Emmanuel Macron, on the one hand, and the new Italian claims, on the other hand). However, it is difficult to completely ignore the difficult situation in Italy and the huge risks it poses to the euro. Basically, the new Italian government seems to demand a return to the original Maastricht Treaty. They want to regain their fiscal autonomy as long as they respect the 3% of GDP ceiling. In a way, we argued that it was reasonable… Yet, Italy is probably the worst country that can be imagined as the standard bearer of these proposals. Italy has experienced a very low growth rate over the past decade and most economists believe that this is not only a consequence of tight fiscal policies, but also reflects some more structural weaknesses of the Italian model. Italy also has a very large public debt. Thus, with a rising cost of debt, their solvency can quickly be challenged by the markets. There is unfortunately no way to accept the Italian proposals from the outsets, especially the 2019 budget they are preparing. However, our approach could offer a solution to the current worrying tensions. In an ideal world, Italians would agree to revise their budget in exchange for recognition that the current rules should be changed and that the Eurozone should finally be seriously reformed. In other words, to give way, Italy should have the reasonable prospect of regaining additional autonomy in the not-too-distant future if it is able to increase its potential growth rate and convince markets to reduce the cost of debt.

Clearly, the main opponents of the opening of such talks would be the Northern bloc of fiscally conservative countries. It is unlikely that they will easily give up their hard won (Pyrrhic?) victories of the years 2010-2012 and the “balanced budget” approach. Yet, the pragmatic and a-theoretical compromises that governments are preparing on “risk sharing” are not sure to save the Eurozone in the long run.

Moreover, as a creditor nation, Germany could derive considerable and specific benefits from such an approach. German populists tend to criticize the ECB for the low level of interest rates, which hurts German savers. But the truth is that the ECB can not manipulate interest rates for a long time: interest rates are low because European savings are quite high and seem to exceed European investment opportunities. Indeed, European interest rates are unlikely to increase much in the long run if all European countries converge on the German model and build fiscal surplus. The strategic and cynical interest of Germany, which has a huge surplus of savings, is to find an optimal balance that allows both to raise interest rates in the future while ensuring the solvency of other Eurozone countries.

7th November 2018



  1. The situation is more complex for the US. If the prime objective is to reduce the current account deficit, less saving in Germany may help. But at the cost of higher interest rates worldwide in the long run.

  2. It is true that for the time being the European Commission is not enforcing the revised Stability Pact in a very rigourous manner. For example, currently, it does not seem to fight very hard against a loosening of Italian fiscal policy. Yet, this “political” implementation of the Stability Pact is not sustainable in the long term. Northern countries are likely to fight back at some stage. Moreover, the negotiations with the European Commission may become progressivly harder as more countries try to benefit from this political flexibility.

  3. « Permanent regime changes sometimes occur, but they are rare. Two examples of true regime changes where “these times were really different” are the changing shape of the yield curve pre- and post- 1933 and the pricing of out-of-the-money put options pre- and post-1987. Pre-1933 the yield curve was downward sloping, compared to its now (post-1933) normal upward-sloping shape» page 141, “Asset Management, A Systemic Approach to Factor Investing”.                                                                                                                                                                         
  4. Can the same redistributive result be obtained using the tax system without the associated risks regarding the government solvency, for example by taxing more capital incomes? This is a very open question. Maybe, the purely redistributive/risk-sharing impact of the government financing policy, both between various socio-economic groups and generations, has something very special and useful that cannot be replicated using other policy instruments. Or maybe not. This short discussion is obviously related to the famous Modigliani-Miller theorem which states that companies have no special interest in issuing more debt, despite a lower risk premium than on equities. A company financed by debt may generate more profits, but it is also more risky. As a result, its total market price should not depend on its financing policy. Indeed, at the margin, the emission of corporate debt should even have a negative impact, since the risk of bankruptcy increases and there are some deadweight costs linked to bankruptcy. Maybe the same can be said of countries which have the illusion that they should issue a lot of short term debts to save money for their tax payers. Yet the jury is still out… The redistributive/risk-sharing properties of various debt policies should be better analysed. We know well that all the rather smart equivalence theorems (the Modigliani-Miller theorem or the “Ricardian equivalence” theorem) are not especially robust when various market failures are introduced (for example, in our case, the difficulty to contract between the current generations and the generations not yet borne which will bear the future cost of servicing the debt…).