Strengthening Eurozone Solidarity While Preserving Market Discipline

Key Points

• In times of market stress, interest rates for weak eurozone members rise, creating an unexpected fiscal loss, and interest rates for strong members fall, generating an unexpected fiscal gain. When market stability returns, the members’ costs of funds reverse direction and return to their structural levels.
• A Eurozone Financing Cost Stabilization Account will reallocate 50 percent of gains of members with temporary decreases in relative financing costs to offset 50 percent of losses of members with temporary increases in relative financing costs.
• This stabilization account will strengthen eurozone solidarity, preserve market discipline, and moderate shocks to member costs of funds, all without mutualization of liability.

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Introduction

In times of market stress, interest rates for weak eurozone members rise, creating an unexpected fiscal loss, and interest rates for strong members fall, generating an unexpected fiscal gain. When market stability returns, the members’ costs of funds reverse direction and return to their structural levels. Shocks to financing costs can be measured by the change in the differential of a member’s cost of funds relative to the average of the cost of funds of all members, weighted by shares in new bond issuance.

Every loss from an increase in relative financing cost for one eurozone member is matched by a gain from a decrease in relative financing cost for other members. A stabilization account that reallocates 50 percent of gains of members with temporary decreases in relative financing costs to offset 50 percent of losses of members with temporary increases in relative financing costs will achieve the following objectives:

1. Eurozone solidarity will be strengthened.
2. Shocks to government financing costs will be significantly moderated.
3. No mutualization of liability and no transfer of credit risk among eurozone members will occur.
4. Market discipline and stabilizing incentives for governments and investors will be preserved.
5. No change to eurozone treaties will be necessary.
6. The requirements of the German Constitutional Court will be fulfilled.
7. No capital will be required. The stabilization account will be self-funding, with inflows matching outflows at all times. The European Stability Mechanism (ESM) can easily manage the stabilization account.
8. All resource flows will be completely rules based, with no possibility of political influence. Governments pursuing unsustainable policies will not receive funds.
9. Any flow of resources should be temporary and should reverse automatically.
10. The impact on national budgets will be minimal.
11. The European Fiscal Compact will ensure that funds will be returned.
12. The European Central Bank (ECB) can be removed from the fiscal policy sphere.
13. Eurozone central control over national budgets will increase.

A simulation of the operation of the stabilization account over the 2010–15 eurozone crisis cycle showed that the mechanism would have functioned as planned. At the peak of the crisis in 2012, more than €2.5 billion per annum would have flowed from Northern Europe to Italy and Spain to offset one-half of the fiscal shock to their financing costs. By the end of 2015, 90 percent of the flows would have reversed direction and returned to the original contributors. The net contribution of Germany would have been €78 million per annum over the crisis cycle.

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Adam Lerrick is a visiting scholar at the American Enterprise Institute, where he focuses on international economic issues. He is known for his work on international financial crises, particularly in Greece, Cyprus, Iceland, and Argentina, where he led the negotiation team of the largest foreign creditor in the restructuring of the country’s $100 billion debt.