3. An alternative strategy would have done better
3.2. Sensitivity to the convergence of sovereign rates hypothesis The euro area crisis started out as a crisis of confidence against the backdrop
of heightened uncertainty in the aftermath of the global financial crisis and the flaws of the euro area economic governance architecture. The resulting high risk premiums on government bonds provoked liquidity troubles and soon more and more countries were drawn into the vicious cycle of high national interest rates, fiscal consolidation, recession and faltering banking systems.
As the crisis strategy of euro area governments continually proved to be inad-equate, the European Central Bank repeatedly came to the rescue to ensure the financial stability of the euro area and prevent its breakup.5 Three-year refinancing operations, purchases of government securities and covered bonds as well as the announcement of possible and potentially unlimited government bond purchases below 3-year maturity (OMT) went a long way toward stabilizing bond markets.
Nonetheless euro-area financial markets are still fragmented and the monetary transmission mechanism is impaired. Although ECB rates are at historical lows, the expansionary monetary impulse fails to reach those euro-area countries most in need of it.
Given the great uncertainty still manifest in high risk premiums carried by some euro-area government bonds, a further decrease in the refinancing rate or a negative deposit rate are unlikely to sufficiently bring down the interest rates
Table 6. Gains and costs of a back-loaded strategy starting in 2011 Variation between delayed strategy and front-loaded strategy Public debt
2015 2032 2015 2032 2011-2015
5. Tober, S., Reluctant Lone Ranger – The ECB in the Euro Area Crisis. In: The Social Dimension of the Economic Crisis in Europe. Edited by Heinz Stapf-Finé. June 2013: 9 – 28.
Economic perspectives for the euro area and euro area countries in 2013, 2014 and 2015 33
demanded of governments, corporations and households in the crisis-hit countries to steer the euro economy towards a path of low unemployment and high produc-tivity growth Likewise, it proves very difficult to explain changes in long-term interest rates by public finance variables (debt and / or deficit) (see Box 2). This led us to propose a scenario of ad hoc simulation using iAGS Model to assess the impact of changes in interest rates on the path of public finances to equilibrium.
A key question is how to bring about these lower interest levels. Monetary policy could play a role and the OMT has been partly designed to this end. It would then have to be more active and explicitly target a significant reduction in government bond yield differentials. Furthermore, in February 2013, the Euro-pean parliament, national governments and the EU Commission agreed to set up an expert group to analyze the feasibility of a debt redemption fund.6 A carefully designed debt redemption fund based on joint guarantee of euro-area public debt could inspire sufficient confidence to engineer an economic turnaround in the euro area7 (see Box 3). First and foremost, it would allow for an effective transmission of monetary policy so that expansionary monetary conditions provide an effective counterweight to the depressing effects of debt deleveraging and fiscal consolidation.
Hereafter, we use the iAGS model to illustrate the impact of an alternative government bond rates scenario on the path of consolidation and growth to achieve the 60% of GDP debt target in 2032. The first scenario assumes no convergence of long-term public bond rates for Italy, Spain, Ireland, Portugal and Greece: risk premiums on bond rates would remain until 2032 at the levels observed in late 2013. In the alternative scenario, all government bond rates would converge to the German government bond rate in 2014 and would remain equal to that rate until 2032.
Table 7 reports results for the scenario in which high risk premiums remain until 2032. In that case, Spain would have to add 4.7 percent of GDP of negative fiscal impulse to achieve the debt target, and Greece and Italy more than 2 percent of GDP. This would add massive cumulated output gap losses to those already incurred by the consolidation necessary to achieve the 60% debt target: -7.7% for Spain, -5.4% for Greece and -4.4% for Italy. These results stress the necessity to rapidly close the public bond yields premiums between these coun-tries and Germany.
Indeed, any device inducing a reduction of risk premiums would relax the constraint on high-debt countries, by diminishing the cost of refinancing existing debt and thereby facilitating fiscal consolidation. Table 8 illustrates that point: the assumption is made that all government bond yields converge to the level of Germany as early as 2014. The required adjustment of the structural public balance to achieve the 60% debt target in 2032 is reduced by about 0.5% of GDP. Spain, Portugal, Greece and Ireland would then have new margins for manoeuvre to alleviate the social cost of fiscal consolidation: the needed cumu-lated fiscal impulse would be reduced by about 1 percentage point for these
6. The working group was launched in July 2013 and is to present results no later than March 2014; EU Commission (2013), President Barroso, in agreement with Vice-President Rehn, launches Expert Group on debt redemption fund and euro. MEMO/13/635, 2 July 2013.
7. It must yet be noted that this view is challenged notably by Mathieu and Sterdyniak (2013).
countries, and cumulated losses of economic activity would be mitigated by about 1% to 3%.
Table 7. Variant: High risk premium
Variation between high risk premium scenario and baseline strategy (60% target)
Average
2014-2020 2018 2032 2011-2015 2016-2032
DEU 0.0 0.0 0.0 0.0 0.0
Table 8. Variant: Redemption fund
Variation between Redemption scheme strategy and baseline strategy (60% target) Average public
2014-2020 2018 2032 2011-2015 2016-2032
DEU 0.0 0.0 0.0 0.0 0.0
Economic perspectives for the euro area and euro area countries in 2013, 2014 and 2015 35
Box 2. Literature review: the effect of fiscal variables on public bond yields
According to the literature review by Haugh et al. (2009), a first conclusion appears: variables associated to public finances have a statistically significant impact on long-term interest rates (see table 1, pp.8). That being said, this is the second conclusion from their study: the magnitude of those effects varies, depending on whether deficits or debts are tested, on the study and the coun-tries considered. For instance, the effect on the long-term interest rate of a one percentage point increase in the public deficit to GDP ratio varies from 9 basis points (panel study on 19 OECD countries by Reinhart and Sack, 2000) to 100 basis points (literature review on the US by Gale and Orzag, 2003). To give an approximate idea, let us consider the Greek public deficit example, which increased to a high of 9% of GDP at the peak of the crisis, between 2007 and 2009. The expected effect on the Greek long-term interest rate would have been between 81 and 100 basis points, which is very far from the increase of 1700 basis points sustained by this state between 2008 and 2012.
The same effect following an increase of one percentage point in the debt-to-GDP ratio would be between 1.5 basis points (panel study on 7 OECD countries by Conway and Orr, 2002) and 49 basis points (panel study on 9 countries by Ford and Laxton, 1999). Given its increase in debt in the Maastricht sense of more than 60% of GDP during the crisis, between 2007 and 2011, Greece should have incurred an increase of 90 to almost 3000 basis points in its long-term interest rates: the increase sustained by the Greek state is indeed within this range, although that range is so large that its predictive power is limited. It is difficult to believe that Greek long-term interest rates can be explained mainly by changes in its public debt, given that a large majority of studies devoted to the effect of debt on long-term interest rates or on spreads (see infra) conclude an effect within the lower range of the review produced by Haugh et al. (2009).
Haugh et al. (2009) also produce their own estimates on the determinants of the sovereign spread of 10 member states of the euro zone relative to Germany, between December 2005 and June 2009. They find a significant positive effect on spreads of the medium 5-year forecast of the public-deficit-to-debt ratio; slightly higher if the country in question has suffered excessive deficits before (higher than 3% of GDP). In a study extended to 22 developed economies, on a sample from 1980 to 2010, Poghosyan (2012) does not find, however, a significant effect of primary public deficit on spreads of rates, whereas on average, an increase of one percentage point of GDP in public debt should produce a nonetheless statistically significant increase in real long-term interest rates of only 2 basis points…This is exactly the same impact that Gruber and Kamin (2012) find on nominal long-term interest rates, from a sample of G-7 countries. According to the authors, this sensitivity is halved when all OECD countries are included in the sample. This result is very close to that obtained by Ardagna et al. (2008) on 16 OECD countries studied between 1960 and 2002: the average impact on the long-term interest rate of an increase of one percentage point in the debt-to-GDP ratio was found to be 0.6 basis points on average. Gruber and Kamin (2012) also find that structural defi-cits influence long-term interest rates: an increase of one percentage point in structural deficit to GDP would produce, in the long term, an increase of 15 (respectively, 7) basis points in long-term interest rates for the G-7 country sample (respectively, the OECD country sample). On American data, Laubach
(2009) concludes as well that public debt has little effect on long-term rates, and his results are in the lower range for effects of deficits on long-term interest rates: an increase of one point in deficit to GDP produces an increase of 20 to 29 basis points in long-term rates. Bernoth and Erdogan (2012) show that the impact of deficits on spread rates is not significant (and positive) as from 2009.
Their sample ends on the first trimester of 2010. On a sample going till September 2011, Beirne and Fratzscher (2013) show that before 2008, varia-tions in public deficit to GDP had a significant impact on spreads of rates, but not after the crisis; as from 2008, only public debt to GDP of the “PIIGS” coun-tries had a strong impact on spreads.
Box 3. The case for a debt redemption fund
A debt redemption fund was initially proposed in 2011 by Vincente Visco (Parello/Visco 2012) and the German Council of Economic Experts (2011). The novel idea behind the debt redemption fund is that a joint guarantee is extended to that part of the public debt financial markets may have doubts about, i.e. the national debt in excess of 60% of the national GDP. If well designed, confidence would return rapidly and national interest rates would decline not only for the government but for private loans as well. Notwith-standing the problem that arises with the choice of the public debt threshold (the 60% debt-to-GDP ratio has never had any economic rationale), the redemption fund is a step forward in trying to resolve the crisis in the euro area.
All euro area countries would be jointly and severally liable for the debt guar-anteed under the debt redemption fund. The responsibility for servicing the debt would, however, remain with each individual country. Member states would, of course, also be responsible for servicing the 60%-of-GDP debt not covered by the Fund and commit to keeping national debt issuance at or below this threshold. An indispensable feature of this debt redemption fund would be that the guaranteed debt is retired within the predetermined life span of the fund, e.g. within 25 years.
The debt redemption fund does not envisage a mutualization of debt. It does not involve financial transfers between euro area countries. It does not identify any culprits in causing the current crisis. The sole objective of the debt redemption fund is to restore confidence and allow the euro area as a whole to exit the crisis.
The main architectural question is which additional features are deemed necessary to accomplish this feat. Key technical features are country eligibility, funding and lending modalities of the DRF as well as the starting point and modality of debt repayment.
To reap the full potential of the DRF in stabilizing the economy, all euro area countries should be eligible and obliged to join. In contrast, excluding coun-tries currently in an adjustment program – as proposed by the German Council of Economic Experts – would imply that those countries most in need of lower nationwide interest rates would profit the least.
The DRF would not require paid-in capital but be based on guarantees, similar to the EFSF. Paid-in capital would furthermore not improve the rating of the Fund because by construction each country is jointly and severally liable. In
Economic perspectives for the euro area and euro area countries in 2013, 2014 and 2015 37
contrast, for both EFSF and ESM member states are only liable for a part of the debt (roughly amounting to their GDP share).
The refinancing costs of the DRF should be roughly equal to low ones Germany currently enjoys.8 The market for these bonds will be more liquid than the one for German bonds so that the high liquidity premium will compensate at least in part for the lower safe-haven premium which currently results from the euro crisis. The interest paid by governments should equal the interest paid by the fund plus a service fee to cover administrative costs of the fund.
The starting point of repayment and size of annual installments are further important issues. Debt repayment presupposes either that the respective country has a budget surplus corresponding to the repayment installment or that nominal GDP growth yields sufficient new funds to cover the installment while at the same time keeping the non-guaranteed national debt at 60%
of GDP.
In 2013, the debt ratios of all euro area countries but Germany increased and currently only 6 of the 17 countries are expected to see a decline in 2014.
However, assuming the DRF is established rapidly and combined with growth-fostering macroeconomic policies, the coming years should be years of rela-tively vigorous growth as confidence not only returns to bond markets and the banking system but to entrepreneurs as well. Within the first three years of the new DRF-regime, therefore, all countries, except maybe Greece, can be expected to be in a position of declining rather than increasing debt ratios.
Consequently, repayment to the debt redemption fund should commence three years after the fund is established. The DRF should, however, buy long-term bonds of the member states immediately and refinance them long-long-term with an emphasis on ten-year bonds, thus creating a very liquid market segment of safe assets in the euro area. The stressed euro countries – both private and public sectors – would then immediately benefit from lower interest payments. Bonds due within this initial period would be refinanced by the respective national government.
Notwithstanding the anticipated positive internal dynamics in the euro area, shocks from international trade or international financial markets as well as other unforeseen events cannot be excluded. The question therefore remains, how to determine the installments by which the euro countries redeem their DRF debt.
The amount that has to be paid back on average each year can be easily determined by dividing the euro amount of the debt in access of 60% of GDP by 22 years, the number of years during which the debt must be fully repaid provided the lifespan of the fund is 25 years and repayment starts in the fourth year. Such constant euro amounts would, however, imply declining install-ments in percent of (rising) GDP. The annual target should therefore be expressed in terms of GDP with a certain amount of flexibility depending on the state of the economy. If nominal GDP growth exceeds expected trend growth, for example, repayment should be swifter, if growth falls short, repay-ment should be deferred. In a world of perfect knowledge this would amount
8. This is likely to be the case even if the fund were not based on several and joint liability, each member state instead being liable for only their GDP-weighted share of total debt. For example, EFSF bonds due in early 2022 currently yield 0.5 percentage points more than comparable German government securities; the yield spread for bonds with a remaining duration of almost 11 years is 0.3 percentage points.
to determining the structural deficit or surplus each country should realize in each and every year. Given the difficulties in determining the structural deficit, governments should instead predetermine a path for government expenditure, or rather government expenditure not sensitive to the business cycle. Non-cyclical government expenditure should increase at a rate compatible with bringing government debt down to 60% of GDP with the 25 years of the Fund’s existence. Extensive fiscal surveillance is already in place that would alert member states to a divergence from the prescribed expenditure path and debt repayment schedule. Should a member state not live up to its responsibilities, funds from the structural funds and cohesion fund could be temporarily with-held and only dispensed once the country is back on track.
Many features included in the proposal of the German Council of Economic Experts (2011) mainly serve the purpose of allying fears of moral hazard, i.e. of governments benefiting from the scheme but then reneging on their repay-ment obligations. These include the proposed pledging of foreign reserves, adherence to the fiscal pact and the possibility of ending the proposed roll-in-phase if conditions of the fiscal pact are not met. Although some measures to ensure repayment compliance may have merit, the case for moral hazard seems to be vastly overstated, in part due to a flawed analysis of the causes of the current crisis. The euro area crisis was caused by flaws in its institutional archi-tecture, especially a misguided early warning system, not by excessive government spending. It was also greatly aggravated by the global financial crisis. The focus of macroeconomic surveillance has now widened to include unit labor costs, inflation and current account balances. Given the current dismal economic outlook, high unemployment and drastically high youth unemployment as well as GDP levels well below their pre-crisis levels, reigniting growth should be the utmost priority and should actually lower the risks that individual countries will pursue economic strategies that harm other member states. With macroeconomic and, specifically, fiscal surveillance in place, member states straying from repayment targets could be disciplined by freezing assigned funds from EU funds, such as the structural funds and the cohesion fund, if such disciplinary are perceived as necessary.
It is conceivable that in ten years’ time euro countries decide that a liquid euro bond market has advantages for all member states and should be main-tained. Conceivably, the DRF could then evolve to include new financing for countries whose public debt would otherwise fall below 60%. But that is neither the purpose of this proposal nor should such longer run issues be decided on in the midst of an economic crisis.