Eurobond, Public Deficit

The following comments on the last three posts were e-mailed by Professor Michael Ellman, Chair of the Department of Business Studies, University of Amsterdam. They deserve wider circulation and are reproduced below with his permission.

Dear Mario,

I read your paper [merging the two recent posts on the Euro crisis] & blog [the post on Schuldenbremse] and am naturally in sympathy with both. I have a few comments:

(1) at the end of your paper you seem to suggest that a default by a EU member state would mean the end of the Euro or even of the EU itself. But why should it? The default of US municipalities or states has never threatened the dollar or the USA. If Greece defaults this will raise interest rates on bonds issued by other 'suspect' EU members and hit badly banks, insurance companies and pension funds that hold Greek debt. This may require the governments of the countries where these institutions are based to recapitalise them, which will worsen their fiscal position. The rise in interest rates for the other 'suspect' countries will worsen their fiscal position and possibly cause more defaults, which might lead to a change in the membership of the EMU. (As for Greece, if it stayed in the EMU it would have to balance its budget immediately since it could neither issue debt on the capital market nor borrow from the central bank, unless - like the UK in World War II - it forced its own banks and other financial institutions to buy national debt which would undermine their solvency and reduce credit to the private sector, as happens under wartime conditions). Of course, if retail depositors were happy to put their money in institutions mainly holding public debt - like the Soviet/Russian Sberbank or the Japanese postbank - then the situation could be stabilised.

(2) motivation for creating the EMU

It is generally considered that the creation of the EMU was a political bargain between Germany and France in which France agreed to German reunification in exchange for Germany giving up its DM. The point of that, from the French perspective, was to end Germany's dominance of European interest-rate policy. However, it now seems that an important result of the EMU will be to impose German ideas about fiscal policy on the EMU - a development which you and I think harmful. It is ironical that an institutional change designed to end German dominance in European monetary policy seems to be heading in the direction of creating a German dominance of fiscal policy.

(3) debt as a "burden"

Naturally John is right that debt interest is a transfer payment. But transfer payments require taxes to pay them. To say that rising debt payments are not a burden is analogous to saying that rising pension payments are not a burden. Rising interest payments on debt are only not a burden if they are of such a magnitude that they do not have negative economic effects (growth of informal sector, emigration, reduction of economic growth). The actual effects are likely to vary from country to country depending on growth rates, employment levels, economic institutions, tax levels, fiscal situation, etc. Try explaining that taxes have no economic effects to Irish ministers under pressure to increase their corporate tax rates.

(4) balanced budgets

There is another aspect to this - the demand for public debt. If states do not continuously issue new debt, where will financial institutions invest the "risk-free" tranche of their investments? To issue too little public debt is to risk a bubble in private sector assets.

(5) EU solidarity

You are quite right to stress that some much discussed possibilities are political non-starters because of a lack of EU solidarity. Here in the Netherlands (which was a gold bloc country in the 1930s) the main aim of economic policy is to bring down the deficit by expenditure cuts (and tax increases) and to bring back the debt level to the 60% level. Support for fiscal transfers to sinners is conspicuous by its absence. Support for EU integration, both among the public and the political elite, has declined markedly in recent years, partly for this reason. Despite everything the Dutch economy is doing reasonably well, with relatively low and declining unemployment. But this is entirely a result of external factors - growth in Germany and elsewhere in the world. Small foreign-trade dependent countries have their level of economic activity largely determined externally. Fiscal orthodoxy enables them to have relatively low interest rates with favourable economic effects.

Best wishes, Michael