European Economy

How to Fix the Euro Zone Without Setting Off Alarms

A proposal by prominent French and German economists is designed to defeat facile arguments against reform.

Could there actually be solidarity on euro-zone reform ahead?

Photographer: Jasper Juinen

Experts may be out of favor these days, but when it comes to reforming the euro zone, expert consensus is as important as political consensus. Most voters only understand the basic drift of such change; if experts agree on details, it can be reassuring. Luckily for political leaders, an expert consensus now exists: It's laid out in a paper signed by 14 French and German economists from all the important research institutions that shape economic policy in these two countries and from several top U.S. schools.

France and Germany have been on different sides of a political divide that's easy for voters to understand. France and the southern European nations that side with it want more latitude to spend and more help in keeping interest rates low. The German view reflects a broader northern European approach to budget discipline and a distaste for debt. French voters prefer less German dogmatism and more stimulus for development. German voters don't want to pay for southern profligacy. The best way to overcome this and give French President Emmanuel Macron and German Chancellor Angela Merkel a chance at a breakthrough is to suggest solutions that shift the focus away from political buzzwords such as "debt mutualization" or "austerity."

That's what the paper by 14 economists, whose affiliations include elite economic research institutions from Germany's Ifo Institute to the Paris School of Economics, Bruegel to the Peterson Institute of International Economics and Harvard to Berkeley, largely succeeds in doing. The economists explain early on:

We believe that the choice between more risk sharing and better incentives is a false alternative, for three reasons. First, a robust financial architecture requires instruments for both crisis prevention (good incentives) and crisis mitigation (since risks remain even with the best incentives). Second, risk‐sharing mechanisms can be designed in a way that mitigates or even removes the risk of moral hazard. Third, well‐designed risk‐sharing and stabilization instruments are in fact necessary for effective discipline.

To prove these points, the paper proposes some deft moves. The economists want EU-level curbs on banks' exposure not to sovereign debt as such but to paper issued by their countries' governments. They propose limiting holdings of any euro-zone country's debt to a third of a bank's capital. Currently, that ratio reaches 120 percent in Italy, 68 percent in Germany and 45 percent in France; few European nations are below the 33 percent threshold.

Imposing a low exposure ceiling, in the economists' view, will stop governments from using national banking systems to absorb their irresponsible borrowing. At the same time, they suggest creating a "euro area safe asset" that is explicitly not a jointly guaranteed bond. Rather, it's a security backed with a standard portfolio of sovereign bonds. It would be issued in tranches of different seniority (more senior ones offer a stronger redemption guarantee).

Risk mutualization? Moral hazard? No and no! Will German or Dutch taxpayers have to pay Italian or Portuguese debts? Under this scheme, not in any obvious way that could be sensationalized for stubborn German or Dutch voters. At the same time, banks would get a flexible instrument for diversifying government bond investments, and the less stable economies would be able to keep down the cost of borrowing.

Another proposal that makes risk-sharing more palatable is a rainy-day reinsurance fund to which euro-area countries would contribute 0.1 percent of their combined economic output or, based on recent numbers, up to 11 billion euros ($13.5 billion) a year if the entire euro area participates. That wouldn't be a given: Only countries with sound fiscal policies would be members. The fund would make one-time transfers to countries that demonstrably try and fail to overcome a serious crisis on their own. The seriousness of the crisis would be gauged by the unemployment rate. The more volatile a country's unemployment rate -- that is, the more crisis-prone a country is -- the more it would contribute to the fund relative to the size of its economy. And the payouts would cease if the unemployment level doesn't drop.

This could be seen as a German plot to penalize the weaker countries and impose austerity on them through fiscal rules like the European Union's (loosely enforced) requirement that countries keep their deficit level below 3 percent of gross domestic product. But the 14 economists propose to scrap that EU tenet as badly designed. They condemn it from an anti-austerity point of view, saying it constrained stabilization policy during the recent euro-area crisis and put too much pressure on the European Central Bank when it came to providing stimulus.

They want to replace the deficit target with a fiscal rule that makes sure government expenditures aren't growing faster than the sum of economic output and inflation -- and that they're growing slower in countries that need to bring down debt, say, to 60 percent of GDP. That rule, however, shouldn't be carved in stone -- there should be exceptions for countries that "undertake solvency-improving entitlement reforms, or major reforms expected to raise potential growth." 

In general, euro-zone government spending has been growing slower than output in recent years, so that kind of targeting would be in line with the trend, and it shouldn't be a hindrance in a crisis because of the exceptions.

As an enforcement mechanism, the economists suggest that countries finance any excess spending by issuing junior bonds -- the first to be subject to a bail-in if a crisis hits -- that won't have the legal advantages of today's sovereign debt. Interest rates on such debt will likely be high, discouraging countries from issuing it.

The proposals are untested on a political level, and the paper includes some proposals, including a common euro-zone deposit insurance system, that are unlikely to fly with German voters no matter how one wraps them in comfortable language and conditionality. But the fiscal rule and safe asset proposals are packaged well enough to avoid ringing alarm bells. Implementing them would do the euro area's economic stability more good than resolving the endlessly discussed matters of a common budget and finance minister. The French and German governments should pay attention to them: If they do nothing else for euro-zone reform in the current election cycle, these moves will be enough to register a major success -- even if most voters won't quite get their heads around the details.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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    Leonid Bershidsky at

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