The great achievement of the EU has been to reduce the probability of violent nationalist conflict among some of its members to a vanishing small probability while improving the economic lot of its members. But in spite of the salesmanship surrounding the adoption of the single currency zone, much of this reduction in the propensity toward violence and economic growth took place before the adoption of the euro. It may be time to consider the notion that giving up the euro is a wiser alternative in the long run, unless someone can synthesize some kind of federal option, which hardly seems likely in the current political context.
But a Federal option is precisely what European Investment Bank economist Massimo Cingolani has in mind. Here, he is expressing his views in a personal capacity, but he does acknowledge the key structural weakness lying at the heart of the Eurozone: namely, that you have a supranational bank to conduct monetary policy, but there is no supranational equivalent on the fiscal side.
Why does that matter? Let, us consider the case of a federal country, such as Canada, for a moment. Imagine that the two largest Canadian provinces, Ontario and Quebec, were independent countries. If this were the case, their debt burdens would consist of their existing debts plus their respective shares of the federal debt (about 23% for Quebec and about 40% for Ontario). Their capacity to repay those debts would be determined by their respective tax bases – i.e. each province’s nominal GDP.
How would those debt burdens look? Answer: probably not very good. In fact, Ontario and Quebec would each be more indebted than Spain (albeit slightly less than Portugal). This reflects the significant social spending responsibilities of the Canadian provinces, which are responsible for healthcare and education – the two largest government expenditure items in Canada. Naturally, these spending commitments are funded via fiscal deficits and debt issuance.
Quebec and Ontario are also somewhat similar to Spain and Portugal in that they do not control the currency in which they issue debt (the Canadian dollar, controlled by the Bank of Canada – a central bank that is, in turn, controlled by the federal government). So, given the poor fiscal fundamentals and inability to print money, surely bonds issued by Ontario and Quebec should trade in line with bonds issued by Spain and Portugal? Wrong – yields on 10-year Ontario and Quebec bonds are significantly lower than yields on Spanish or Portuguese bonds.”
So, why are Canadian provinces getting away with high debt loads and the inability to print money? Because of fiscal federalism and the pooling of risk within the Canadian monetary union. There is an implicit understanding that the federal government will rescue any Canadian province that runs into trouble in the bond market, which provides a strong indication that the monetary union is also complemented by a robust fiscal union.
If Europe did opt for this solution, the creditworthiness of each country would be aggregated into that of the broader Eurozone. This would be credit-positive for the entire region, since the overall debt burden of the Eurozone is not much higher than that of the United Kingdom or the United States. The joint-and-several guarantee, coupled with robust fiscal rules, would make Eurobonds more or less similar to the bonds issued by the most creditworthy entities within Europe.
We are a long way from that and there are many challenges with which to deal in the short to medium term, notably unemployment, as Cingolani acknowledges in the interview. He also discusses some potential short term fixes which addresses the existential threats which could blow up the whole currency bloc, if these serious problems remain unresolved for much longer.