When the corona pandemic hit the euro zone in early 2020, many politicians and voters were appalled to find that they lacked fiscal or monetary policy leverage to counter the devastating economic slump. Many member countries felt as helpless as they did during the euro zone crisis in 2010.
When they joined the euro, the member states willingly handed over sovereignty over monetary and exchange rate policies to the European Central Bank (ECB). At the same time, however, they have also lost sovereignty over fiscal policy.
The reason for this is not the restrictions imposed by the growth and stability pact and the fiscal pact that was added later. Rather, the reason is the ease with which capital can flow between the 19 different government bond markets in the euro zone. Because everyone has the same currency.
Traditionally, government bonds have been the safest fixed income investment in local currency in any country. If, in a non-euro country, the private sector is a large net saver even with zero interest rates, pension funds and other institutional investors receiving this excess savings will have to buy that country’s government bonds.
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Because these are the only high-quality fixed income assets in local currency, and these investors cannot take significant exchange rate risk or invest all their money in stocks.
The resulting run on domestic government bonds allows the government to use the country’s savings to fight recessions without interest rates rocketing.
Capital flight at the heart of the euro zone’s problems
Investors in the euro zone, on the other hand, can choose from 19 different government bond markets, all of which are denominated in euros. This means that there is no guarantee that Spanish household and corporate savings will be invested in Spanish government bonds or that Portuguese savings will be used to purchase Portuguese government bonds.
Any government that deviates from the norm set by the country with the best fiscal position—that is, Germany—is punished by capital outflows and higher interest rates.
This became very clear during the euro zone crisis of 2010: investors sold the government bonds of many peripheral countries, even though all of these countries, with the exception of Greece, generated more than enough domestic private sector savings to fund their budget deficits.
Selling off in bond markets forced peripheral governments to cut borrowing even further, worsening their recessions and banking problems in a vicious cycle.
A simple option to allow governments to compensate for a demand shortfall would be to allow them to borrow more than 3 percent of gross domestic product (GDP) if their private sector saves more than 3 percent of GDP.
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But that would not be enough to fix the Pact’s flaw, as fiscally weaker member states would continue to face relentless outflows of capital. Rather, fiscal unbundling is required for monetary union to function.
A real solution to the capital outflow problem would be to replace the budget deficit ceiling with a rule that a currency union country’s bonds could only be held by that country’s citizens. Portuguese government bonds could then only be held by Portuguese citizens.
If a member state goes bankrupt, only its own citizens would be affected
Such a proposal might sound outrageous at first glance, but it would not only restore full fiscal space to member governments, but also help normalize the ECB’s monetary policy.
The problem of capital flight between government bond markets, unique to the euro zone, would be eliminated. Institutional investors, who need to buy high-quality fixed income, would go back to buying their own government bonds instead of transferring private savings abroad.
This allows governments to use their own private sector savings to fight recessions.
This system would make financing budget deficits a purely internal matter for each country: if a Member State goes bankrupt, only its own citizens are affected.
This eliminates the justification for Brussels to interfere in the financial policies of the member states. This strengthens the democratic institutions of the member countries because the voters no longer feel helpless: the governments responsible to them can react to recessions and health crises with their own financial policies.
Under this system, residents of the euro zone would lose the right to buy government bonds from other member countries. In turn, member governments would lose the right to sell their bonds to foreigners.
That would be a small price to pay for restoring fiscal sovereignty.
The internalization of fiscal policy would impose discipline on individual governments, as they would no longer be able to blame their problems on international investors or supranational institutions such as the EU and the International Monetary Fund.
Foreign government bonds have never been the most efficient way to use capital
A government that cannot even convince its own people to hold its bonds has no reason to expect foreigners to buy those bonds.
That should be welcome news for Germans and others who worry they may be forced to shoulder the debt of governments that have opted for wasteful fiscal policies.
The efficiencies from the free movement of capital within the euro area would remain with the private sector as the proposed capital controls would only apply to government bonds. Foreign government bonds have never proven to be the most efficient way to use capital.
By allowing member governments to use fiscal measures to fight recessions, this proposal would also free the ECB from the need for many unconventional monetary policy measures.
This is because quantitative easing and negative interest rates were introduced to help countries that were unable to support their economies with fiscal measures.
It was hardly to be expected that these measures would take effect as long as potential borrowers held back because of high debt. This ineffectiveness was demonstrated by the fact that the ECB has missed its inflation target for a full 12 years since 2008.
Regaining member countries’ fiscal sovereignty and normalizing the ECB’s monetary policy would be more than worth the price of giving up the right to hold foreign government bonds.
About the author: Richard Koo is a consultant at the Center for Strategic and International Studies and chief economist at the Nomura Research Institute in Tokyo.
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