European Redemption Fund: Unlikely to Work

With Greece looking no more likely to break out of its austerity/depression spiral following elections and the Spanish bank bailout having failed to restore confidence in Spain, all eyes are on the EU summit on June 28/29 for a fix for the EZ crisis. German chancellor Merkel has promised that there will be no big announcements at this summit, but a number of senior EZ policymakers have told me that there is a lot of momentum behind the idea of a European Redemption Fund (ERF). Whether it is agreed by the end of the month or not, the ERF is certainly on the table and will be discussed over the next few weeks. There are a few reasons why I don’t think this ERF can work.

The ERF is a form of debt mutualisation that will last for a limited period of time—25 years according to the proposal put together by the German Council of Economic Experts. Public debt up to 60% of GDP will continue to be the responsibility of individual countries. Debt above 60% of GDP will be joint and severally guaranteed in the EZ, but there will be conditions. First, countries already in a bailout programme are not allowed to participate. Second, participating countries must introduce a debt brake into their constitutions that serve to reduce their public debt to 60% of GDP by the time the ERF is dissolved. If a country violates these conditions, it will be expelled from the ERF. Third, the ERF debt will be rolled in over the next few years. It will be guaranteed by a 20% deposit of gold and foreign exchange reserves from each country and will be serviced by receipts from special tax provisions.

Some positives
The ERF represents a few significant positives. First, it is a way to have debt mutualisation is acceptable not only to the German government, but to the German constitutional court as well. The German constitutional court would almost certainly oppose debt mutualisation in an unlimited fashion, but the ERF expires after 25 years. Second, the ERF removes immediate rollover risk in Spain and especially in Italy, where the amount of debt rolled over each month is formidable.

Still unlikely to work
Despite these positive features, the ERF is unlikely to succeed in putting an end to the EZ crisis. For starters, the ERF addresses the debt crisis in the EZ, but nothing to address the banking crisis or the balance of payments crisis. Just as importantly, it is going to be impossible for Spain and Italy to hit the conditions required to avail of the ERF. Both Spain and Italy have public debt trajectories that are completely unsustainable. Given their growth outlooks, there is little chance either country can stabilize its public debt levels over the next few years, let alone reduce them in line with the debt brake. The primary balance adjustment required to do so would be huge, requiring a hike in taxes or a cut in spending so severe that it would not only undermine growth but would be completely self-defeating.

If countries fail to hit their targets, the German Council of Economic Experts suggests they be expelled from the ERF. This means they would lose their 20% deposit to the ERF (in the form of international reserves). Being thrown out of the ERF would likely be a negative signal for the markets, and even if a country could finance itself in the markets in the short-term, borrowing costs would likely be high owing to concerns about the country’s fiscal dynamic. We can expect that any country expelled from the ERF will be forced to undergo a debt restructuring—the very thing EZ policymakers would be looking to avoid by implementing the ERF.

If a country does not get expelled from the ERF for missing its targets, then the fund will not even succeed in addressing the debt crisis in the EZ. If countries can get away with pushing back on the fiscal adjustment they are required to make, then they will—and Germany and other core countries will be forced to finance it. It will be a bit like going to dinner with a group of friends and splitting the bill: everyone always orders more and racks up a bigger tab.