Authors: Peter Bofinger, Claudia M Buch, Lars P Feld, Wolfgang Franz, Christoph M Schmidt
The European Redemption Pact
There is an impasse between the measures aiming at short-term stabilisation and the provision of the structural basis for long-term prosperity. There is also a lack of any device enabling European policymakers appropriately to balance short-term solidarity and long-term solidity. These deficiencies of the current situation were already addressed by the GCEE in the fall of 2011. In its annual report to the German government published in November 2011, the GCEE suggested a bridge between short-term stabilisation and long-term governance: The European Redemption Pact, one element of which is the European Redemption Fund. In fact, the European Redemption Pact (henceforth “the Pact”) rests on three pillars:
(i) a European Redemption Fund (henceforth “the Fund”), relying on mutualising part of eurozone debt;
(ii) the Fiscal Compact, in particular a commitment to national debt brakes preferably at the constitutional level;
(iii) the installation of a crisis resolution mechanism, with provisions for the possible involvement of the private sector in future crises.
It is the Pact's aim to provide a credible device for restoring national responsibility for fiscal solidity. Its principal idea is to reduce financing cost for the Fund by accepting joint and several liability and to pass the low interest rates on to participant countries when buying their debt in the primary market, in exchange for the commitment that they will be using this advantage exclusively to facilitate the reduction of their sovereign debt overhang. Specifically, all participant countries would have to accept the obligation to individually redeem their own transferred debt; it is not to be rolled over perpetually. Given the ultimate aim of leading each participant economy back to a sustainable debt-to-
GDP ratio, this device would be specified to be temporary and limited in magnitude. Nevertheless, it would have to operate over the course of as long as about 25 years. And at its maximum, the magnitude of this unprecedented operation would be enormous – the Pact would allow member countries not yet supported by the European rescue funds to refinance via a joint refinancing scheme all of their current debt which exceeds 60 per cent relative to GDP. If the Fund were to be initiated now, slightly under €2.6 trillion would qualify.
The actual operation of the Pact will proceed in two different regimes. In a “roll-in phase” of roughly five to six years, participant countries will transfer their eligible debt to the Fund, whereby the concrete path will be determined differently from country to country according to the structure of outstanding debt. While short-term debt of up to two years would still be financed directly through the market, countries would not directly raise longer term debt on the markets but instead refinance it at the rates offered to them by the Fund. They will have to start redeeming their transferred debt immediately, using this interest advantage. (It will presumably be a disadvantage in the case of Germany, though.)
This roll-in phase will be decisive in three respects. First, these initial years will be a practical test of the commitment of all participant economies to the conditionality imposed and thus the more painful aspects of the Pact. Specifically, the roll-in years must be used, secondly, to reduce the structural deficits, and to initiate, thirdly, the structural reforms which are necessary to restore the currently lacking competitiveness. The interest advantage is destined to provide the breathing space to follow the respective consolidation and reform paths which have to be agreed upon as part of the Pact.
In the subsequent “redemption phase”, the Fund will shrink continuously due to debt redemption. Consequently, individual governments will be refinancing a declining amount of transferred debt via the Fund, while the share of their payments to the Fund which is used for redemption is continuously increasing. The remaining debt which is not transferred to the Fund needs to be financed via financial markets. That is, at the end of the roll-in phase participant economies will be confronted with the full force of market discipline, over and above the short-term debt which remains the object of market scrutiny throughout the process. Because the remaining debt henceforth has to be retained within the 60 per cent limit, at the beginning of the redemption phase effective debt brakes must take over full responsibility from the consolidation agreements which are operative during the roll-in phase. In addition, the reform plans for ascertaining competitiveness will have to extend well into the redemption phase.
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