Opinion

Hugo Dixon

A workable euro zone fitness regime

By Hugo Dixon
February 17, 2014

The euro zone has gone from the emergency room to rehab. As often with patients, the question is how to maintain a stiff exercise regime now the immediate danger is over.

Germany has an idea. At December’s summit, it got the rest of the zone to agree in principle to what are called “partnerships for growth, jobs and competitiveness”. The idea is that governments will sign contracts committing them to do things like reform their labour markets, liberalise product markets and improve the efficiency of their public sectors. Countries such as Greece and Cyprus, which are already in bailout programmes, wouldn’t be covered.

The snag is that the leaders haven’t yet been able to agree on what sort of carrot to give countries in return for signing these contracts. They have, though, set an October deadline to reach conclusions.

One option would be to dust off an idea that was doing the rounds at the peak of the euro crisis two years ago: get countries with low interest rates to give some of the benefit they get from cheap money to those with relatively high financing costs.

Here’s how such a scheme, call it “euro-rates”, could work. At the end of each year, the euro zone would work out the average cost of all the bonds issued by participants in the scheme during that year. There would then be a transfer of cash from those who had borrowed cheaply to those who had borrowed expensively. The transfer would be designed to cut but not eliminate the divergence between different countries’ borrowing costs.

The amount of money that low-interest countries, such as Germany and France, put into the pot would depend on how cheaply they borrowed and how many bonds they issued. Conversely, the amount of cash high-interest countries, such as Italy and Spain, took out of the pot would depend on how expensively they borrowed as well as their bond issuance.

The euro-rates scheme would start by covering just bonds issued that year. But next time round, it would cover bonds issued in that year and the year before. Each year it would cumulate so that, by its seventh iteration, the cash transfer would cover seven years’ worth of bond issuance.

DOUBLE BOOST

Euro-rates would have several attractions. First, there would be an objective way of calculating how much was paid into the pot and how much was taken out – based on countries’ ability to pay. The difficulty of finding an objective mechanism was one of the factors that flummoxed leaders last December, according to somebody who attended the summit.

Second, the scheme would show solidarity between countries without making them liable for each others’ debts – a problem which has sunk ideas such as “eurobonds” under which governments would guarantee each others’ borrowings.

Third, because euro-rates would operate on a year-by-year basis with the scheme growing bigger each year, there would be a strong incentive for countries to keep up their reform drives. If they did not, donor governments could take away the payments.

Fourth, countries such as Germany probably enjoy low rates in part because they are seen as safe havens. In other words, they benefit from the travails of their neighbours. For example, the yield on Berlin’s 10-year debt is only 1.7 percent compared to Rome’s 3.7 percent. Giving back part of the benefit would be fair.

Fifth, countries in the periphery would get a double boost. Not only would they get money out of the pot each year; financial investors would be willing to lend them money at a lower rate, knowing that they had signed contracts to reform their economies and that more fortunate countries were showing them solidarity.

NOT THAT EXPENSIVE

The final advantage is that euro-rates wouldn’t be that expensive. Suppose governments agreed to halve the gap in interest rates that countries paid. That would balance the need to show mutual support with the need to maintain some market discipline on governments.

Assume, too, that the governments agreed the scheme would run for seven years. That should be enough for reform programmes to bear fruit. Imagine, also, that countries in the periphery were able to borrow money at half a percentage point less than they currently can because of the boost to market confidence.

Given these assumptions, the cost of the euro-rates scheme in its first year of operation would be just 1.2 billion euros. Even by year seven, the cost would be only 8.5 billion euros.

The biggest beneficiaries would be Italy and Spain. Their cost of funds, after taking into account the subsidy and the market moves, would fall by about 0.8 of a percentage point.

The main sugar daddy would be Germany. It would contribute about 60 percent of the cost, followed by 18 percent from France and 12 percent from the Netherlands.

Euro-rates could be seen as complementary to the European Central Bank’s promise to do “whatever it takes” to stop the euro falling apart. That pledge led to a dramatic convergence in borrowing costs paid by different euro governments. The euro-rates scheme would lead to a further convergence while encouraging countries to keep up their reforms. It could be a nice carrot for Germany’s Angela Merkel to dangle in front of Matteo Renzi when she meets Italy’s new prime minister.

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