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Hugo Dixon: The euro zone's last hope

A politically acceptable, legal and effective idea is interest subsidies from low-yield to high-yield euro zone countries

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The break-up of the euro would be a multi-trillion euro catastrophe. An interest subsidy costing around euro 50 billion over seven years could help save it.

The immediate problem is that Spain’s and Italy’s borrowing costs – 6.3 per cent and 5.8 per cent, respectively, for 10-year money – have reached a level where investors are losing confidence in the sustainability of the countries’ finances. A vicious spiral – involving capital flight, lack of investment, and recession – is under way.

Ideally, this week’s would come up with a solution. The snag is that most of the popular ideas for cutting these countries’ borrowing costs have been blocked by Germany, the (ECB) or both.

Take “eurobonds”, under which countries would collectively guarantee each other’s debts. They would allow weak countries to borrow more cheaply. But Germany won’t stand behind other countries’ borrowings unless they agree to a tight fiscal and political union that prevents them racking up excess debts in future. Such a loss of sovereignty France, for one, will find hard to swallow.

Or look at pleas for the ECB to buy Italian and in the market. That too would cut their borrowing costs — for a while. But when the bond-buying ends, the yields would just jump up again. Private creditors would merely use the opportunity to offload their bonds onto the public sector. The ECB has already spent euro 220 billion buying sovereign debt with no lasting impact, and is reluctant to do more.

Italy’s idea that the euro zone’s bailout funds should buy bonds in the market has the same drawbacks. What’s more, the bailout funds only have euro 500 billion left. If they use their firepower to bail out private creditors, they will not have enough to fund governments. Giving the bailout funds banking licences and allowing them to borrow from the ECB would solve that problem. Unfortunately, both Germany and the ECB are against the idea.

But what about a direct interest subsidy? Core countries – such as Germany and France – could pay into a pool an amount that depended on how much their cost of funding was below the euro zone’s average. Peripheral countries – such as Italy and Spain – would then take a sum out of the pool depending on how much their cost of funding was above the average.

The euro zone's last hopeThe idea recently surfaced in an article by Ivo Arnold, programme director of the Erasmus School of Economics in Rotterdam. It has also been touted by Pablo Diaz, economics professor at the IE Business School in Madrid. But it has not yet had much oxygen.

Under such a scheme, the final cost of funds paid by all countries could be equalised or just narrowed. The key questions are: would it work, would it be politically acceptable and is it legal?

First, look at workability. An interest subsidy would help the peripheral countries in two ways. They would benefit from cash payments from the core. But the yield they pay on their own bonds would also drop as worries about the sustainability of their finances eased.

The yields on core bonds, by contrast, would rise. Investors would be worried that Germany and others were shouldering part of the burden of bailing out their neighbours. What’s more, some of money that has rushed into German bonds in recent years would flood out. But, in a sense, this would just be giving back to the periphery a windfall Berlin has enjoyed as investors have panicked over the possibility of a euro collapse.

My colleague and I have crunched the numbers. Suppose the yield on Spanish and Italian bonds fell by one percentage point as a result of the scheme, and that the yield on the bonds of core countries rose by 50 basis points.

Also assume that core countries were willing to make up half the remaining difference between their interest rates and those in the periphery. That would limit the scale of the subsidy while maintaining pressure on peripheral countries to reform. In this scenario, Spain’s cost of borrowing for 10 years would drop to 4.4 per cent, while Italy’s would drop to 4.1 per cent — no longer worrying levels.

Now look at political acceptability. The interest subsidy would start off being cheap. On the above assumptions, the first year cost would be only euro 1.9 billion, about 60 per cent provided by Germany. Each year, of course, the cost would mount, as countries added new debt to the scheme. But the cumulative cost over the first seven years would still be a manageable euro 53 billion.

The core wouldn’t have to guarantee the periphery’s debt. And subsidies could be provided one year at a time. So if a country didn’t keep up with its reform programme, it could be kicked off the scheme. What’s more, if markets settled down, the operation could be wound down.

Such limitations mean the scheme would be unlikely to fall foul of the German Constitution or the no-bailout clause in the Treaty. Of course, investors may not be convinced that the safety net is strong enough. So it wouldn’t remove the need for Europe’s leaders to come up with a credible long-term vision as well as continue with their reforms. But interest subsidies are still a reasonably cheap and practical answer to the zone’s most pressing problem.


 

The author is Editor, Reuters Breakingviews

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