Seeking Redemption in Europe

Currency in Crisis

Last November, the Germany's economic advisor council, known as the Wisemen, recommended a redemption fund in the euro zone as an alternative to joint bond proposals and as a strategy to put the region's debt on a sustainable path. At the time, proposal seemed to die an ignoble death, but it has been resurrected this week. Reports suggest that just yesterday Merkel conceded she would re-examine the proposal.

The redemption fund proposal has a few components. Countries would segment their debt. That which is over 60% of the countries' GDP would be placed in the fund. It would be mutualized (jointly and severely guaranteed) in exchange for very aggressive commitments to retire that debt in 20-25 years and would only be open to countries not yet receiving funds from the EFSF/ESM.

The initial proposals suggested the redemption fund could be as much as 2.3 trillion euros and backed by the region's gold holdings. While some are suggesting the proposal is really a euro bond with a different moniker, it is probably better to think of it as part of a stronger firewall, especially for Italy. Italy's debt above 60% of GDP is equivalent to about 1 trillion euros, which would alone account for more than 40% of such a redemption fund. 

The fact that Germany itself would be the second biggest participant, with its debt in excess of 60% accounting for about 500 bln euros. Its participation would reduce stigma that could be associated with the redemption fund.

In exchange for participation, countries would have to agree on a strict fiscal plans, likely even more stringent than current commitments. Some estimates, for example, suggest that in order for Italy to brings its debt to GDP to 60% in two decades would require it to run a primary budget surplus of more than 4% a year, assuming 4% refinancing costs of the debt covered by the redemption fund and 5% for the remaining debt and assuming nominal GDP grew 3% a year. 

And even with this relatively optimistic assumptions the 4% primary budget surplus for a prolonged period of time would risk a potent political backlash.

We continue to believe that the condition for a joint bond in Europe is greater fiscal union. Countries have to become more willing to part with fiscal sovereignty. The redemption fund is one form that it could take. The German government and the opposition parties are set to meet again on this on June 13. It could be Germany's counter-proposal at the EU Summit at the end of June.

The devil as always is to be found in the details. How much fiscal sovereignty must be sacrificed? How large of a primary surplus is required and for how long? Is it politically sustainable ?

EU President Van Rompuy encouraged members to think big and that nothing should be taboo. Instead of the best minds thinking of ways to minimize the fall out from an imagined Greek ejection (since a vast majority do not want to leave), perhaps more brainpower should be devoted to creating a roadmap toward fiscal union. And if monetary union and fiscal union, then why not political union, a United States of Europe, if you will ?