Kiss the rod
As the euro zone charges ahead with plans to impose fiscal rigour by bureaucratic diktat, it is in danger of forsaking the potentially more effective rod of market discipline. France and other euro zone countries want to drop rules forcing losses on creditors of insolvent states. That would be a mistake.
The disputed clauses are part of the draft treaty for the European Stability Mechanism (ESM), the permanent rescue fund to be introduced in 2013. They force bondholders of bailed out states to take losses if those states are insolvent, and require sovereign bonds to include collective action clauses (CACs) to make debt restructurings easier.
The clauses’ significance is more symbolic than legal. They comfort taxpayers in northern Europe who are sick of bailing out peripheral economies. And they promote fiscal discipline by reminding investors they may lose money, encouraging them to price risk properly. The counter argument is that they sully the risk-free status of sovereign debt, destabilising markets. Why else do markets keep punishing Spanish and Italian debt despite commitments by their governments to rein in deficits?
Some argue that the ESM clauses aren’t necessary. Euro zone member states have already agreed to tougher fiscal monitoring. The next stage, being pushed by Germany’s Angela Merkel, may involve a more drastic transfer of sovereignty as countries surrender control of their budgets. Fiscal discipline will be enforced through the iron will of euro zone bureaucracy, not market gyrations.
However, there are reasons to keep the clauses. For one, German politicians like them, making it hard to get the ESM approved without them. What’s more, even if euro zone countries agree treaty changes imposing fiscal discipline, the implementation could fall short, as happened with the stability and growth pact that supposedly already limits debts and deficits. Euro zone apparatchiks will find it easier to dictate policy to miscreant states if they can use market yields to back up their arguments. Equally, docile markets could lull the region into a false sense of security and reduce the pressure to enforce discipline, as happened in the years before the crisis. Having finally woken markets after years of slumber, politicians shouldn’t seek to send them to sleep again.