A New Mechanism for the Eurosystem

By Biagio Bossone and Marco Cattaneo

Lost hopes and new realism

Today’s Eurosystem is certainly not the system that many European citizens had in mind when they first thought about the single currency. Indeed, they expected a system built on strong rules and discipline. Yet they expected above all a system whose new currency - the euro - would be a symbol of and a vehicle to further European integration, cooperation and economic prosperity. To that vision the euro has become the biggest obstacle, proving to be an instrument of division, a source of conflicts, and a generator of arrogance and subjugation.

For those who cultivated the dream of a unifying currency, thinking today of reforming the EU institutions with a view to bringing them back into that dream is pure illusion. We start from this premise. Yet, being aware of the deep uncertainty surrounding a traumatic breakup of the system, we propose a set of measures that would make possible within the system’s  current structure to:

·         Engineer economic recovery by those member states that are most affected by the crisis

·         Minimize the risk of default from member states that are most exposed to debt, and

·         Allow a soft exit for those member states that choose to leave the euro.

A fiscal plan

In an economy where the public sector may not increase spending, we propose that the government issues special non-debt instruments, the Tax Credit Certificate (TCCs). These certificates entitle their holders to a reduction of taxes, fees and all other financial obligations to the public sector, two years from their issue-date and for amounts equivalent to their face value. We will discuss the two-year deferral period shortly. The TCCs are transferable securities that can be traded for euros, thus making immediate spending possible. Likely, these securities will trade at a discount of a similar size to that on a two-year zero-coupon bond. Those who sell TCCs want to be able to spend their value. Those who buy them acquire the right to future tax cuts (and therefore to future savings). Financial intermediaries can buy TCCs at a discount from those who want to sell them, and will either use them for future tax cuts or sell them at a lower discount and make a profit in return.

TCC assignments

Individual member states of the Eurozone issue TCCs and assign them (free of charge) to a number of social categories and for a number of purposes, including:

·         Employees and self-employed workers, both in the private and public sector: this adds to their actual net income

·         Companies, based on their labor costs: this reduces the tax wedge (and hence their gross staff costs) and improves their competitiveness

·         Measures to support social spending, such as unemployment benefits, integration of income and minimum pensions, benefits for disadvantaged social groups

·         Financing and co-financing of public investment and public works (public procurement with payments partially or totally paid out in TCCs instead of euros).

As the state assigns TCCs to households and companies, many households will want to convert them into euros for spending purposes. Companies, on their side, will likely do the same or will take advantage of the lower tax burden to lower their prices and restore competitiveness. In a depressed economy, spending stimulated by TCC issuances will have a multiplier effect on income and employment. Prospects of credit risk will improve and strengthen the incentive for banks to resume lending to production and investment. During the two-year deferral on the TCCs, new output will follow from new spending and will generate new tax revenue that will finance the tax reduction. This will prevent the deficit-to-GDP ratio from going up.

TCC volumes and allocations

Eurozone member states shall establish a program for the issue of TCCs, aiming to achieve the following results:

·         Stimulating domestic demand and consequently increase GDP and employment

·         Improving external competitiveness of domestic production (via TCC assignments to companies): this prevents the increase in domestic demand from resulting in foreign trade imbalances, by supporting exports and encouraging import substitution

·         Fighting deflation or chronically below ECB-target inflation.

The TCCs are hybrid securities...

The TCCs are not debt instruments: the issuing state makes no commitment to repaying them in euros, it only promises to reduce taxpayer obligations by an equivalent amount. There is no possibility, either theoretical or practical, that the issuing state might be forced to default on the TCCs.

The TCCs are not legal tender. The only legal tender of the Eurozone member states remains the euro. No private or public entity is obliged to accept payments in TCCs. Bank deposits continue to be denominated in euros, and public and private budgets and balance sheets continue to be drawn up in euros.

...yet they are a store of value and potential means of payment

While they are not legal tender, the TCCs bear two characteristics that are typically associated with money. They are a store of value, since the right to future tax reliefs attached to them is a source of value. And they are a potential means of payment since, apart from legal obligations, it is likely that the TCCs will circulate and be accepted for payment in exchange of goods and services, provided that the payment infrastructure allows for circulation of electronic (dematerialized) securities.

Fiscal stability

Public budget targets

The treaties that govern the operation of the Eurosystem bind member states to attain certain fiscal targets. When general economic conditions are bad, the attempt to achieve a reduction of the public deficit through restrictive fiscal policies produces pro-cyclical effects. Under such effects, either the governments fail to achieve the given targets, or they have to impose additional costs on the society if they want to secure their achievement. The introduction of the TCCs addresses this internal inconsistency of the Eurosystem. Each member state can commit, for example, to maintaining a zero balance between euro receipts and payments, as it can rely on TCC assignments to engineer the necessary stimulus.

Sustainability of the program CCF

For all countries of the Eurosystem that need to stimulate demand and recover external competitiveness – most notably Italy, Spain and France – a TCC program would in all likelihood be sustainable. With a fiscal multiplier (ratio of GDP growth and TCCs issued) slightly less than one, these countries would achieve the policy objectives described above (raise output and employment, balance foreign trade, price stability) without worsening the deficit-to-GDP ratio. Moreover, if the fiscal multiplier exceeds 1 (as econometric evidence generally shows to be the case in all highly depressed economies), the program non only fully funds itself but also generates additional fiscal resources. When two years after issuance the TCCs start being used to reduce tax payments, the higher tax revenues resulting from the higher level of GDP offset the decline in revenue due to the use of the TCCs.

Safeguard clauses

However, if a government that is implementing a TCC program has difficulty reaching its fiscal targets, due to, say, less than favorable economic conditions, it can take a number of actions to ensure a balanced euro budget and public debt consolidation. Specifically, it may introduce a number of safeguard clauses into the program, which would be triggered in the event that output growth were to generate less tax revenues than expected. The government may:

·         Announce its commitment to finance a (presumably small) share of its expenses in TCCs

·         Compensate taxpayers for tax raises by assigning them with new TCCs (this would be equivalent to replacing tax increases with compulsory TCC-for-euro swaps)

·         Incentivize TCC holders to delay the use of their maturing TCCs for tax rebate by increasing the value of their TCC holdings (this would be equivalent to paying an interest in the form of new TCCs)

·         Raise euro funds from the capital market by placing TCCs with longer maturities instead of issuing debt.

The effect of these clauses would be way far less pro-cyclical than cutting public expenditure and/or raising taxes since, as under EU rules, they would not drain purchasing power from the economy and would only replace one type of assets (euros) with another (TCCs) in the portfolio of TCC holders.

Financial stability

Breaking the spiral between sovereign debt crisis and banking crisis

The introduction of the TCCs also creates conditions for reducing and gradually eliminating another serious problem inherent in the Eurosystem. Financial institutions, in particular the national banking systems, hold large amounts of government bonds issued by their government. As a result, state insolvency causes severe disruptions to them.

As TCCs starts being issued, banks can partially replace traditional government bonds with TCCs on the asset side of their balance sheet. This progressively lowers the risk that state default hits the local banking system.

Eurosystem monetary stability and “soft” exit option

Underperformance of fiscal targets, due to, say, less favorable than expected revenues, may lead certain countries to increase excessively the issuance of new TCCs (for example as they need to resort to safeguard clauses too often). In this case, the TCCs would lose value in terms of domestic prices but that would not affect the value of the euro, avoiding any negative impact on the countries that do not issue (or do not over-issue) TCCs.

A country that would over-issue TCCs eventually might find itself in a situation where the domestic circulation of TCCs would be predominant with respect to that of euros. At that point, there will be the possibility (which might in fact be regulated a priori) to transform the TCCs into a national currency, thus de facto enacting a soft exit from the Eurosystem.

What would our partners think?

German leading opinion – currently personified by Germany’s Minister of Finance Wolfgang Schaeuble – has got the point that the Eurosystem, as it is, doesn’t work, unless Keynesian policies and fiscal transfers are adopted. But this is taboo for Germany and the other North-European countries. In this light one should read the wisemen report and the plan written by Schaeuble himself, both just released.[1] In practice, both documents delineate proposals to strengthen the ordoliberal rules governing the system and to provide for the exit of those members that are not able to live with the rules. In this regard, Germany was (and still is) ready to let Greece go.

Against this background, it would be reasonable to assume that the TCC program might not be rejected by Germany and its satellite states, since it would eventually allow for the exit of Italy, Spain, and probably even France. While Germany would further on its integration with countries that can follow its rules (the Netherlands, Austria and some others), other countries would de facto part with the system. Yet the TCC program would ensure their debt repayment capacity, since their public debt would rapidly decline in proportion to their GDP thanks to the balanced euro budget rule and the safeguard clauses discussed above.

For a new mechanism of the Eurosystem: Conclusion

A sweeping reform of the Eurosystem would require an overhaul of its architectural design, its central institutions, and even the principles underpinning its policies. We do not nurture such an ambition, as we see neither the premises of it nor the countries and the leaders who can inspire it. On the other hand, we are aware that breaking up the system might have destabilizing and potentially dangerous and costly consequences.

We therefore propose a revision of the system, which, on the one hand, would allow crisis countries that want to remain in it to achieve rapid economic recovery, as well as fiscal and financial sustainability, while on the other it would prepare for a soft exit those countries that do not want to stay in the system or cannot live by its rules.

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[1] Ses on Reuters, “German "wisemen" say euro zone states should be able to go bankrupt”, 28 July, 2015 (http://mobile.reuters.com/article/idUSB4N0ZN01L20150728) e on the Financial Times, “Schäuble outlines plan to limit European Commission powers”, 30 July 2015 (http://www.ft.com/intl/cms/s/0/88352cf2-3697-11e5-bdbb-35e55cbae175.html#axzz3hYe9OAHs).