Eurozone needs a flexible euro – not “some” flexibility

By Biagio Bossone and Marco Cattaneo

Talks of “flexibility” are currently much in fashion in the Eurozone. The EU Commission accepted many of the Italian proposals to exclude certain extraordinary items – including costs to manage the immigration crisis – from the budget deficit limits. Italy will then not be forced to implement contractionary budget actions in 2016.

Meanwhile, Spain missed her own budget targets. A 5.2% deficit was recorded in 2015, exceeding the 4.5% commitment (in itself already a concession, since the Stability and Growth Pact (SGP) and the Fiscal Compact (FC) call for much stricter limits). The Commission could sanction and fine Spain, but everybody expects a waiver to be granted.

Clearly, enforcing fiscal rules is a problem in Europe. It’s easy to see why. Fiscal consolidation was imposed starting from 2011, much before the Eurozone had fully recovered from the 2008 financial crisis. Many countries experienced a heavy double-dip recession. Demand is still depressed and unemployment is far too high.

Many Eurozone countries require demand expansion, which implies a temporary increase in deficits and debt (as a percentage of GDP) to achieve much stronger growth and lift the economies from current depressed conditions. But the political consensus to thoroughly revise the SGP and the FC is just not there.

As a result, the “flexibility” granted by the EU Commission is just a “kick-the-can-down-the-road” exercise. Fiscal rules are neither enforced nor revised. The Eurozone as a whole keeps stagnating. Disaster may well be avoided as the ECB’s “whatever-it-takes” commitment and its Quantitative Easing program prevent a run on sovereign debts, but lack of growth and employment opportunities feeds Euroscepticism and strengthens anti-establishment parties.

In a few months (October 2016), next year budget programs will start being proposed by country governments, discussed by national parliaments and submitted in draft to the Commission. Under the current set of rules, a further round of postponement exercises is all too easy to predict.

How can this be avoided? Can the Eurozone be fixed in a satisfactory and permanent fashion?

Yes, it can, provided the Eurosystem is reformed to make itself flexible. An effective way to do it is to have selected countries issuing national Tax Credit Certificates (TCC).

TCC are securities that entitle their holders to reduce tax payments some time after (say, two years) their issuance. They will be assigned, free of charge, to employees (to supplement their income) and to enterprises (to reduce total labor costs). A portion of the TCC issued could help fund social programs and public investment, as appropriate.

TCC would be marketable securities. Holders could convert them into cash, at a discount (presumably small, as the market would be wide and liquid) on their face value. TCC recipients’ disposable income and net worth would immediately increase, supporting demand, consumption and corporate investments. Per capita income and employment would be permanently higher, lifting the Eurozone as a whole out of the depression.

On the budget side, higher GDP – led by higher demand and the income multiplier effect – would increase tax revenues during the two years prior to TCC redemptions. Even under conservative estimates, the larger gross tax revenues following GDP growth would exceed the fiscal revenue shortfalls due to the tax discounts from TCC redemptions.  

Importantly, TCC are not debt: issuing countries have no obligation to reimburse them, and issuing governments may not be forced to default on TCC-related obligations. TCC, therefore, imply no risk to financial stability.

As a result of the nominal GDP growth induced by the TCC, each TCC-issuing country would fulfill its commitments under the SGP and the FC, reducing on a timely and consistent fashion its public debt / GDP ratio. Level and allocation of future TCC issuances would be managed to stabilize each country economy, to achieve satisfactory employment, and to improve enterprise competitiveness (as labor costs would be reduced by TCC allocations). This would also allow each country to avoid external trade imbalances following from higher domestic demand.

A wide range of additional tools would be available for each country to manage negative, temporary deviations from fiscal consolidation targets. Holders of TCC could be induced to postpone TCC redemptions for tax discounts by offering them an increase in the face value of their TCC holdings in exchange for their decision to postpone redemption. In addition, long-term TCC could be issued to refinance euro-denominated debt, thus speeding up the consolidation of the total stock of public debt outstanding.

In the unlikely event that all of this were insufficient, countries could implement “safeguard clauses” by raising taxes (to be paid in euro) or cutting expenses, while at the same time increasing TCC issuances. All the above measures would be “non-procyclical safeguard clauses” and would not imply the recessionary impact created by “debt brakes” as currently envisaged by the Eurozone rules (which is the reason why they are, in practice, difficult or even impossible to enforce).

An efficient, sustainable “flexible Eurosystem” can be created. The TCC would be deeply instrumental to that purpose. The time to act, and to end the Eurozone depression, is long overdue.