How eurozone can save itself

At their meeting in Rome last week, the leaders of the eurozone’s four largest economies agreed on steps towards a banking union and a modest stimulus package to complement the European Union’s new “fiscal compact.” Those steps are not enough.

German Chancellor Angela Merkel resisted all proposals to provide relief to Spain and Italy from the excessive risk premiums that both countries are now confronting.

As a result, the EU’s upcoming summit could turn into a fiasco, which may well prove lethal, because it would leave the rest of the eurozone without a strong enough financial firewall to protect it from the possibility of a Greek exit.

Even if a fatal calamity can be avoided, the division between creditor and debtor countries will be reinforced, and the “periphery” countries will have no chance to regain competitiveness, because the playing field is tilted against them.

This may serve Germany’s narrow self-interest, but it will create a very different Europe from the open society that fired people’s imagination and propelled European integration for decades.

Merkel argues that it is against the rules to use the European Central Bank to solve eurozone countries’ fiscal problems – and she is right.

ECB President Mario Draghi has said much the same. Indeed, the upcoming summit is missing an important agenda item: a European Fiscal Authority (EFA) that, in partnership with the ECB, could do what the ECB cannot do on its own.

In particular, the EFA could establish a Debt Reduction Fund – a modified form of the European Debt Redemption Pact that was proposed by Merkel’s Council of Economic Advisers and endorsed by Germany’s Social Democrats and Greens.

In exchange for specified structural reforms in Italy and Spain, the Fund would acquire and hold a significant portion of their outstanding stock of debt.

It would finance the purchases by issuing European Treasury bills – joint and several obligations of the member countries – and pass on the benefit of cheap financing to the countries concerned.

The Treasury bills would be assigned a zero-risk rating by the authorities and treated as the highest-quality collateral for repo operations at the ECB.

The banking system has an urgent need for risk-free liquid assets. Banks are currently holding more than €700 billion of surplus liquidity at the ECB, earning only one quarter of 1 per cent interest.

This assures a large and ready market for the bills at one per cent or less.

Should a participating country subsequently fail to abide by its commitments, the EFA could impose a fine or other penalty, which would be proportionate to the violation, thereby preventing enforcement from becoming a nuclear option that can never be exercised.

It is not too late to turn this proposal into a political declaration that outlines not only the long-term goal of a political union, but also a road map toward a fiscal and banking union.