Flawed Integration Risks More European Divisions

Nov. 21, 2013 5:26 p.m. ETIn their quest for closer financial integration, the 17 countries that use the euro have to go full speed—into reverse.
That is at least what Ashoka Mody, a former deputy director at the International Monetary Fund, argues. Mr. Mody is a member of a growing group of economists who believe the euro-zone bailouts of the past few years have taken Europe in the wrong direction.
Instead of sharing the burden of outsize debts of some countries among all of the bloc’s members, they want governments to take back responsibility for their own fiscal affairs and for private holders of bank and sovereign debt to face the consequences if those investments turn sour.

Closer integration has been at the center of the euro zone’s crisis fighting. The currency union has set up common bailout funds, tightened restrictions on national spending and economic policies and is now struggling to build a system that can prevent bank failures from ruining the finances of individual governments. Those efforts—driven primarily by European institutions in Brussels and the IMF in Washington—have been accompanied by demands for common euro-zone bonds, a central euro-zone budget or a mixture of the two.
But the results have been far from perfect. Germany and other “Northern” countries don’t want to pay for other states’ debts, while France and others in Europe’s “South” chafe at the erosion of their sovereignty.
“Countries are responsible for their fiscal affairs,” is how Mr. Mody sums up his take-away from the past 60 years of European integration. “That is one theme that you can just not walk away from.” Instead, he says, solidarity efforts have resulted in a bitter mixture of loans resented by both borrowers and creditors and hard-to-enforce rules that some see as too rigid, while others complain they are too weak.
The bailouts have paid off private investors and transferred a large part of poor countries’ government debt to the hands of fellow euro-zone members and other international institutions. The economic hardships caused by rapid spending cuts and economic overhauls, meanwhile, have eroded trust in the national and European political process, the very opposite of the civic dreams that were at the root of the European project.
Faced with such resistance, Mr. Mody says the euro zone needs to stop striving for further flawed integration and, instead, chisel away at the notion that guided governments when they moved to bail out Greece 3½ years ago: That a country’s debt is ultimately a safe investment.
Apart from the restructuring of Greece’s privately-held government debt—an episode that many euro-zone policy makers now brand as a mistake—that tenet has been upheld and many market players now regard euro-zone sovereign bonds as safe, despite doubts over debt sustainability.
In an essay published this week in the traditionally pro-integration Brussels-based think tank Bruegel, Mr. Mody says the euro zone needs to treat debt restructuring as a less dramatic and more predictable process.
To do so, governments should start issuing bonds whose terms are linked to their economic performance. Once debt reached a certain level, those bonds would come due later and carry lower interest—similar to bank bonds that can be turned into equity when a bank runs into trouble.
That idea was also endorsed in a paper published this week by four economists at the Bank of England and the Bank of Canada, though the authors stress their views aren’t necessarily in sync with their institutions. They propose two changes to sovereign-bond contracts: one that automatically extends maturities when a country asks for international help, and another that lowers repayments if gross domestic product drops below a certain level.
“This predictable and transparent means of bailing-in creditors would increase market discipline on sovereigns to prudently manage their debt,” they write. The central-bank economists cautioned they don’t see their proposals as an answer to the euro zone’s current problems and still accept, albeit smaller, international bailouts.
Mr. Mody, meanwhile, says performance-linked bonds have to come hand-in-hand with credible no-bailout commitments. And he sees no way around messy write-downs of existing government and bank debts that are holding back the euro zone’s recovery.
The euro zone’s incomplete integration, though, means that such write-downs would likely have to be deeper and be borne mostly by countries that have suffered the most from the debt crisis. Northern European banks have cut their exposure to the euro zone’s weak members, while cheap central-bank liquidity has allowed southern European banks to bulk up on their own nations’ bonds.
“The question is: Just because something improper was done four years ago, do you not prevent something worse from happening four years from now?” Mr. Mody asks.
Mr. Mody doesn’t see his proposals as an obstacle to future integration, he says, but as a precondition. Only once Northern European countries know they won’t be bank-rolling their Southern neighbors, governments can decide whether they want to integrate.
Write to Gabriele Steinhauser at gabriele.steinhauser@wsj.com

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