Putting questions of immediate political feasibility aside, Simon Wren-Lewis asks in a new post if there is a better approach to establishing a fiscal Lender of Last Resort (LOLR) for the eurozone.
As Simon notes, I expressed some sympathy for the Commission in a previous post. The Commission recognises the fragility of the eurozone in the absence of a LOLR. This follows from the well-know multiple equilibria problem (see here). There is good equilibrium with low expectations of default and consequent low interest rates, creating a debt sustainability situation that validates the initial expectations. But there is also a bad equilibrium with high expectations of default and consequent high interest rates, again creating a debt sustainability situation that validates the initial expectations. In part to develop the political support for a fiscal LOLR to coordinate expectations around the good equilibrium (where it is thought to exist), the Commission has pushed the strengthening of fiscal rules and support programmes for countries in difficulty that lean heavily fiscal (and other) conditionality and intrusive surveillance.
Simon usefully asks it there is a better way, while recognising the huge political obstacles at present. His proposal centres on a significant change in the approach to OMT. Based on an assessment of debt sustainability by a collective of independent fiscal councils – effectively an assessment of whether a good equilibrium exists – the ECB would commit to the necessary bond market interventions to keep interest rates low. Assuming no change in its mandate, the rationale for the ECB’s participation would presumably be that it would otherwise be unable to operate a single monetary policy where, without their own central bank capable of acting as a LOLR, many countries in the eurozone are susceptible to falling into a bad equilibrium, with the added risk the entire single currency project could unravel. One question is whether countries facing debt sustainability concerns would be politically capable of making the necessary difficult adjustments without in the absence of programmes with explicit conditionality.
Another dimension of Simon’s proposal is that the fiscal rules should become more sensitive to the aggregate fiscal stance of the eurozone in the context of a zero lower bound on monetary policy, with the obligation to adopt less contractionary policies falling on countries with stronger fiscal positions.
It is interesting to contrast this proposal with the recent widely discussed observations of Ashoka Mody on the relative merits of adjustment/assistance and default as a means of dealing with debt sustainability challenges (Morning Ireland interview here). Ashoka’s view is informed by his reading of history of sovereign defaults as involving relatively low output costs. A rather different reading of the history is given in this survey of the literature on sovereign defaults. Moving to a regime with a low default trigger would also make private investors extremely wary of sovereign debt, increasing the fragility of market access. For the long-term, such a low moral-hazard regime certainly has attractions — but it would be one hell of ride along the way.