Corsetti and Dedola: Is the euro a foreign currency to member states?

Giancarlo Corsetti and Luca Dedola have a really good VoxEU piece on how cooperation between the central bank and the fiscal authority can avoid the “bad equilibrium” problem for sovereign debt.   The paper on which the Vox article is based is available here; Paul Krugman discusses it here.  

Although the initial focus is on a country with control over its own “printing press”, they also examine how it could work in a monetary union.   I won’t try to summarize the subtle analysis, but the key is how the difference between the interest rates on sovereign debt and central bank reserves can be used to lower the cost of funding below the level that triggers the bad equilibrium.   In contrast to claims that potential central bank intervention has to be unlimited, a central finding is that limited central bank intervention may be sufficient to avoid a bad equilibrium. 

In regard to how it might work in a monetary union, a sting in the tail comes in the last sentence of their closing paragraph.  

The analysis here bears key lessons for the current debate on sovereign default in a monetary union:

·        Countries in a monetary union could indeed be more vulnerable to debt crises, to the extent that the common central bank cannot count on the joint support of national fiscal authorities;

·        The common central bank, however, still has the power to engineer successful interventions.

In doing so, it will have to weigh the benefits and costs of providing a backstop to countries exposed to debt crises, possibly drawing on seignorage accruing to all countries in the union.

“[D]rawing on the seignorage accruing to all countries in the union” raises the familiar political-economy of-transfer-risk problem that has complicated the task of stabilising stressed euro zone sovereign debt markets. 

14 replies on “Corsetti and Dedola: Is the euro a foreign currency to member states?”

… the familiar political-economy of-transfer-risk problem that has complicated the task of stabilising stressed euro zone sovereign debt markets. ”

The Solidarity Principle demands that it be done. Jurgen Habermas, leading German Philosopher, deems it essential if the Euro and the Union are to proceed.

from the Habermas link: Solidarity, not Austerity, is the future. [not an easy reas but well worth the effort]

For the present the German government is insisting that priority be accorded to stabilizing the budgets of the individual states by national administrations, mainly at the expense of their social security systems, of public services and collective goods. Along with a handful of smaller “donor countries,” it is vetoing the demand of the rest of the members for targeted investment programs and for a form of joint financial liability that would lower the interest rates of the government bonds of the crisis-hit countries.
In this situation, the German government holds the key to the fate of the European Union in its hand. […]
If there is one government among the member states capable of taking the initiative to revise the treaties then it is the German government. Of course, the other governments could demand assistance on grounds of solidarity only if they themselves were ready to accept the complementary step of transferring required sovereignty rights to the European level. Otherwise, any assistance founded on solidarity would violate the democratic principle that the legislature that levies the taxes has also a say in the decision on how to allocate the funds and for whose benefit to use them. So the main question is, whether Germany not only is in a position to take the initiative, but also whether it could have an interest in doing so. In particular, I am looking for a specifically German interest that goes beyond the kind of interests shared by all the member states (such as the interest in the economic benefits of stabilizing the monetary union or the interest in preserving European influence on the international political agenda in the emerging multicultural world society, an influence which is in any case diminishing. […]
Germany not only has an interest in a policy of solidarity; I would propose that it has even a corresponding normative obligation. Claus Offe tries to defend this thesis with three contested arguments. To date, Germany has derived the greatest benefit from the single currency through the increase in its exports. Because of these export surpluses Germany furthermore contributes to aggravating the economic imbalances within the monetary union and, in its role as a contributory cause, is part of the problem. Finally, Germany itself is even profiting from the crisis, because the increase in interest rates for the government bonds of the crisis-hit countries is matched by a decrease in the interest rates on German government bonds.[14] Even if we accept the arguments, the normative premise that these asymmetric effects of the politically unregulated interdependencies between the national economies entail an obligation to act in solidarity is not quite easy to explain. […]
These European states assumed their present-day form of welfare states only after the catastrophes of the two world wars. In the course of economic globalization, these states find themselves in turn exposed to the explosive pressure of economic interdependencies that now tacitly permeate national borders. Systemic constraints again shatter the established relations of solidarity and compel us to reconstruct the challenged forms of political integration of the nation state. This time, the uncontrolled systemic contingencies of a form of capitalism driven by unrestrained financial markets are transformed into tensions between the member states of the European Monetary Union. If one wants to preserve the Monetary Union, it is no longer enough, given the structural imbalances between the national economies, to provide loans to over-indebted states so that each should improve its competitiveness by its own efforts. What is required is solidarity instead, a cooperative effort from a shared political perspective to promote growth and competitiveness in the euro zone as a whole.
Such an effort would require Germany and several other countries to accept short- and medium-term negative redistribution effects in its own longer-term self-interest — a classic example of solidarity, at least on the conceptual analysis I have presented.

Too late. There are not enough German voters willing to agree to fiscal transfers or Eurobonds to help the (lazy, corrupt, drunk ….) residents of the periphery.The periphery must inevitably default and leave the EZ, with all the austerity acceleration that is implied for this country.
The game is almost up for the EU.


Thanks for the interesting link to the Habermas piece, and we should certainly hope that he has influence on German thinking. But I think it is useful to distinguish been idealist and realist views of solidarity. Habermas is more towards the idealist end of the spectrum (though I understand that he presents his argument for solidarity in terms of a longer-term enlightened self interest).

While the Habermas contribution has significant value, I think we need also to take serious a more realist view. This is captured well in a paper by Jean Tirole linked to at the bottom. (It is a technical paper, but the basic thrust can be gleaned from the introduction). He models the possibilities for solidarity in terms of the collateral damage that distress in partner countries can impose on other countries. Unfortunately, the view on the extent of this damage may be quite limited, in turn limiting the solidarity that is shown.

One interesting aspect of the Tirole paper is that there can be a role for a “contract” that can increase the optimal help that stronger countries are willing to provide. In his model, this contract takes the form of a “debt brake”, with obvious parallels to the fiscal compact. The debate here on the fiscal treaty here largely missed the essential element of what it was about. This was certainly not all our fault as the quid pro quo of developing solidarity mechanisms was left far too vague. Although when it was made explicit, as with the linking of access to the ESM to signing up to the treaty, it was roundly criticised as a “blackmail cause”.

The German response to the crisis is often criticised as being too driven to see the crisis as a morality play, with lazy Greeks, feckless Irish, etc. There is something to this criticism, but there is a danger of falling into the same trap with indignant claims of lack of solidarity. As I said, the more idealist discussion is certainly worth having, but there is a danger in being so driven by a sense of grievance, that we fail to properly explore the possibilities for mutually advantageous arrangements that could help fix the massive revealed flaws in monetary union.

@John McHale

While the Habermas contribution has significant value, I think we need also to take a more realist view.

There seems to me to be a certain pattern to your thoughts on the European component of the global financial crisis Professor McHale.

First you suggest opposing opinions are not alive to the “political realities” of the situation and then explain how unfortunately the “political reality” based approach you recommend (the fiscal compact, front loaded debt reduction) has not worked well due to circumstances beyond our control.

After all who could have known that having had European economic policy surrendered to them the German’s would become more intransigent? Who could have guessed that the ensuing enforced aggregate fiscal contraction would lead to a steadily worsening economic and social outcome in the periphery?

A realist would have.

It is also very difficult to avoid a little cynicism about the motivations of anyone who recommends against being trapped by ideological positions but who was an advocate for the neoliberal nonsense (actual nonsense) of Alberto Alesina.

Thanks Shay.

In your eagerness to see everything through an ideological lense, you attribute beliefs to me that I do not hold. On many occassions I have expressed scepticism that the evidence support the “expansionary fiscal contraction” idea. Of course, that is not to say that the confidence channels Alberto Alesina invokes are not present, especially in the context of a debt crisis. But saying that these effects are strong enough to overcome more standard contractionary effects of fiscal adjustments is a much stronger claim, which I again do not see the available evidence supporting. It is interesting, however, that many are willing to countenence expectations-related effects when considering the effects of commitments to keep interest rates low in the context of the zero lower bound problem — effects that I find convincing by the way. Brad DeLong makes some interesting observations on that here:

You also say that I claim that developments such as the fiscal compact have not worked well. While the development of the necessary LOLR mechanisms has been too slow, there certaintly has been significant if fragile successes. It is unlikely that OMT, for example, would have come into force without the fiscal compact. The significant improvement in the odds of an Irish default is, I believe, in substantial measure due to the developments that have taken place so far.

I don’t pretend to be free of ideological biases. But I try as best I can to take a problem solving approach. It is hard not to think of pots and kettles.

“I won’t try to summarize the subtle analysis, but the key is how the difference between the interest rates on sovereign debt and central bank reserves can be used to lower the cost of funding below the level that triggers the bad equilibrium. ”

It comes down to credibility and firepower. And does whoever calls the shots WANT to avoid the bad equilibrium? Do the markets have to force the issue? If they do, the price is paid by a lot of people.

@John McHale

In your eagerness to see everything through an ideological lense, you attribute beliefs to me that I do not hold.

I may have you wrong on this Professor McHale, but I only have your postings at the Irish Economy to go on and you have referenced Alesina quite a bit in way that suggested to my, perhaps impressionable, mind that you have a fair bit of sympathy for his analysis.

What makes fiscal consolidations successful?

Expansionary Fiscal Contraction

Alpha Politics

Am I wrong in saying that you broadly share the analysis of Alesina on the high importance of cutting budget deficits versus stimulating demand and the appropriate adjustment mechanisms to reduce the deficit? (I have been wrong before).

The rest of your comment deserves a longer response than I have time to give but I will be reading at de Long’s post on whether there is a difference between the confidence fairy and what Krugman has described as the expectations imp. It is a good question.

@John McHale

Habermas is an epestemological realist and an ontological pluralist (with his own unique twists). Major influences on his thought are continental European philosophy and American pragmatism. Rather than being viewed as an ‘idealist’ (which he has brushed off for more than 60 yrs) he is best viewed as a Kantian Pragmatist. Most interesting here is his take on ‘solidarity’ which I see as derived from his (and Karl-Otto Apel’s) reconfiguration of Kant’s categorical imperative (individualism, philosophy of consciousness) to ‘discourse ethics’ (human interaction; philosophy of language). This does not draw on altruism but on the norms of reciprocity and mutual advantage.
From simple system theory, a fu*k up derived from the centre (poorly designed €) has been devolved to the lower level of sovereign states, loading them with further debt and austerity. This won’t work (and empirically we now know it doesn’t). To address this fu*k up on must meet it at the appropriate systems level – i.e. a strong centre which demands gifting of further sovereignty to the centre, and appropriate institutional innovations (properly functioning ECB etc). None of this is new – he simply puts it better! Habermas’ take on Solidarity – reciprocity and mutual advantage – supports this.
Key, of course, is Germany. To wreck Europe for a third time OR to lead and lead its progress to the next level …

I will get to the Tirole paper.


I did find the Habermas piece very useful and certainly wish him well. But the goings on at the constitutional court suggests an uphill struggle in convincing his fellow citizens. That is why I believe we have to do our part to minimise their concerns. Just putting it up to them with talk of grievances they simply don’t recognise is a recipe for maintaining a potentially deadly status quo.

I doubt if you will enjoy the Tirole paper. But it does set out a hard headed take on the possibilities of solidarity.

@John McHale

I have waded through Tirole between the Lions and the US Open, and it has contributed to improving somewhat my ‘veil of ingorance’ in this area albeit I’m not a fan of agency theory.

In the Irish case, from this reading, to prevent default, official debt will need to be forgiven or (more likely) kicked so far into the future as to become irrelevant. At a EuroZone level, the Principle of Solidarity must hold and the sooner the agent and principal morph into each other, the better! EuroBonds, a banking union, and a proper ECB.

Patricia_the_Irish_Sovereign_in_Exile is dead. Brunhilda, the EZ Sovereign_to_come, is in the womb but a difficult birth is predicted.

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