The successful haircut imposed on private holders of Greek debt in early March 2012 has led some observers to conclude that the euro zone is finally on its way toward solving its debt problems.
The move followed the decision of the European Central Bank (ECB) in December 2011 to lower its core refinancing rate to 1 percent and, in cooperation with the U.S. Federal Reserve, to ease the borrowing of U.S. dollars for banks via foreign central banks. The ECB has also offered two new longer-term refinancing operations (LTROs) with three-year maturity dates. These steps have significantly reduced bank financing costs and improved the funding conditions for sovereigns in the euro zone periphery. In response to the LTRO offerings, European banks borrowed €489 billion in December 2011 and a record €530 billion in February 2012.
In parallel, European governments have agreed to several measures to restore confidence in the euro zone. In addition to the decision in March 2011 to implement a permanent European Stability Mechanism (ESM) by June 2013, these measures comprise more stringent limits for structural deficits of the member countries, the close supervision of national budgets, and additional contributions to the International Monetary Fund (IMF).
Is the combination of these measures enough to solve the euro zone’s problems? Unfortunately, we doubt it. These measures are really only a short-term fix. They fight the symptoms but do not cure the disease.
The real issue facing the euro zone is dealing with two fundamental problems: unsustainably high debt levels and the lack of competitiveness of some member countries. The introduction of the ESM, the intervention of the ECB, and the reduction in Greek government debt can only buy time to address these broader issues. Any long-term solution to the euro zone crisis has to reduce the debt overhang and restore the competitiveness of some countries—notably Portugal, Greece, Spain, and Italy.
In previous papers, we have discussed alternative ways to address the euro zone’s overindebtedness—introducing the concept of financial repression in which interest rates are kept below the nominal rate of growth in GDP—and pointed to the need for a possible debt restructuring financed through a wealth tax. In this paper, we unveil a detailed proposal for how euro zone governments can reduce the debt overhang through a combination of financial repression and wealth taxes, following a euro zone–wide pooling of excess debt to reduce interest rates.