The eurozone needs a new common policy to manage the sovereign debts accumulated by member states to deal with the pandemic. The European Central Bank currently holds a large portion of these debts, but will have to start unwinding them when monetary policy can no longer maintain its ultra-expansive attitude. Once this process begins, new turmoil could occur in the financial markets of the Eurozone. These, in turn, would cause sovereign bond prices to fall, raising the specter of systemic instability in a banking sector already weakened by the new wave of non-performing loans.
Because of these concerns, public debt held by the ECB should be kept off the financial markets indefinitely, through purchase by the European Stability Mechanism (ESM). This operation would be financed with the issue of its own securities by the ESM. This would not require any changes to the ESM treaty and would not involve any violation of the rules of the treaty on debt mutualisation or its monetary financing.
The eurozone's debt-to-GDP ratio is currently around 102%, with seven neighboring countries at or above 120% (Italy at 160%, Greece over 200%). With nominal annual GDP growth of around 3% (assuming inflation returns to 2% soon), take the debt-to-GDP ratio to 60% in 20 years – as required by the Stability and Growth Pact (now suspended) – would require these countries to have large primary surpluses of 2-4% of GDP.
Given the need to provide ongoing support to the recovery, the traditional recourse to restrictive fiscal policies to repay sovereign debt would not be compatible with debt sustainability. Furthermore, this would reduce the ability of member states to prevent the economic and social wounds caused by the pandemic from becoming permanent scars. Debt restructuring is not a viable option either, as it would wreak havoc on the economies of highly indebted countries, potentially endangering economic and financial stability across the eurozone.
Ultimately, therefore, the management of the public debt explosion cannot be left to individual member states. Since the political problems it raises concern all member countries, it must be addressed collectively. At the start of 2021, sovereign bonds held by the ECB had exceeded €3 trillion ($3,64 trillion) – about 30% of total outstanding sovereign debt in the eurozone and roughly the same share of eurozone GDP. Ongoing pandemic response programs could involve an additional €1.000 trillion before being halted.
If these debts are not renewed at maturity, liquidity conditions could tighten due to the placement of equivalent securities on the financial markets by the member states. To ensure the eurozone's financial resilience and prevent highly indebted countries from being pushed into the wall, these sovereign bonds should be kept out of the capital markets for longer than is justified by pure monetary policy considerations. It makes no sense to think that the refinancing of COVID-19 emergency debt should be subject to market discipline, as this would penalize governments in trying to protect their citizens during the pandemic.
In other words, financial stability, and not monetary policy, is the main reason for intervening and managing sovereign debts in the eurozone. The task could not be permanently entrusted to the ECB without crossing the line between monetary and fiscal policy, as established by the EU Court of Justice in Gauweiller et al and Weiss et al. This is why we are proposing a new credit line that will allow the ESM to gradually acquire the sovereign bonds held by the ECB and to renew them indefinitely.
In this scheme, sovereign risk it would not be transferred to the ESM, but would remain the responsibility of the national central banks. The ESM would become a debt management agency of the eurozone, and since the cost of the repayment would not be passed on to the ESM, the no-bailout clause foreseen by the Treaties on the functioning of the EU would not be violated.
To finance its sovereign purchases, the ESM would issue its own securities, which would be backed by its sovereign portfolio, its large capital and ESM member states. The instrument would thus create an adequate basis for a large, deep and liquid market for a new European safe-asset.
The MES purchases would continue for as long as necessary a to reduce below 75% of GDP sovereign debt left to private investors in the eurozone – this debt-to-GDP ratio could be set (by amending the treaty protocol on excessive deficit procedures) as the new public debt benchmark.
The facility would be established under Article 14 (precautionary financial assistance) of the new ESM Treaty. Consequently, the macroeconomic conditionality foreseen in case of financial assistance from the ESM under Article 16 of the Treaty would not apply. On the contrary, a light conditionality requiring the fulfillment of general eligibility criteria sufficient to ensure the financial stability of the euro area would suffice. For such a scheme to be accepted, a reform of the Stability and Growth Pact must be envisaged which establishes a credible regime of fiscal discipline.
Once implemented, our proposal would allow the ECB to recover its independence. Monetary policy decisions would no longer be constrained by the need to maintain stable conditions in European sovereign debt markets. Better still, issuing large quantities of safe euro-denominated securities would ease interest rate pressures on German Bunds and other “safe” debt instruments in member states' financial markets.
Finding a way to manage the huge amount of debt accumulated in the eurozone during the pandemic could stabilize growth expectations and create a favorable environment for investment of the private sector. Allowing the ESM to buy all COVID-19-related eurozone debt from the ECB in the way we propose can offer a permanent and credible solution to what otherwise threatens to become a nagging long-term problem.
