Debt Sustainability and Economic Convergence of Euro-Area Member States: Challenges and Solutions (Xavier Ragot)

23-02-2015

Countries within the euro zone are facing three main perils. The first is the problem of nominal divergences, which materialize in unit labor cost differences. The second is the lack of aggregate demand in Europe. This is the main issue in the short run. The third is the high level of public debt, which generates an issue of sustainability in some countries, like Greece. The exclusive focus on both public debt and unit labor costs hasproduced a demand crunch in the euro area, which is the main cause of the deflation risk and the high current account. The lack of demand is creating concerns about debt sustainability. A sustainable debt is not in fact a low public debt or a rapidly decreasing public debt. It is a public debt for which there is no risk of default. The default risk in advanced countries is not an economic risk, but a political risk. High unemployment and a long-lasting recession are eroding political support for the European project, which can ultimately reduce countries’ ability to generate a sufficiently high primary budget.All the flexibilitiesin the current treaty should be used to boost demand in Europe, without increasing the public debt burden of the heavily indebted countries. As some surplus countries, like Germany, have decided not to use their fiscal space, one efficient way to promote public demand is to design a public investment plan that is much bigger than the initial Juncker Plan and is financed by funds backed by either national or European debt, which could be bought by the central bank.In addition, the European Semester should clearly start with an assessment of the aggregate fiscal and monetary stance in the euro area so as to provide the desired orientation for the European policy mix. This orientation should be consistent with country-specific recommendations.

Countries within the euro zone are facing three main perils. The first is the problem of nominal divergences, which materialize in unit labor cost differences. The second is the lack of aggregate demand in Europe. This is the main issue in the short run. The third is the high level of public debt, which generates an issue of sustainability in some countries, like Greece. The exclusive focus on both public debt and unit labor costs hasproduced a demand crunch in the euro area, which is the main cause of the deflation risk and the high current account. The lack of demand is creating concerns about debt sustainability. A sustainable debt is not in fact a low public debt or a rapidly decreasing public debt. It is a public debt for which there is no risk of default. The default risk in advanced countries is not an economic risk, but a political risk. High unemployment and a long-lasting recession are eroding political support for the European project, which can ultimately reduce countries’ ability to generate a sufficiently high primary budget.All the flexibilitiesin the current treaty should be used to boost demand in Europe, without increasing the public debt burden of the heavily indebted countries. As some surplus countries, like Germany, have decided not to use their fiscal space, one efficient way to promote public demand is to design a public investment plan that is much bigger than the initial Juncker Plan and is financed by funds backed by either national or European debt, which could be bought by the central bank.In addition, the European Semester should clearly start with an assessment of the aggregate fiscal and monetary stance in the euro area so as to provide the desired orientation for the European policy mix. This orientation should be consistent with country-specific recommendations.