Blogs & Comment

A simple fix for European woes: Federalize euro zone sovereign debt

The Europeans should follow the lead of Uncle Sam, who uses his economic weight to attract investors.

Misguided or not, investors around the world still put faith in Uncle Sam’s ability to cover his US$15-trillion debt. The European Monetary Union, on the other hand, is at risk of breaking up because of creditor concerns and it is a federation that owes no one a dime.

Sovereign debt in the EMU is held at the country level. That fact has allowed a handful of weaker euro zone members to create a global financial crisis. But it also opens the door to a simple answer to European woes, according to Bob Eisenbeis, chief monetary economist at Florida-based Cumberland Advisors.

The former executive VP and research directors with the Federal Reserve Bank of Atlanta proposes a clear four-step program to put the EMU on a stable fiscal footing without walking away from the financial obligations currently held by EMU members, including the so-called PIIGS.

The first step is to federalize all sovereign debt in the 17-member euro zone, making it an EMU obligation backed by the taxing power of the mother ship. When all sovereign financial obligations are lumped together, the EMU’s debt-to-GDP ratio is a lot less ugly than in Italy and Greece. And as the world’s second largest economy under one currency, the EMU’s credit worthiness carries more weight when it comes to instilling confidence in investors.

Eisenbeis proposes funding the pooled EMU obligations with a new tax on member states levied in proportion to the amount of debt federalized by each state. With the tax in place, he then suggests placing strict limits on private bank and national central bank investment in new debt offerings by EMU members, which would be forced to adopt balanced budget schemes.

“This is a radical proposal,” the Cumberland economist admits, “and admittedly one that would be difficult for European nations to adopt, because it runs counter to their strong desires to preserve national identities. But the alternatives are even less attractive and dangerous for the subsequent survival of individual European nations, not to mention the threats that the collapse of the EMU would pose to world financial stability.”

As I write this, of course, global markets are responding in a positive way to co-ordinated action taken by the world’s major central banks to ensure financial institutions in Europe (and elsewhere) have access to cheap, emergency U.S. dollar loans. But long-term investors need to be aware that the new liquidity measures do nothing to address the euro zone’s debt and budget woes. They simply buy time by alleviating their impact on global markets while highlighting the growing alarm among policy makers about the strain that is being placed on the fragile global financial system.

Anyway you slice it, putting the euro zone on a sustainable path will involve a solution that is politically ugly. Eisenbeis’ idea fits the bill. You can read his full proposal here. But keep in mind that it makes too much sense to have a real shot at being deployed.