Outline of a Redistribution-Free Debt Redemption Fund for the Euro Area

Abstract

Public debts in the euro area have increased sharply due to the economic crisis, and remain at historically high levels in several countries. In a monetary union, high-debt members represent a permanent threat to financial stability, as they are subject – even if fundamentally solvent – to significant rollover risk. Given the tight financial and economic links between member states, a liquidity crisis in one of them would trigger area-wide turmoil. While prudent fiscal policies are essential to address the legacy debt problem, it takes time for them to bring the debt back to (at least) pre-crisis levels. Against this background, the paper explores the feasibility and desirability of transferring a share of national public debts to a European Redemption Fund. In exchange, each country would transfer a yearly flow of resources to the Fund. We show that it is possible to design such a scheme so that it does not entail any ex-ante cross-country redistribution, while the euro area as a whole would benefit as the lowering of member states’ annual refinancing needs would improve financial stability. The fraction of mutualized debt would be fully redeemed over a reasonable number of years. The scheme would not jeopardize national commitment to debt reduction; if anything, market discipline would become more effective at the margin.

Keywords: euro area, sovereign debt, debt redemption fund, financial stability

JEL Classification: E6, H12, H60