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EUROPEAN REDEMPTION FUND
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German Council of Economic Experts proposed in the Annual Report 2011/12 a European redemption pact: 184. With their resolutions of 26 October 2011 the governments of the member states made a renewed strong effort to steady the monetary union. At the same time, the Italian government has undertaken to implement additional structural reforms over and above the consolidation measures already decided, in particular as regards labour law and pension insurance. The package now resolved is no definitive solution to the euro area’s problems. But it offers politics a window of opportunity in time that it must use consistently in order to create an overall policy framework for the euro area characterized not only by sound government financing but also by a stable financial system. This is not to advocate overly hasty measures. The key contribution to stabilizing the markets must come from the problem countries themselves by coherently implementing the austerity packages announced. The key contribution to stabilizing the markets must come from the problem countries themselves by coherently implementing the austerity packages announced. Together with the increased clout of the EFSF it should then be possible to steady market confidence in euro area government finances. This should initially be prioritized.

186. However, in particular under more unfavourable economic conditions and given the increasingly uncertain political situation in Greece there is no excluding that investor uncertainty will nevertheless persist and make what is not an easy task of consolidation all the more difficult. In the event of such an unfavourable scenario, the strategy pursued since last year of gradually expanding the EFSF would come up against its limits. There would then be the threat either of the uncontrolled break-up of the EMU or of the ECB’s unlimited purchase of securities, which would be very dubious.
187. In the event that the now resolved strengthening of the EFSF proves to be insufficient despite on-going efforts by the member states to consolidate and reform, a model should be tested that on the one hand hinges on more extensive support than the EFSF and on the other includes far more stringent mechanisms to reduce government debt. The model for a “European redemption pact” outlined below is a conscious departure from the practice hitherto of covering debts by ever greater debts by setting out a binding repayment plan that (alongside the binding introduction of national debt caps) will be secured by the currency reserves of the member states and taxes specifically foreseen for repayment.

188. Under the European redemption pact, debt amounts above the Maastricht reference value of 60 per cent of GDP would be transferred to a common redemption fund subject to joint liability. A consolidation path would concurrently be laid down for each country under which it would be obligated to autonomously redeem the transferred debt over a period of 20 to 25 years. This is roughly equivalent to the debt reduction rule contained in the Stability and Growth Pact (SGP), which stipulates that excess debt above the 60 per cent ceiling must be reduced at an annual rate of 1/20. The debts that remain exclusively with the participating countries would be additionally limited by the introduction of national debt brakes. To stabilize the European financial markets, the redemption pact offers euro-area member countries the possibility of covering their current funding needs (for the redemption of outstanding bonds and new borrowing) via the redemption fund until the credit facility is fully utilized. As existing debts are thus not transferred to the fund all at once but instead successively over a roll-in-phase of around five years, this would provide strong incentives for fiscal discipline. Thereafter a country's outstanding debt level would comprise− debts for which it is individually liable amounting to 60 per cent of its GDP, and− debts that, at the time of the transfer, exceed the reference value of 60 per cent of GDP and are transferred to the redemption fund. These debts are likewise redeemed by the individual country. The transferring country bears the primary liability and the redemption fund a secondary liability.
In this way, in the years that follow (roll-in-phase) the redemption fund would accrue bond holdings of about € 2.3 trillion. Germany would account for 25 per cent of the portfolio, placing second behind Italy with 41 per cent. Other important borrowers of the redemption fund would be France, Belgium and Spain (Chart 32, page 108).

189. Key features of the concept are that there would be an upward cap on the amount of the debt in the redemption fund after the roll-in-phase and that, in addition, each country is obliged to redeem its own debt over a period of between 20 and 25 years. The joint liability during the repayment phase means that safe bonds would be created by means of which the European financial system could be stabilized until the national bond markets regain sufficient functionality. The transfers to the redemption fund would have to be structured in a way that ensures that the transferred debt is indeed paid down over a period of approximately 20 to 25 years. At the same time it must be ensured that:

− the establishment of the redemption fund is and remains an exceptional episode of limited duration, and
− the debts for which the member countries are solely liable do not again exceed the ceiling of 60 per cent of GDP stipulated in the Maastricht Treaty.

190. The redemption fund, which draws on the historical example of a comparable fund in the United States in 1790 (Box 9), can only be justified in this form if joint liability is coupled with strict fiscal discipline. This must rest on five pillars:

− By way of institutional framework the redemption fund requires implementation of a national debt brakes in the national constitutions of the participating nations as only then can credibility in the long-term commitment to consolidation be guaranteed. The debt caps should take their cue from the goals of the reformed Stability and Growth Pact. In particular, it should be ensured that after a transitional phase the structural budget deficit does not exceed the threshold of 0.5 per cent of GDP. The binding nature of the national debt caps should also be intensified by having them monitored by an independent European agency such as the European Court of Auditors. If a country violates the stipulations of its debt cap, an immediate fine would have to be paid to the redemption fund to which the countries would commit before taking part in the redemption pact (analogous to the “debt solidarity surcharge”, JG 2009, item 128). Since the proposal is limited to the euro area, it would be simplest in the event of each violation of a debt brake ascertained to automatically assign the country in question’s share of the central bank profits to the redemption fund by way of accelerated repayment.
− A second central fiscal hedge for the redemption fund: a jointly defined medium-term consolidation and growth strategy for all participating countries. It should be designed such that over a period of 20-25 years it is possible to cut the debt-to-GDP ratio to 60 per cent. A key role should be accorded medium-term paths for the public expenditure which politicians control. Moreover, the strategy should contain a catalogue of actual measures for structural reforms. As an important hedging mechanism there should be the option to terminate the joint liability for new debt if a country does not meet the commitments innate in the consolidation and growth strategy. The “roll-in” would then be immediately discontinued and the country in question would be fully exposed once again to the international financial market.
− To ensure debt repayment to the fund, a participating country must, thirdly, undertake to charge a mark-up on a national tax (VAT and/or income tax), whereby the revenue does not accrue to the national budget but is injected straight into the redemption fund. Following the example of most US federal states it is conceivable that the payments to the redemption fund could be granted precedence in the national constitutions over other expenditure (Cooley und Marimon, 2011).
− To limit the liability risks and also factor in a national contribution, fourthly, all countries participating would have to pledge part of their national currency reserves (foreign currency or gold reserves) to cover their liabilities. The central banks’ gold reserves have for decades now become functionless in terms of monetary and currency policy and could therefore be used as a pledge without this impairing national economic policy. For the individual euro area member states the foreign exchange reserves have also ceased to have a function as the ECB is now responsible for intervention in the foreign exchange market. All in all, a sum of 20 per cent of the loans provided by the fund would need to be guaranteed in this way.
− To cover the eventuality that an individual participating country is called on to pay up under its joint and serveral liability, its risk would have to be limited by agreeing a burdensharing scheme among the remaining solvent participating countries.

191. The redemption pact would no doubt stand up to scrutiny by the German Supreme Court. According to its ruling of 7 September 2011, German Parliament may not transfer its responsibility for the budget to other actors by indeterminate budget policy authorizations. What is decisive here is first the option the German legislative then has on a case by case basis to decide on support payments to its European partners that impact on expenditure. Second, the potential encumbrance of the German federal budget must be constrained in time, scale and in substance. The upper and lower houses can decide to establish a special fund as part of the redemption pact. This sets the maximum financial volume for which Germany would be liable. The special fund created in the above-mentioned manner would be refinanced by issuing own bonds that would, owing to the structure involved, come under joint liability. Once the last debt in the special fund is redeemed, there would cease to be any need to issue such bonds. Over time, the joint bonds would therefore automatically abolish themselves. While the legislative would not be able to decide over every individual bond issued by the redemption fund, it would be able to set the maximum volume of the fund in the context of which it issues bonds. Decisions by the other member states would not raise this sum, meaning that the legislative would duly participate in the fund’s decisions such as impact on national expenditure.
Just like the other member states, Germany would have to cover its own repayment obligations under the debt transferred to the special fund. No new encumbrance would arise owing to these redemption payments. Presumably, higher interest would then have to be made than at present, especially as Germany can in this regard be considered the beneficiary of the debt crisis. While there would be joint liability for the redemption fund of a maximum of € 2.3 trillion, for which Germany would have to stand tall if all other European borrowers default and cannot service their debt, such a case of liability is highly improbable. There is a somewhat greater probability that a single country cannot cover its interest payments. The resulting burden is limited, however. The liability risk that Germany would face each year would therefore not tie the hands of the German legislative particularly tightly and prevent it from exercising its effective right to set the budget.
The guarantee mechanism related to the redemption pact also serves to limit the liability risk to which the financially strong countries, in particular Germany, are exposed. Since the foreign exchange reserves have to be deposited in full at the beginning of the “roll-in”, precautions
would have been made even for the unfavourable event that one country should not be able to enshrine a debt brake in its constitution, meaning that its membership of the redemption pact would have to be terminated. It should therefore be possible to ensure the limitation in scale of the obligations under fiscal policy that Germany would have to shoulder in the redemption pact.

192. More critical is the limitation in time of the special fund. For the reduction of the debt transferred to the redemption fund some 20-25 years would be needed. In this relatively long period, there will presumably repeatedly be temptations to the players in European policy and to the member states to turn the redemption fund into a permanent institution. This would turn the indebtedness in the euro area into a community property in the long run. Establishing a redemption fund can therefore only be seriously undertaken if the contractual terms exclude the special fund becoming a permanent agency to refinance the euro countries. However, the completely credible creation of the fund as a temporary institution in the European treaties will not be possible. The analysis of centralizing processes in federal states shows impressively that institutions at a supra-ordinated state level, once created, can hardly ever be transposed back into the jurisdiction of subordinate local corporate entities. The German legislative would therefore from the outset have to pre-empt any perpetuation of the redemption fund with article 146 of the German Basic Law.

193. Of crucial importance to the redemption pact is the structure of the interest and redemption payments to be made by the participating countries. They should be defined and set as a firm portion of GDP as if the liabilities would be repaid completely in 20-25 years.
Since the payments then depend on the economic cycle, an automatic stabilizer to hedge against asymmetric shocks would be established that would however be comparably weak in nature.
In order to give a country the chance to accumulate the primary surplus needed for the payments to be made in the medium term, the payments could in the first five years gradually be adjusted to the level needed in the medium term. This adjustment path could be structured such that each country initially repays one per cent of the debt transferred to the fund and additionally makes interest payments on its portion of the redemption fund. After five years, the payments as a proportion of GDP would be kept constant.

194. The joint liability for the redemption fund means that the highly indebted countries participating have an interest advantage on the debt held in the fund which can be used to redeem debt without placing additional strain on the national budgets. This creates strong incentives for participation that should make it easier for national parliaments to agree to the measures set in the consolidation and growth pact. For Germany, by contrast, there will probably be a slight additional burden, one that would be limited by the fact that given the volume of the redemption fund of € 2.3 trillion a highly liquid market would be created that we can expect to trigger effects lowering interest rates.

195. We will take the example of Italy and 2012 as a starting year to show how the financing mechanism functions (Table 13, page 112). With a debt to GDP ratio of 120,3% and nominal debt totalling 1 911 billion Euro, Italy would finally transfer 958 billion Euro to the redemption fund; this amounts to the 60.3 percentage points by which the debt-to-GDP ratio lies above the target level of 60 per cent in the first year. The debt will be transferred to the fund by allowing Italy to refinance its financial needs in the next years up to the agreed amount of 958 billion Euro (roll-in phase). Given the current maturity profile of Italy’s outstanding debt, this would be the case in 2016. Because each country has to service and redeem its obligations already transferred to the fund, the final amount after completing the roll-in is 923 billion Euro (Table 13, row 2). The debt still coming under national liability would increase to 1 073 billion Euro given that the debt ratio is fixed at 60% and the annual growth rate of nominal GDP is assumed to be 3% (Table 13, row 5).




Calculation of the annual payments starts with the final status of the debt transferred to the fund of € 923 billion and with the goal of repaying this given an annual growth rate of nominal GDP of 3 per cent over a total of 25 years. If we assume that the fund could refinance itself at an interest rate of 4 per cent, then for Italy in the first year after the five-year roll-in phase payments of an annual 3 per cent of GDP would be incurred, which would be composed of interest and redemption payment. The current payments would remain constant relative to economic output for the entire remaining term, with only the split between interest and redemption payments changing. After 24 years, Italy would have completely repaid its debts in the redemption fund. During the roll-in phase, allocations would initially be lower and would be geared to the proportion of debt already financed through the redemption fund. After 24 years when the redemption fund expires, Italy had its debt fully repaid.
In order to limit the debt level to 60 per cent of GDP through to the end of the redemption fund’s lifetime, from the beginning a constant primary surplus of 4.2 per cent would be required (Table 13, Chart 33). This is an ambitious goal, but current budget planning envisages, so the IMF’s forecast, a primary surplus of 2.6 per cent in 2012 and of 4 per cent (2013) and 4½ per cent (2014 to 2016) thereafter. It bears considering here that for Italy the financing through the fund spells a clear easing of current interest payments. If one assumes that Italy would, were it not to participate in the redemption fund, have to pay interest of 7 per cent for its debt, then after the roll-in phase a primary balance of 7.3 per cent would have to be booked in order to likewise reduce the debt level to 60 per cent (Table 13). The consolidation task would then be considerably harder to achieve.

It needs to be noted, that the sample repayment path considered above, which is in accordance with the SGP’s reformed debt rule, is less ambitious than the repayment path required by the deficit rule of the SGP under which the structural budget deficit must not exceed 0.5 per cent
of GDP. The national debt brakes that participating countries would have to implement in their national constitutions would in principle have to be in accordance with this more ambitions goal for the structural deficit. Similar to the debt brake already implemented in Germany, the national debt brakes would have to define a transition period, until they reach their maximal binding force. In the case of Italy, a debt brake with these features would create an additional consolidation requirement of 1 per cent of GDP in the medium term. This would cause gross national debt to decline to 40 per cent of GDP until the time the redemption fund expires (Chart 33).

196. For Germany, participation in the redemption fund would mean that the debt transferred would likewise be repaid in 2035. Since the payments to the redemption fund impact on the deficit, implementation of the redemption pact would actually lead in Germany to consolidation
that goes beyond the stipulations of the debt brake already implanted in Germany. The required primary surplus would be about 0.5 per cent of GDP higher than if consolidation were to be undertaken solely by the debt cap, meaning that Germany could dip below the limit of 60 per cent of GDP for its entire sovereign debt as early as 2023. If it relied only on the debt cap, it would not reach the goal until three years later.
As regards the additional interest costs, assuming an interest differential of one percentage point between the refinancing costs of the redemption fund and those for Germany, and a debt of € 579 billion transferred to the fund, the additional annual interest payment would be about 0.3 per cent of GDP. It bears considering here that the current extremely low interest rate for German bonds is primarily the product of the crisis-stricken situation in the euro area and cannot therefore be viewed as a medium-term equilibrium level.

197. Should it not be possible in the time gained by the 26 October 2011 resolutions to turn the EU debt crisis around, and should the euro area member states not be able to agree on a solution in the sense of a redemption pact, then two possibilities would remain to avert an impending financial crisis. In its function as lender of last resort, the European Central Bank would in an unfavourable setting not be able to avoid having to again buy treasury bonds in the secondary market. This would be highly questionable. Another option would be to pursue a strategy of small-step changes and leverage the European Stability Mechanism by relying on the recent resolutions. The danger here would be that the financial volume to be applied could likewise reach dimensions such as are envisaged for the redemption fund, without it being possible to establish an appropriately structured consolidation programme to reduce the debt in the overly indebted member states. The ECB would then likewise not be clearly relieved of its function as lender of last resort.