Debt Mutualization in the Euro Area: A Quantitative Exploration

Debt Mutualization in the Euro Area: A Quantitative Exploration Sakai Ando, Giovanni Dell’Ariccia, Pierre-Olivier Gourinchas, Guido Lorenzoni, Adrian Peralta-Alva and Francisco Roch WP/23/59 IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management. 2023 MAR *We thank Carlos Angulo for excellent research assistance. The views expressed in this paper are those of the authors and do notnecessarily represent those of the IMF, its Executive Board, or its management.© 2023 International Monetary Fund WP/23/59IMF Working Paper Research Department Debt Mutualization in the Euro Area: A Quantitative Exploration Sakai Ando, Giovanni Dell’Ariccia, Pierre-Olivier Gourinchas, Guido Lorenzoni, Adrian Peralta-Alva and Francisco Roch* Authorized for distribution by Pierre-Olivier Gourinchas March 2023 IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management. ABSTRACT: This paper explores the feasibility of an idea proposed first by the German Council of Economic Experts in 2011 and revisited by Italian and French authorities in 2021: the one-off mutualization of some European legacy debt through the creation of a European Debt Management Agency (EDMA). The paper does not argue in favor or against these proposals or make a proposal of its own. Rather it outlines a conceptual framework that can be used to quantify the contours of mutualization proposals and draws lessons from the debt assumption in the United States in 1790. The framework suggests that by capitalizing the convenience yield on European-wide safe assets, the EDMA could issue up to 15 percent of euro area GDP, helping to put national debts on a sounder trajectory. The analysis suggests that, without mutualization, some euro area countries are likely to experience decreasing debt-to-GDP ratios over the forecast period. This is not the case for Belgium, Finland, France, Italy, and Spain, where further fiscal consolidation would be needed. For these countries, we consider the effects of a debt mutualization equivalent to 26 percent of their GDP. For Italy, this operation alone is enough to ensure a decreasing debt-to-GDP path. For the others, the news is more mixed: while the additional fiscal consolidation is smaller, 1.3 to 2.3 percent of GDP are still required to reduce debt with 95 percent probability. JEL Classification Numbers: E61, F34, F45, H63. Keywords: Sovereign Debt; Debt Mutualization; Debt Assumption; ConvenienceYield; Safe Assets.Author’s E-Mail Address: sando@imf.org, gdellariccia@imf.org, pgourinchas@imf.org, guido.lorenzoni@chicagobooth.edu, froch@imf.org 3 WORKING PAPERS Debt Mutualization in the Euro Area: A Quantitative Exploration Prepared by Sakai Ando, Giovanni Dell’Ariccia, Pierre-Olivier Gourinchas, Guido Lorenzoni, Adrian Peralta-Alva and Francisco Roch 4 Introduction In response to the COVID-19 crisis, both advanced and emerging market economies have implemented large fiscal stimulus programs that have pushed public debt to historically high levels. In the euro area, fiscal rules were suspended, and the lockdown-driven contraction and associated policy response led sovereign debt to new heights. Further, while large increases in debt-to-GDP ratios were widespread, these were not symmetric, with some countries suffering more than others. Some relief on COVID related debts has been provided by NextGenerationEU, but these countries remain in an asymmetric situation. The swift post-COVID recovery and surprise inflation, together with the discontinuation of several costly crisis-related measures have led to a stabilization and in some cases reduction in debt ratios. However, some countries’ debt remains at a level at which sustainability can be questioned in the future, leaving them potentially exposed to self-fulfilling runs. This is especially relevant since real interest rates are rising and likely to remain relatively higher for some time. Put differently, elevated debt levels and higher interest rates move debt dynamics in the ‘danger zone’ where liquidity runs are more likely and could morph into solvency problems (Calvo, 1988; Lorenzoni and Werning, 2019). Indeed, sovereign spreads, while remaining well below the levels experienced during the GFC, have started to rise and become more volatile. In practice, central banks have a critical role to play to prevent liquidity runs on domestic debt via temporary interventions—preferably ‘off the equilibrium path,’ coupled with a strong institutional setting that enshrines monetary independe