This article builds upon a highly stylised but widespread definition of the ‘Southern’ and ‘Northern’ views on debt mutualisation. It explains both positions in the ongoing Eurozone crisis and what both sides hope to achieve in reshaping the governance of the euro. Both sides agree on many things, such as the current threat to the survival of the euro. But the ‘South’ sees the main threat to the Eurozone as coming from the fear and panic that can suddenly increase borrowing costs and push countries into insolvency. The ‘North’, on the contrary, reckons that the principal menace stems from removing this market pressure too quickly, dampening the need to reform. Both speak of the political backlash that the crisis creates. For the ‘South’ it is excessive austerity in debtor nations that should be resisted; for the ‘North’ it is excessive liabilities in creditor states that can cause resentment. The article concludes that the debate about mutualisation of debt is not just about the future of monetary union, but also about the political future of the European Union. Any successful deal must come up with a recipe of how to (re-)create trust between European citizens and their elected governments.

Introduction

The European summit that ended on 29 June 2012 declared that it was ‘imperative to break the vicious circle between banks and sovereigns’. Markets revived in the hope that the political leaders were finally ready to act to deal with the threat to the euro, and then soon lost heart amid the cacophony of rival interpretations about what had been agreed. Still, the leaders had identified the right issue: weak banks and weak sovereigns are like two bad swimmers that are pulling each other under water (Pisany-Ferry 2012).

But which one should be saved first? Proponents of the ‘Southern view’, like, for instance, Paul de Grauwe (2012) say we should start with the sovereigns, by throwing them the lifejacket of joint-issued debt. In effect, richer countries would guarantee at least part of the debt of weaker ones.

Representatives of the ‘Northern’, and let’s say especially the ‘German’ view, reckon instead that it is better to start by saving the banks. This would be done through stronger central supervision and the mutualisation of some liabilities in the banking sector, for instance through a joint fund to wind up failing banks and provide a Europe-wide guarantee of bank deposits. In effect depositors in solid banks would be guaranteeing the savings of those in more fragile ones.

This article builds upon a highly stylised but widespread definition of the ‘Southern’ and ‘Northern’ views. The former is usually held by countries like Greece, Italy, Portugal and Spain and, since François Hollande has taken office, also France. The latter is often used synonymous with the ‘German’ view and also includes countries like Austria, Finland and the Netherlands and, for some periods under French President Nicolas Sarkozy, also France (Merler and Pisany-Ferry 2012; see also a recent statement by the French Minister of Finance who points to the need for common debt instruments: http://www.reuters.com/article/2012/10/30/Eurozonefrance-germany-idUSL5E8LU44020121030). Since the exact characteristics of both views may still remain unclear, the remainder of this article examines them more deeply.

Both sides – the ‘North’ and the ‘South’ – agree on many things, such as the current threat to the survival of the euro. They both recognise the danger that debt mutualisation could bring moral hazard and higher costs for creditor countries. For representatives of the ‘Northern view’ there is no getting around these problems. For the ‘South’, though, these risks can be removed, or at least mitigated through careful design of the system. For instance, the Eurozone could impose conditions on countries seeking the benefit of jointly issued debt.

The ‘South’ sees the main threat to the Eurozone as coming from the fear and panic that can suddenly increase borrowing costs and push countries into insolvency (Pisany-Ferry 2012). The ‘North’, on the contrary, reckons that the principal menace stems from removing this market pressure too quickly, dampening the need to reform (Sinn and Wollmershäuser 2012).

Both speak of the political backlash that the crisis creates. For the ‘South’ it is excessive austerity in debtor nations that should be resisted; for the ‘North’ it is excessive liabilities in creditor states that can cause resentment. In some ways, though, they are not so far apart. The ‘North’ concedes that it is necessary to have some mutualisation of debt, if only to recapitalise banks (Belke 2012a). The ‘South’ accepts that debt mutualisation must be limited to avoid moral hazard (de Grauwe 2012).

Contrasting the ‘Southern’ and ‘Northern’ Views

In the following, the basic ingredients of the ‘Southern’ and the ‘Northern’ view are contrasted.

The ‘Southern’ View: Some Basics

The main argument of the ‘South’ runs as follows: since the 1970s economists have warned that a budgetary union would be a necessity for a sustainable monetary union. But the founders of the Eurozone had no ears for this warning. It is now patently clear that they were mistaken and that the governments of the euro area member countries face the following hard choice today: either they fix this design failure and move to a budgetary union; or they do not fix it, which means that the euro will have to be abandoned (Pisany-Ferry 2012). Although analysts such as Paul de Grauwe were sceptical about the desirability of a monetary union during the 1990s (contrary to Gros and Thygesen 1998), the same author now takes the view that we cannot properly manage a deconstruction of the Eurozone (de Grauwe 2012). A disintegration of the Eurozone would produce huge economic, social and political upheavals in Europe. If the euro area governments want to avoid these, they have to look for strategies that move us closer towards a budgetary union.

A budgetary union, such as the US one, appears to be so far off that there is no reasonable prospect of achieving this in the Eurozone ‘during our lifetimes’ (Henning and Kessler 2012). Does that imply that the idea of establishing a budgetary union and thus a ‘genuine’ EMU is a pure chimera? De Grauwe (2012) argues that this drastic assessment is not at all valid and that there is a strategy of taking small steps that lead us in the right direction. But before this strategy can be outlined it is – according to the ‘Southern’ view – important to understand one of the main design failures of the Eurozone, which will inform the debate about what exactly has to be fixed.

The ‘Southern’ argument starts with the basic insight that Eurozone governments issue debt in euros, which is a currency they cannot control. As a result, and in contrast to ‘standalone’ countries like the UK, they endow bondholders with a guarantee that the cash to pay them at maturity will always be available (Belke and Burghof 2010).

The fact that governments of the Eurozone are not able to deliver such a guarantee to bondholders makes them vulnerable to upsurges of distrust and fear in the bond markets. This can trigger liquidity crises that in a self-fulfilling way can drive countries towards default, forcing them to apply austerity programmes that lead to deep recessions and ultimately also to banking crises (Claessens et al. 2012; de Grauwe 2011, 2012). This is not to say that countries that have overspent in the past do not have to apply austerity – they will have to (Pisany-Ferry 2012). It is rather that financial markets, when they are driven by panic, force austerity on these countries with an intensity that can trigger major social and political backlashes that policymakers may not be able to control. The effects are there to see in a number of Southern European countries (de Grauwe 2011, 2012; Freedman et al. 2009): namely Greece, Italy, Spain and Portugal.

Their previous diagnosis of a design failure of the Eurozone leads proponents of the ‘Southern’ view to the idea that some form of pooling of government debt is necessary to overcome this failure (Pisany-Ferry 2012). By pooling government debt, the weakest in the union are shielded from the destructive upsurges of fear and panic that regularly arise in the financial markets of a monetary union and that can hit any country. ‘Those that are strong today may become weak tomorrow, and vice versa’ (de Grauwe 2012).

Representatives of the ‘South’ see the ‘moral hazard’ risk that those that profit from the creditworthiness of the strong countries will exploit this and lessen their efforts to reduce debts and deficits. This moral hazard risk is the main obstacle to pooling debt in the Eurozone. The second obstacle is that inevitably the strongest countries will pay a higher interest rate on their debts as they become jointly liable for the debts of governments with lower creditworthiness. Thus debt pooling must be designed in such a way as to overcome these obstacles (Claessens et al. 2012; Pisany-Ferry 2012).

Moderate proponents of the ‘Southern’ view agree, apparently in line with theMerkel government that there are three principles that should be followed in designing the right type of debt pooling (Claessens et al. 2012; de Grauwe 2012; Pisany-Ferry 2012). First, it should be partial – that is, a significant part of the debt must remain the responsibility of the national governments, so as to give them an ongoing incentive to reduce debts and deficits. Several proposals have been made to achieve this (among them Delpla and Weizsäcker 2011, and German Council of Economic Advisors 2012). Second, an internal transfer mechanism between the members of the pool must ensure that the less creditworthy countries compensate (at least partially) the more creditworthy ones (de Grauwe 2012). Third, a tight control mechanism on the progress of national governments in achieving sustainable debt levels must be an essential part of debt pooling. The Padoa-Schioppa group has recently proposed a gradual loss of control over their national budgetary process for the breakers of budgetary rules (Padoa-Schioppa Group 2012).

Proponents of the ‘Southern’ view acknowledge that the Eurozone is in the midst of an existential crisis that is slowly but inexorably destroying its foundations. They immediately conclude that the only way to stop this is to convince the financial markets that the Eurozone is here to stay (de Grauwe 2012; Pisany-Ferry 2012). Their main argument is that debt pooling, which satisfies the principles outlined above, would give a signal to the markets that the members of the Eurozone are serious in their intention to stick together. Without this signal, the markets will not calm down and an end to the euro is inevitable (Aizenman 2012; de Grauwe 2012). In the words of the German Chancellor Angela Merkel: these policies are without alternative.

Materially, the ‘Northern’ view sketched in the following represents the accumulation of a multitude of reactions of the ‘North’ to these much more activist ‘Southern’ proposals of several kinds of debt mutualisation which have been frequently put forward since the onset of the euro crisis (Claessens et al. 2012).

The ‘Northern’ View: Important Facets

One of the main priorities of the ‘Northern’ view is that the mutualisation of the Eurozone’s debt to bring about the convergence of interest rates, as proposed within building block 2 of the Interim Report, will not in the long run tackle the root of the problems. Instead it has the potential to sow the seeds of an even larger crisis in the future (Sinn and Wollmershäuser 2012; Weidmann 2012). They allude to what happened in the early years of the euro, when interest rates largely converged. Paradoxically, perhaps, this paved the way for a greater divergence of national fiscal policies. A reckless lack of discipline in countries such as Greece and Portugal – be they more (Greece) or less (Portugal) insolvent – was matched by the build-up of asset bubbles in other member countries, such as Spain and Ireland, deemed merely illiquid. Structural reforms were delayed, while wages outstripped productivity growth. The representatives of the ‘Northern’ view stress that the consequence was a huge loss of competitiveness in the periphery, which will by definition not be resolved by the mutualisation of debt (Belke 2012a).

Debt mutualisation can take different forms (Aizenman 2012). One is to mutualise newsovereign debt through Eurobonds (Delpla and von Weizsaecker 2010, develop one ofmore than seven variants; Pisany-Ferry 2012). Another is to merge part of the old debt, as advocated by the German Council of Economic Advisors (2012), with its proposal for a partly gold-backed European Redemption Fund (Belke 2012b). A third means is to activate the Eurozone’s ‘firewall’ by using the rescue funds (either the temporary European Financial Stability Facility or the permanent European Stability Mechanism) to buy sovereign bonds on the secondary (or even primary) market, or to inject capital directly into distressed banks. Indeed, the ECB is already engaged in a hidden form of mutualisation – of risk if not (yet) of actual debt – through its programmes of sovereign bond purchases (the Securities Market Programme, SMP, and the announced conditional Outright Monetary Transactions,OMTs) and its long-term refinancing operations for banks.

The view of the ‘North’ is that almost all these are bound to fail, either for economic or political reasons, or both. The governments of even financially strong countries cannot agree to open-ended commitments that could endanger their own financial stability or, given that they are the main guarantors, of the bailout funds. And the danger of moral hazard is ever-present (Belke 2012a).

Proponents of the ‘Northern’ view point to the fact that any form of mutualisation involves an element of subsidy, which severely weakens fiscal discipline: the interest rate premium on bonds of fiscally weaker countries declines and the premium for stronger countries increases. Fiscally solid countries are punished and less solid ones, in turn, are rewarded for their lack of fiscal discipline and excess private and public consumption.

If yields are too low there is no incentive for private investors to buy sovereign bonds. The countries risk becoming decoupled from the capital markets permanently and the debt problems become increasingly structural (Belke 2012b).

This is true also for the ECB’s bond-buying announcements and activities. The credit risk is thus just rolled over from the bonds of the weaker countries to those of the stronger ones (depending on the buyback price), and the ECB is made responsible for its liability. Over time, the ECB’s measures might even be inflationary. Having the rescue funds buy bonds is little different, except that they lack the lending capacity to be credible. If they are given a banking licence, as demanded by the ‘South’ (for instance, by French President Hollande) it would be no different from having the ECB buy bonds directly (Belke 2012b).

What about the European Redemption Fund (ERP) from the ‘Northern’ perspective? This type of fund could be of particular help to Italy, which could unload half of its debt. But its partners could not force Italy to tax its citizens to ensure that it pays back the dormant debt. And with the assumption of debt, the credit rating of Germany might drop, due to the increase of the German interest burden. The pressure on Italy and Spain to consolidate their budgets sustainably would be reduced. The problems of Greece, Ireland and Portugal would not be resolved, since these countries are unlikely to qualify for the ERP.

In addition to moral hazard, there are political obstacles, which would be most acute in the case of Eurobonds. Germany demands political union before Eurobonds can be considered. But this is sometimes said to put the cart before the horse: a political union would be created simply to justify Eurobonds (Gros 2011). Advocates from the Merkel government, like Finance Minister Wolfgang Schäuble, say treaty changes and high-level political agreements would be sufficient to make sure that euro area member countries comply with all decisions taken at the euro area level. This became clear when Wolfgang Schäuble came up with a plan a plan drawn to bolster the power of the EU’s economic and monetary affairs commissioner (Daily Telegraph2012). Even Mario Draghi, President of the European Central Bank, has supported this German scheme to allow the EU to intervene in countries’ budgets and propose changes before they are agreed in parliaments. But the experience with Greece’s adjustment casts severe doubt on the optimism expressed by such a proposal.

Even a quick glance at the World Bank’s databank of ‘governance indicators’ shows that differences between Eurozone members, on everything from respect for the rule of law to administrative capacity, are so great that political union is unlikely to work, at least in the next couple of years. It follows from the perspective of the ‘North’ that the basis for Eurobonds is extremely thin.

According to the ‘Northern’ or ‘German’ view, the introduction of Eurobonds would in principle have to be backed by tight oversight of national fiscal and economic policies. But this view neglects that there is no true enforcement as long as the individual Eurozone members remain sovereign.

Intervening directly in the fiscal sovereignty of member states would require a functioning pan-European democratic legitimacy (Claessens et al. 2012), but we are far from that. Voters in Southern countries can reject the strong conditionality demanded by Brussels at any time, while those of Northern countries can refuse to keep paying for the south. And either can choose to exit the Eurozone (Gros 2011).

The emphasis on pushing through a fiscal union as a precondition for debt mutualisation means the debate, at least in Germany, has become a question of ‘all or nothing’: either deeper political union or deep chaos (Belke 2012a; de Grauwe 2011). This unnecessarily narrows the strategic options for the players and causes the permanent ‘North—South’ divide described in this section, which is severely hampering the realisation of a ‘genuine’ monetary and economic union (President of the European Council 2012).

However, I argue that there is in fact an alternative option to the notion of cooperative fiscal federalism involving bailouts and debt mutualisation: competition-based fiscal federalism, of the sort successfully operating in the USA, Canada and Switzerland, among others. These countries have largely avoided serious and sustained public debt in their component states. The sub-federal entities, faced with insolvency, have a great incentive to take early corrective action – without having to force the member states into a corset of centralised fiscal policy coordination (von Hagen 1993). This approach seems to be a good compromise between the ‘Southern’ and ‘Northern’ views.

To achieve this sort of federalism, it is necessary to separate the fate of the banks from that of the sovereigns. What is needed is not a fiscal union in first instance, but a banking union. It should be based on four elements: a European bank with far-reaching powers to intervene; reformed banking regulation with significantly higher equity capital standards; a banking resolution fund; and a European deposit insurance scheme. At least the first ingredients have also been recognised and acknowledged by the Merkel government.

A banking union – a less comprehensive, more clearly delineated and rather technical task – should be much more acceptable for the ‘North’ than the Europeanisation of fiscal policy as a whole. This is exactly because it touches upon only a small fraction of the fiscal policy areas which have to be subordinated to central control in a fiscal union.

Obviously, a central resolution authority has to be endowed with the resources to wind up large cross-border banks. Where does the money for this come from? In the long run, the existence of a resolution authority goes along with a deposit insurance scheme for cross-border banks. This should be – according to the ‘German’ view – funded partly by the banking industry. But there should also be a backstop by the euro area governments provided through the EFSF or the ESM in order to cope with situations of systemic bank failure (Gros and Schoenmaker 2012).

As a temporary transition measure, however, limited debt mutualisation may then be necessary – but only to recapitalise banks that cannot be sustained by their sovereigns. The amounts required are much smaller than for, say Eurobonds (Gros and Schoenmaker 2012).

With the banking system and the debt crisis thus disentangled, banking sector losses will no longer threaten to destroy the solvency of solid sovereigns such as Ireland and Spain. Eurobonds will then not be needed, and neither will the bailout of sovereigns. The debt of over-indebted states could be restructured, which means that the capital market could exert stronger discipline on borrowers (Belke 2012a).

There are at least two questions left which have yet to be covered in this article and which will be answered in the next sections. If the banking sector is really to be stabilised, a solution will surely have to deal with the devalued sovereign debt that some are holding. Would the banks not be better off holding at least some Eurobonds instead of, say, Greek or Spanish bonds? That said, ‘Southern’ economists who advocate Eurobonds need to find a way of making them politically acceptable. And how much political union is feasible, or even desirable, just for the sake of a single currency that many never loved? And also, where does the burden end up?

Rebuttal – Banking Union and Other Issues

For ‘Northern’ governments like the German one, mutualisation of debt is just another form of subsidy and bail-out that the markets clamour for, be it the overt help given to Greece or the more discreet liquidity provided by the European Central Bank.

The fact that there is a loud chorus demanding subsidies does not, in Germany’s view, make it right (Belke 2012a). The Merkel government argues that assistance does not help countries make the necessary macroeconomic adjustment in either public or private borrowing. Safeguards and conditions as standalone measures will not work. Anything that puts off the rebalancing of the current account deficit only builds up the forces for the disintegration of the Eurozone. Watching the ‘South’ borrow and spend themselves into bankruptcy and then bailing them out is called both immoral and irresponsible.

In their rebuttal, ‘Southern’ governments target what they regard as the contradiction in the ‘North’s’ position, rejecting debt mutualisation while supporting a joint Eurozone backstop for the banking sector (de Grauwe 2012). Are banks any more trustworthy than sovereigns?

The ‘South’ usually argues, moreover, that mutualisation of banking liabilities will inevitably be followed by the pooling of debt. Banking union on its own, for instance, de Grauwe (2012) notes, would protect the sovereigns from banking crises. But it would not protect banks from sovereign debt crises. If banking union must be followed by the fiscal sort, it would be best to do it at the same time, the ‘South’ argues.

Many questions remain unresolved. Some German politicians identify the tendency of the single currency to push the economies of its members apart (Belke 2012a). If each country is to fend for itself, as some proponents of the ‘German’ view say, would they not be better off restoring their own national currencies so that macroeconomic adjustment can take place more painlessly? As a blogger in The Economist Online put it, ‘The south will end up having to leave the euro to save what’s left of its economy’. (https://www.economist.com/users/turbatothomas/comments?page=1).

Closing – Debt Mutualisation Versus Fiscal Federalism

‘South’: A Monetary Union Cannot Last Without Debt Mutualisation to Avoid Deflation

The key issue is this: can a monetary union last without some form of fiscal union? Economists have been debating this issue for decades. It seems, at least to the ‘South’, that the consensus among them is that a monetary union without some form of fiscal union will not last.

What kind of fiscal union is necessary to sustain a monetary union? ‘Southern’ governments tend to argue that such a fiscal union must have two components. First, it must have some insurance component, i.e. there must be some transfer mechanism from regions (countries) that experience good economic times to regions (countries) that experience bad times. (The Interim Report alternatively proposes a central budget with a similar function; see President of the European Council 2012). According to the ‘South’, the USA is often seen as a successful monetary union, partly because the federal government’s budget performs this role of insurance (Henning and Kessler 2012). Also ‘Southern’ governments are eager to point out that the opponents will not cease to stress that such an insurance mechanism creates moral hazard issues. But that is the case with all insurance mechanisms. Representatives of the ‘Southern’ view argue as an analogy that one generally also does not conclude that people should not have fire insurance because such insurance creates moral hazard, i.e. it will lead to more fires.

The second component of a fiscal union is some degree of debt pooling. Economists defending the ‘Southern’ view have argued that this is necessary because, in becoming members of a monetary union, countries have to issue debt in a ‘foreign’ currency and therefore become more vulnerable to upsurges of distrust and fear in financial markets. These can in a self-fulfilling way push countries into a bad equilibrium that makes it more difficult for them to adjust to imbalances (de Grauwe 2012). Of course, debt pooling does not solve these fundamental problems (as ‘Northern’ governments suggest that the ‘South’ believes), but it avoids pushing countries, like Spain today, into a deflationary spiral that makes their debt problems worse, not better.

Thus monetary union and fiscal union (including some degree of debt mutualisation) are the opposite sides of the same coin. As has become clear in the previous sections, the proponents of the ‘Northern’ view like to refer to history. The ‘Southern’ economists do this also. According to them, there are no successful monetary unions that are not embedded in a fiscal union that includes debt mutualisation.

Some economists, especially in Northern Europe, continue to argue that one can have a monetary union without a fiscal union. Paul de Grauwe (2012), for instance, reduces the ‘Northern’ view to something like ‘all we need is discipline (a fiscal compact?), including a credible no-bail-out clause. If we allow governments to default, financial markets will do their work in disciplining these governments’. According to the ‘South’ and the Interim Report by the President of the European Council (2012) as well, this view can certainly not be taken seriously any more (de Grauwe 2012). This is because financial markets are entirely incapable of applying the right discipline on governments. When markets are euphoric, as they were during the 10 years before the crisis, they intensify indiscipline by giving incentives to borrowers and lenders alike to create excessive debt and credit. Since the crisis erupted, financial markets have been in a continuous state of fear and panic, leading them to apply excessive discipline that has improved nothing and could not prevent increasing debt burdens (de Grauwe 2012).

When this debate will have been settled it will – according to the ‘Southern’ view – be clear that the greatest obstacle to debt mutualisation and to the continuing existence of the Eurozone is a lack of trust (Belke 2012c; de Grauwe 2011). Northern European countries distrust southern European countries and have propagated the myth that the North is morally superior compared with the corrupt regimes in the South. In Northern mythology, southern European countries are seen as completely incapable of setting their house in order. Lending money to these countries is pouring the ‘hard-earned money of virtuous German savers’ into a bottomless pit.

‘North’: Towards a Concept of Competition-Based Fiscal Federalism in the Eurozone

The most important components of a competition-based fiscal federalism that would make Eurobonds unnecessary were set out earlier in this article. This is not because banking union is equivalent to Eurobonds (as claimed by de Grauwe 2012) but because it would disentangle a banking and a sovereign-debt crisis. With a solid banking system in place, banking sector losses would no longer threaten the solvency of solid sovereigns (such as Ireland and Spain), and the bail-out of less reliable sovereigns would no longer be necessary. That means there would be a lower chance that fundamentally sound sovereigns would suffer from a confidence crisis and rocketing risk premiums.

Proponents of the ‘Northern’ view do not accept the argument of the ‘South’, coined for instance by de Grauwe (2012), that a banking union does not protect the banks from sovereign failures. In a banking union, the capital market could exert its disciplining influence more effectively than it does now. Debt restructuring for insolvent states would become more probable. The debtor state would lose its strongest asset (the claim that default would cause huge damage to the entire financial system) and creditors could not rely on taxpayers to get their money back. This, in turn, would put governments with unsound finances under pressure to curb their deficits.

Instead they hint at a wide array of econometric studies showing a systematic relationship of sovereign bond yields and the anticipated sustainability of a country’s public debt – at least in the medium term. They leave it to the Banca d’Italia’s research department to come up with convertibility risk (measured by google-nomics, counting google searches for ‘euro area breakup’) as an explanatory variable of Southern sovereign bond yield spreads over the German one (Di Cesare et al. 2012). Only recently, the spread on Spanish bonds moved up after Mariano Rajoy, the Spanish prime minister, announced that he intended to relax Spain’s deficit-adjustment path; the same was true when Italy decelerated its pace of reforms. Hence proponents of the ‘Northern’ view can sleep quite well with the idea that ‘capital markets will take care of the rest’.

To get rid of the fragility of the banking system, we need to establish a temporary or even permanent European Resolution Authority (ERA), whose task would be to sort out fragile banks across Europe, regardless of size. Weaker banks would receive a one-time injection of capital or be wound down, wholly or partly. This body should have the power to turn bank debt into equity capital. Creditors of ailing banks – but not the taxpayers, as de Grauwe (2012) assumes – should as far as possible be made liable for their risky investments. In contrast with Eurobonds, which tend to cover a lot of bad risks, a European deposit scheme based on funding from the banks themselves (in order to avoid the taxpayers bearing the risk) would in the end embrace only stronger banks (Gros and Schoenmaker 2012).

The ‘North’ admits to the ‘South’ that is right to argue that the lack of a budgetary union, akin to the American system, is a design failure of the Eurozone. Proponents of the ‘Northern’ view also strongly support the ‘South’s’ view that a proper application of the American system would prevent a costly disintegration – but most probably for different reasons. Since the US system prevents central bank loans from being more attractive than market loans, it avoids permanent balance-of-payment imbalances between member states. In America, neither the individual state nor the private sector has access to the printing press to finance itself and can also default. If the inhabitants of a state need to finance their current account deficits, they have to offer attractive interest rates and provide sufficient collateral to private lenders from other American states (Henning and Kessler 2012; Belke 2012a).

Yet the ‘South’ argues, essentially, that the main problem of Eurozone countries is that they do not have direct access to the printing press (de Grauwe 2012). According to the ‘North’, it is thus following the strange behaviour of rating agencies, which penalise members of the Eurozone simply for being part of the single currency. For too long the agencies rated countries too generously, pricing in a potential bail-out rather than basing ratings purely on macroeconomic fundamentals. This pattern made possible riskless profits from riskless speculation against sometimes hopelessly noncompetitive member states. The ‘South’ reinterprets this as a question of ‘panicked financial markets’ in its mother of all arguments for debt pooling (de Grauwe 2012).

Especially according to the ‘Northern’ view, the members of the Eurozone are intentionally kept away from the ECB to avoid them activating the inflation tax to finance themselves. The scope for an individual country to incur government debt is simply lower within a currency union than outside. This scope cannot be extended through debt pooling without risking the disintegration of the Eurozone (Belke 2012a).

But the ‘Northern’ view contains a lot more. As a rule, the burden on bank balance sheets should be borne by the country of domicile and not – as in the case of Eurobonds – be passed on to other countries. However, it is not clear whether and to what extent over-indebted countries will be capable of doing this. Using the rescue funds would make sense as a fiscal backstop. Subject to negotiation, a temporary debt mutualisation to cover the cost of bank recapitalisation would make sense, to avoid a larger and permanent mutualisation of sovereign debt. But only after a proper pan-European banking oversight has been worked out and implemented (Belke 2012a).

Remarkably, the “South” on some occasions outlines hard budget constraints to accompany debt pooling (Pisany-Ferry 2012; de Grauwe 2012). Its representatives propose binding mechanisms of compensating the more creditworthy countries and controlling the behaviour of those that are less so. But, according to the “Northern” view, historical experience gives reason to doubt that this will work – for several reasons.

One is that, for instance, Spanish foreign debt is currently among the greatest risks for the euro zone, and it is essentially private. As long as the private sector has access to the ECB system at interest rates that are below the market rate, the correction of external imbalances through real internal devaluations will not take place or if it does, at least not in sufficient quantities. The “South’s” approach would require not only public debt limits but also private debt barriers to bring about such a correction, the “North” claims, but that would be an absurd endeavour.

According to the “North”, the “South” should draw some lessons from the current conduct of monetary policy. The latter already uses debt pooling, of a sort. The quality of the collateral that the ECB accepts varies considerably from country to country. In the case of the ECB’s lending to Greek banks, it consists of doubtful private Greek assets and Greek government debt whose value depends on election results, as has been recently observed. Thus the ECB acts as a central counterparty for crossborder lending which incurs risks along national lines (Gros et al. 2012). Risk mutualisation could well, if things go wrong, turn into full debt mutualisation, and lead to conflicts between member states. It provides an advance warning of how debt pooling could lead to the disintegration of the eurozone.

Conclusion – The Pre-eminent Role of Trust

Throughout the Eurozone’s debt crisis, many Europeans have looked across the Atlantic for lessons on how to run a successful monetary union. The European Commission boasts that, taken together, the Eurozone’s fiscal deficit and debt are lower than America’s. Yet the euro faces an existential crisis while the dollar, despite the troubles of the American economy, still remains a shelter.

So, how much banking and fiscal integration does the Eurozone need in order to restore stability? And how much political unity does it need to maintain checks and balances, and democratic legitimacy? Looking at the USA, ‘Southern’ and ‘Northern’ economists and politicians more or less agree on the need for some kind of federalised system to recapitalise, restructure or wind down ailing banks. That is where the ‘North’ thinks integration should stop – in contrast to the Interim Report (President of the EU Council 2012). The key lesson from the USA is, in its view, that it pays to enhance market discipline on the states: as long as the banking system is stabilised at minimal cost to the taxpayer, over-indebted states can be allowed to go bust (Henning and Kessler 2012). But proponents of the ‘South’ think that this deals with only half of the vicious circle between weak banks and weak sovereigns. So it cannot work in the long run. What makes America and other monetary unions stable is a system of joint bonds and other forms of mutual insurance, and internal transfers to redress economic imbalances (de Grauwe 2012).

So the debate about mutualisation of debt is not just about the future of monetary union, but also about the political future of the European Union. Leaders usually try to avoid such questions about the end point, known as the finalité politique. Any successful deal must come up with a recipe of how to (re-)create trust between European citizens and their elected governments.

See Also