In return for offering the exchange against a haircut, the EMF would acquire the claims against the defaulting country, which would then receive any additional funds from the EMF only for specific purposes that the EMF approves.
Other EU transfer payments would also be disbursed by the EMF under strict scrutiny, or they could be used to pay down the defaulting country’s debt to the EMF. Thus, the EMF would provide a framework for sovereign bankruptcy comparable to the procedures that exist in the US for bankrupt companies that qualify for restructuring.
How would the EMF finance its interventions? We propose to establish a common insurance fund with contributions proportional to the risk that each member country represents. Ideally, one should base the contributions on market indicators of default risk. But the very existence of the EMF would distort credit-default swap spreads and yield differentials among EMF members.
We therefore propose that contributions to the EMF should be based on member countries’ fiscal deficits and public debt levels, because both represent warning signs of impending liquidity or insolvency risk. The EMF could receive a levy that would be proportional to any fiscal deficit in excess of 3 percent of GDP and public debt in excess of 60 percent of GDP — the caps imposed by the Stability and Growth Pact. This levy would represent a sort of automatic fine, thus making the elaborate structure of the pact redundant.
These two simple elements — orderly default and a financing mechanism — could resolve the current crisis within the euro zone: By creating a European monetary fund along these lines, the euro area would acquire an institution that could support member countries in difficulties, but that would also ensure that market discipline really worked.
Daniel Gros is director of the Center for European Policy Studies.
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