During the current financial and economic crisis, in most developed countries,
public deficits and debts have ballooned as a result of automatic fiscal stabilizers,
governments’ fiscal packages to support the economy, and direct large (and mostly
needed) interventions to rescue banks and the financial sector. This process is still in
action. At the same time risks of sovereign debt default around the world are
increasing; in Europe the single currency has been under attack by the markets, the
same markets that benefited from the large public bailouts that contributed to the
escalation of public debt.

Indeed, according to the IMF, by the end of 2011 the public debt-to-GDP ratio is
projected to be on average in the advanced economies 29 percentage points higher
than before the crisis (with peaks of 40% and more). By 2014 in the same countries
the debt-to-GDP ratio will exceed 100%.

In order for the most developed countries to reduce their public debt to less than
60% of GDP by 2030, the IMF has also estimated that governments ought to deliver,
on average, over the coming years a structural primary balance improvement in their
annual public budgets of 8 to 9 GDP percentage points. In addition, several countries
need further adjustments of about 4 to 5 percentage points of GDP to cope with
growing expenditures for pensions and health care. How could these goals be
achieved ?

The IMF suggests a mix of policies including: setting the real growth rate
of per capita public spending at zero for ten years, reforming social security and
health entitlements to reduce their costs (e.g. raising the retirement age, and
increasing private costs to access public health services), and increasing taxes. In
particular tax increases would include rising VAT revenue (increasing reduced rates,
and introducing the VAT in those countries such as the United States where it does
not exist) and excise duties on alcoholic beverages, oil and tobacco products,
introducing or rising property taxation, adopting a carbon tax and other eco taxes
and, finally, adopting measures to combat tax evasion. Overall the size of tax
packages could be on average as high as 5 percentage points of GDP.

The likely result of such a policy would be a prolonged stagnation coupled with
high unemployment. And the same fiscal adjustment might be jeopardized by the
negative effect on aggregate demand and resource allocation. No country would be
excluded from this picture. For example the German economy exports today
approximately 50% of its GDP, but 60% of this 50% is actually exported to the euro
area countries that would be most heavily hit by the proposed adjustment policies,
and would be forced to reduce internal consumption and imports. As a matter of fact,
at least in Europe, the public is told that to overcome the crisis we need to cut public
debt and deficits; in other words that deficits have been the cause of the crisis. Of
course this is not true, since the increase in debts and deficits has been the effect of
the crisis, and the proposed therapies could leave us with still higher debts and
deficits.

A protracted deflationary policy could also cause the default of some euro
area countries. In this case, given the exposure of European banks toward these
countries the entire financial structure of Europe could be at risk. In this situation
even the hypothesis of a debt restructuring (the so called haircut) in some countries
could have a strong negative impact on the whole European financial system whose
stability could be severely harmed.

Not surprisingly, the perspective of such draconian policies terrorizes Governments
and Parliaments around the world, and is rejected by people who do not share the
view that they should pay for the excesses that financial sectors around the globe run
into over the recent years. As a result,many governments will find difficult to embark
on large scale fiscal adjustments, and some governments will be pushed out of office.
Do alternative policies exist ? Probably yes, but such policies have to be agreed
and coordinated at a global level: a global crisis inevitably requires global solutions.
In my opinion the fundamental issue to be addressed is how to free national public
finances from the debt burden accumulated during the crisis and bring public accounts
back to where they were in 2007 before the crisis.

For developed countries, this amounts so far to about 30 percentage points
of GDP and could increase up to 40%. A possible solution would be to create
a Global Debt Fund (GF). The process would be the following: identify for
each country the share of public debt due to the recent global crisis,
recognize the global collective nature of this debt, and spin-off this share
of debt from national fiscal accounts into this specially created Fund.
Initially the GF’s assets would be bonds issued by different countries
so that the Fund would enjoy an implicit guarantee. Over time interest payments
and the repayment of the debt injected in the GF will be covered by the
annual proceeds of a financial transaction tax (or of a new levy on the financial
sector) agreed at international level. Theese levies should be collected
in a coordinated way across all the Member States participating inthe GF.

In this way national debts would be transformed into GF’s assets (capital).
The Fund should operate according to market rules as they apply to any other market
player, making investments and profits. The Fund could also be charged with the task
of supplying the banks of the Member States with the extra capital needed to cope
with the prescriptions of Basel 3 agreements in order to avoid any credit crunch
Eventually, as its debts will be repayed and the GF will turn into a profitable
institution, a resolution scheme may be designed to terminate the Fund and reallocate
to individual countries its accumulated net worth – possibly in the case of the
European Union at a supranational level.

Since national liabilities brought to the GF by each country and the amount of
financial transactions (and tax revenues) on domestic markets would not match
exactly, some clearing mechanism should be adopted in the working of the GF in
order to avoid any substantial cross-subsidization across countries. It is also important
to note that while the introduction of the financial levy could reduce the amount of
market transactions, the very existence of a new big player like the GF could
compensate this effect and increase the overall market activities. Finally, the need to
fund the GF would provide a clear justification for introducing the new forms of
taxation on the financial sector so much discussed in the (often confused and
uncoordinated) recent public debate. It is also interesting to notice that quite recently
a new tax on capital inflows was introduced in South Korea with its proceeds were
directed to supply new capital to Korean banks.

Indeed, such a Fund would make it clear that financial markets, market players
and investors are all expected to contribute the resources needed (for the time that is
necessary) to free national finances from the debt burden generated by the financial
crisis. At the same time citizens, also bearing some indirect burden of the new tax,
would avoid the direct tax increase and the spending cuts for which they see no
justification. Finally, governments would reduce the risk of a prolonged stagnation in
most of the developed economies.

What would be the benefits of setting up the GF ? There are at least four benefits,
as the GF would: a) reassure markets about the repayment and solvency of the extra
debt created during the crisis by different countries; b) restore national public
finances at the 2007 pre-crisis level, each with their own problems of course, but
without the overhead of the devastating effect of the crisis that cannot be managed at
national level; c) guarantee the interest payments and the repayment of the crisis
related debt, and, d) avoid the necessity of restructuring sovereign debts.

A number of more technical features of such a Fund ought to be further
investigated and agreed at the international level. For example, it is important to
address the risk that financial activities might move away from the countries applying
the new financial sector levy towards those that do not; clearly this requires some
degree of international cooperation. In addition, all financial transactions (including
those currently OTC) ought to be cleared in clearing houses to allow the collection of
national taxes; in any case all parties would benefit from the proper functioning of the
GF, including national governments, markets, citizens, and the global economic
system. If addressing the coordinating issues at the global level were not to appear
feasible, the GF might also work at the U.S. or E.U. level.

Critical to the success of the Fund is the commitment of participating countries to
tightly control national public finances, avoiding to bring domestic public debt on
unsustainable dynamics, and reducing national debt gradually whereas is deemed to
be too high.

The present proposal shares some evident similarities with other hypothesis put
forward by European experts and politicians in order to cope with the problems
deriving by the dimensions reached by the public debt in some of our countries. I am
referring to the blue bond proposal put forward by professors J. Delpla and J. von
Weizsäcker in the Bruegel Policy Brief in May 2010, and also included among the
proposal contained in the Report to the European Commission on the completion of
the internal market presented by Mario Monti, and to the recent proposal of Ministers
Juncker and Tremonti.

Both proposal suggest that E.U. countries pool an equal share
of their national debts (60% of GDP according to Bruegel, 40% in the Juncker-
Tremonti version) in the form of “a common European Government bond”
(Eurobonds) in order to reduce the cost of financing governments’ debt. All these
proposals are similar since all would create an eurobond market and reduce the
individual Member States’ public debts, but the Bruegel-Junker-Tremonti hypothesis
would not eliminate the necessity by the single States and their taxpayers of servicing
both debts, the common and the national ones (i.e. blue and red bonds).

Moreover the borrowing cost of the residual national debts could increase considerably
 for high debt countries, (perhaps more than) offsetting the cost reduction  in the new
Eurobonds market. Finally, since the market value of national bonds held by banks
and other financial institutions would decrease vis-à-vis the new Eurobond, stability
problems could occur for European banks. My proposal (that has not been imagined
with reference only to European problems) would avoid all these shortcomings thanks
to the transaction tax specifically addressed to the servicing of the extra debt. In any
case the two approaches are not incompatible: one could imagine for example to
leave each single Member State in the European Union with a national debt equal to
60% of his GDP, pooling any exceeding amount into a special Fund supported by a
dedicated tax.

Finally a recent stimulating proposal advanced by David McKie of J.P.Morgan could
be mentioned which is interesting as it makes clear that the current stability problems
in the euro area might so far require in principle a rather limited intervention and are
enlarged and overstated by the current lack of coordination of fiscal policies in Europe.
“What the region really needs is a one-off fiscal transfer. If around 350 billion euro of
debt were transferred from the balance sheet of the Greek, Irish and Portuguese
sovereigns to the balance sheets of the sovereigns in the core of the region, this
would reduce the debt-to-GDP ratio in this peripheral economies to 60%, but would
push up the debt-to-GDP ratio in the core by less than 5% pts…. Such a one-off fiscal
transfer would have two benefits. First it would dramatically reduce the extent of the
fiscal tightening needed in this peripheral economies; they would still need to tighten
further, but not by as much as otherwise.

This would ease the macro pain on these citizens, who have already suffered quite a lot.
Second it would eliminate the political, financial and economic disruption caused by
a debt restructuring. Importantly, we have excluded Spain from these calculations,
 largely because its debt-to-GDP ratio is expected to peak at a level not that
much higher than 60% anyway.

Of course the fiscal burden in the core would be increased, but there would be no
immediate consequences for everyone’s income. At the margin, fiscal policy
 would need to be tighter in the core than otherwise over the medium term,
 but only to a very small extent”.

In conclusion, all the proposal discussed above could be useful to overcome the
present difficulties. Unfortunately the possibility that governments and international
institutions begin thinking in such globally cooperative and collective terms, as the
proposals require, might today appear unlikely. However, over time (in months or
even years), the realization of the intrinsic difficulties in fully exiting from the crisis
and getting rid of its economic impact might well increase the wisdom of our
governments. As the former Israel’s foreign Minister Abba Eban once remarked:
“History teaches us that men and nations behave wisely once they have exhausted all
other alternative”.

* Hearing of Professor Vincenzo Visco at the Committee on Economic and Monetary
Affairs (ECON) of the European Parliament on Innovative Financing at a Global and
European Level. Monday 10 January 2011.