Countercyclical ‘Haircuts’ Could Make The Eurozone Workable

The basic problem for European monetary union is that Europe isn’t an optimal currency area. Not only is there no fiscal union to buffer shocks, but the labor market is only kinda sorta integrated. If the labor market is tight in Germany and unemployment is high in Portugal, German firms can’t just hire Portugese workers. These countries speak different languages, have different school systems, different social safety nets, etc. Consequently, they can wind up having very different inflation rates, and it’s impossible to set a monetary policy that’s appropriate in all these places.

Kantoos suggests that there is something the European Central Bank can do to make this work, if it stops acting like all European sovereign debt is equal:

As a short explanation: when a central bank accepts a bond as collateral for refinancing operations, it usually calculates the market value minus a valuation haircut, as the final value of that collateral. By failing to use this tool appropriately, the ECB sent the wrong signal: suggesting that default risk was equal across all government bonds, which it clearly wasn’t. […]

So imagine the ECB had introduced a haircut policy on government debt that was related to such overheating/bubble measures: when your country overheats, your government’s bonds take an extra valuation haircut when checking in at the ECB hotel. This would have made these governments’ bonds less attractive and might have induced governments to take a more restrictive fiscal policy and regulatory stance in the build-up of the Euro crisis. To take this proposal to the extreme for the sake of argument: if inflation is more than 0.5% above target, or credit above a resonable level of GNP, the bonds of that country become ineligible as collateral at the ECB.

There are various political problems with this, but it is at least something you could do that should appeal to German hatred of inflation. On the other hand, it seems to me that a national government complaining that any haircuts on its bonds should be based on actual credit risk rather than local price level issues would have a sympathetic argument.