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Arguing about justice

Axel Gosseries
Philippe Vanderborght

Too much punishment and too little forgiveness in the Eurozone

Paul De Grauwe


De schuldencrisis die de Eurozone heeft getroffen in 2010 heeft de Europese leiders ertoe gebracht nieuwe oplossingen te ontwikkelen voor de crisis. Deze oplossingen zijn al te veel beinvloed geworden door de idee dat het system met sancties moet overladen worden. De kern van mijn betoog is dat in plaats van zoveel aandacht te besteden aan sancties meer ruimte zou moeten gegeven worden aan vergevingsgezindheid.

Note de l’auteur

I am grateful to Daniel Gros for very helpful comments.

Texte intégral


1The debt crisis that hit the eurozone in 2010 forced European leaders to develop new solutions and cures to deal with the crisis. These cures for the debt crisis have been dominated by the idea that sanctions should be imposed everywhere in the system. Thus, European leaders are tightening up the Stability and Growth Pact (SGP) and are imposing stiffer sanctions on governments that do not obey the rules. Bondholders who have the temerity of buying government bonds will face sanctions in the form of haircuts when governments get into payment difficulties. The financial rescue mechanism aimed at providing liquidity to distressed governments carry punitive interest rates. Thus Ireland was subjected to an interest rate of close to 6% for the financial assistance it received from the European Financial Stability Facility (EFSF).

2In this paper, I argue that too much emphasis is put on designing punishment mechanisms to deal with the crisis, and to prevent future ones. I will then ask the question why so much emphasis was put on punishment. Finally, I will argue that a greater role should be given to debt forgiveness, and I will discuss what the latter means.

3In order to analyze whether punishment is the right approach it is useful to draw a distinction between punishing governments and punishing private market actors. Let me concentrate on the latter first.

Punishing private agents

4Threatening to punish private market participants leads to two problems.First, it works only when these agents know they are doing something wrong that is subject to punishment. If they are not aware that they do something punishable, the threat of punishment will not discipline them. During the good years prior to the crisis, few people realized that they were doing something wrong that would lead to punishment. Private investors were blinded by euphoria and did not see the risks. Bankers took excessive risk because they massively underestimated it. This underestimation had two dimensions. First, bankers underestimated the risk on their own balance sheets. Second, they did not take into account the systemic risks they created by over-leveraging. They were driven to do this by the sense of euphoria that existed during the bubble and boom periods that blinded almost everybody, including the supervisors, in not seeing the risks. Thus most of them were not aware of doing something punishable. So having the punishment would not have changed their behavior.

5The second problem with punishments is that they lead agents to run for cover when punishment is imminent. This running for cover is easy in financial markets. Investors just sell. In other words, punishments have very little disciplinary effects in financial markets, because if investors are quick enough they know they can avoid punishment. In addition, this ”running for cover” can in fact trigger a crisis where none would have occurred without the punishment scheme.

6This idea can be applied to the proposed bail-in mechanism that will be attached to future sovereign bond issued in the eurozone. At the insistence of Germany, the European Councils of October and December 2010 decided to make future financial assistance to eurozone governments conditional on making sovereign bondholders pay in the form of haircuts. Example: if the haircut is 20% this means that the government will pay only 80% of the nominal value of its debt. Thus, eurozone governments have announced that sovereign bondholders will be punished in the future for the sins of the sovereigns.

7This announcement has a twofold effect. First, it makes sovereign bonds riskier and therefore increases the interest rate. Second, and more importantly, it destabilizes the government bond markets in the eurozone for the reasons developed in the previous paragraphs. The threat of punishment now hangs over the sovereign bond markets in the eurozone. This will have the effect of regularly inducing bondholders to run for cover. They will do this each time they expect future payment problems of one of the eurozone governments. But this running for cover will in turn make a default crisis more likely. When investors sell their bonds the interest rate increases, thereby increasing the risk of default, which in turn triggers more selling. This self-fulfilling prophecy mechanism will make the government bond markets more fragile and volatile. In fact this has already happened since the decisions made by the European Council in October and December 2010. Thus, the idea that somebody must be punished has a disastrous effect. Instead of solving a problem, it creates a new one.

Punishing governments

8The other major cure proposed by the European leaders is to tighten up the SGP, i.e. to have a stronger punishment scheme of governments. This cure based on the same moral hazard thinking will certainly not solve the debt crisis. It even risks making it worse.

9There are two reasons why tightening the rules of the SGP is the wrong answer to the sovereign debt crisis. The first one is that with the exception of Greece, the other Eurozone countries (Ireland, Spain) were not pulled into a debt crisis because of an excessive public debt accumulation prior to the crisis. The government debt crisis in most eurozone countries has nothing to do with undisciplined government behavior prior to the crisis, but with excessive risk taking by the private sector. If the tighter SGP rules now being implemented had been applied before the crisis, they would not have made a difference in most of these countries (with the exception of Greece). Governments like Ireland and Spain would have passed these tighter rules with flying colors; yet they would not have escaped the subsequent crisis.

10The second reason why the tighter SGP-rules will not work has to do with the political economy of these rules. As long as budgetary policies (spending and taxation) remain vested in the hands of national governments and parliaments, the political responsibility for the decisions about spending and taxation rests with these national governments and parliaments. The latter face the political sanctions by national electorates. Neither the European Commission nor the other members of the Council face the political sanction for the measures they impose on one member country. ”No taxation without representation” belongs to the essence of democracies. The SGP has been an attempt to short-circuit this principle, by giving powers to individuals and institutions, in particular the European Commission and the European Council, that do not face the political responsibility for their actions. For example, when the members of the European Council take a decision to force budgetary austerity on, say, Portugal, most of these individuals do not face the political cost of this decision, only the Portuguese government does. Such an attempt has to fail and happily so.

11This is also the fundamental reason why the French and German governments decided in 2003 to ignore the then prevailing fiscal rules. They were urged by the Commission to overhaul their spending and taxation decisions. But the Commission did not face the sanctions of the French and German electorates; the French and German governments did. Each time such a situation occurs in the future (and provided the countries concerned are sufficiently large and powerful) it is the European Commission that will lose the battle.

Bad design of financial assistance

12The idea that punishment should be part of the cure to the debt crisis has also infected the design of the financial assistance in the eurozone. The EFSF that was instituted during the Greek debt crisis in May 2010 has been forced to provide financial assistance to Greece and Ireland at punitive interest rates. The interest rate applied to the Irish loans in early 2011 amounts to almost 6%. This high interest rate has a very unfortunate effect. First, by charging this high interest rate it makes it more difficult for the Irish government to reduce its budget deficit and to slow down debt accumulation. Second, by charging a risk premium of about 3% above the risk free rate that the German, Dutch and Austrian governments enjoy, the EFSF signals to the market that there is a significant risk of default, and thus that the Irish government will not succeed in putting its budgetary house in order. No wonder that financial markets maintain their distrust and also charge a high-risk premium. All this, in a self-fulfilling way, increases the risk of default. It is quite sad that the EFSF that was created to solve a problem contributes to creating one.

13The intelligent approach in financial assistance consists in using a policy of the carrot and the stick. The stick is the conditionality, i.e. an austerity package spelled out over a sufficiently long period of time, so that economic growth gets a chance. Without economic growth debt burdens cannot decline. The carrot is a concessional interest rate that makes it easier for the country concerned to stop debt accumulation (see Gros and Mayer 2011). A low interest rate also expresses trust in the success of the package; trust that financial markets need in order to induce them to buy the government debt at a reasonable interest rate. I will come back to this point.

Did the debt crisis result from moral hazard?

14This intelligent approach was not followed. Why is this? Why has the idea that punishment should be meted out become so important in the design of mechanisms to deal with the crisis? My answer is that the punishment idea has been much influenced by the idea that the crisis was caused to a large extent by moral hazard.

15Moral hazard can be defined as additional risk taking by agents who believe to be insured against the risk they take. Applied to the sovereign debt crisis in the eurozone, moral hazard means that some governments have issued too much debt in the past, expecting other governments to bail them out. In the context of the banking crisis, moral hazard arose when bankers were taking excessive risks also because they expected governments to bail them out.

16There is a strong popular perception today that the core of the sovereign debt crisis is moral hazard. This is especially the case in Northern Europe. Many well-known economists in these countries have stressed the irresponsible behavior of governments of peripheral countries as the root cause of the crisis and have warned that providing financial assistance will induce these governments to remain irresponsible. This view has dominated the popular press in countries like Germany and the Netherlands (see Sinn 2010, Plenum der Okonomen 2011). As a result, the popular sentiment in these countries has very much turned against financial assistance for ”irresponsible governments”. This popular sentiment has been very influential in shaping the official German and Dutch policies. It is therefore important to look at whether the debt crisis is indeed the result of moral hazard.

17Let’s consider the debt problems of Ireland and Spain (I’ll turn my attention to Greece later). The government debt ratios in these two countries declined dramatically prior to 2007. When the bank crisis erupted, the governments of these countries were forced to rescue the banks and to sustain economic activity. The effect was that the government debt exploded in these countries. With no stretch of the imagination can one interpret these events as being the result of moral hazard. The Spanish and Irish governments did not increase their debt because they expected to be bailed out by Germany or any other country. They did this because any government responsible for the welfare of its people would have done the same thing. There was no other valuable option except letting the economy and the market system in these countries implode.

18Proponents of the moral hazard diagnosis may object here, by noting that even if the governments’ actions were not driven by moral hazard, the latter was at the core of the banking crisis that forced the governments to intervene. Thus, ultimately the cause of the crisis is moral hazard: banks took excessive risks because they expected to be bailed out by their respective governments. This interpretation does not make sense either. It is true that bankers took excessive risks. But not because in the back of their mind they had this idea that governments would rescue them. Top management of the banks could not possibly have hoped that governments would bail them out, as such a bailout operation could have cost them their heads. As argued earlier, they took excessive risk because for several reasons they massively underestimated it.

19What about Greece? No doubt, there was a lot of irresponsible behavior of successive Greek governments. But to think that these governments were spending excessively because they expected Germany to bail them out is far fetched. It had everything to do with a weak political system that fell prey to pressures of domestic interest groups trying to obtain part of government largesse. In this process, politicians like bankers and many others, were swept by euphoria produced by (unsustainable) growth rates. The latter created the perception that the sky was the limit.

20Surely there was misbehavior of many actors in this drama. When interpreted in the light of moral hazard it leads to the conclusion that punishment is necessary because it has the salutary effect of changing incentives. It teaches a lesson that should prevent those who have sinned from sinning again. And it teaches a lesson to the others who have not sinned that bad behavior will be sanctioned.

21This punishment approach to the crisis, however, is counterproductive. Too many actors would have to be punished, and not only the bad governments at the periphery of the Eurozone.

The need for forgiveness

  • 1 These interest rates are of course hypothetical ones. The interest rate on the outstanding debt of (...)

22The solution of the debt crisis must be sought not in systematic punishments of governments and private market participants. More emphasis should be put on a willingness to be forgiving. Note that I am not arguing that there should not be conditionality in lending programs. These remain important so as to give enough incentives to the debtors to avoid future profligacy. Thus, there is a need for a stick. At the same time, there is a need for a carrot, in the form of a concessionary interest rate. The main reason is that this is in the interest not only of the debtor but also of the creditor nations. Let me develop this point further. The best way to do this is to start from the following table. I show the primary surplus that is needed to stabilize the government debt ratios in different problematic eurozone countries. Let us assume that the debt level these countries aim at stabilizing is the likely level that will be reached at the end of 2011. The interest rate that is applied in this calculation matters a great deal. I use two opposite scenarios. In one scenario I apply the present punitive interest rate used by the EFSF, which is close to 6%. In the second scenario, I assume that the EFSF would apply a gentle interest rate, i.e. 3.5%, which is the interest rate paid by Germany on its debt plus some gentle risk premium of 0.5% (so as to ensure that the creditor nations do not lose out). Thus, this scenario takes the view that the appropriate interest rate is the one that is approximately free of default risk1.

23The contrast between the two scenarios in table 1 is striking. When the punitive interest rate is used (6%) the fiscal effort needed to stabilize the debt ratio is considerable, leading to the question whether these problem countries will be able or willing to make this effort. In the second scenario using the gentle risk free interest rate, the fiscal effort required to stabilize the debt ratio is considerably reduced. Countries like Ireland, Portugal and Spain are clearly capable of making that effort, and thus they are capable of avoiding default, making the gentle interest rate applied to lending to these countries a self-fulfilling one, i.e. one that avoids default. It is unclear whether this also holds for Greece, where we see that applying the gentle interest rate will still require a considerable fiscal effort in that country. In addition, in the case of Greece this effort stabilizes the debt ratio at 145% of GDP which can be considered to be unsustainable in the long run. Thus for Greece other solutions will have to be considered, i.e. debt restructuring.

Table 1: Primary surplus needed to stabilize debt ratio

24The previous calculation illustrates that there are several possible equilibria (for more formal analyses see Calvo 1988, De Grauwe 2011). There is a nasty equilibrium. This is the equilibrium obtained in the punitive scenario with a high interest rate that in a self-fulfilling way increases the default risk in all countries concerned and thus keeps the interest rate high. There is a gentle equilibrium in which the lower interest rate reduces the fiscal effort needed to stabilize the debt ratio. By having a greater probability of success this scenario leads to a lower default risk. The gentle interest rate produces a gentle equilibrium with a low interest rate. This gentle equilibrium is in the interest of both the debtor and the creditor nations.

25Achieving this gentle equilibrium, however, is only possible if the creditor nations commit themselves to providing liquidity. They have the means to do so. The only possible obstacle is a political one. It will require convincing the German, the Dutch, (and a few other) populations that it is indeed in their national self-interest to commit themselves to financial assistance.



CALVO, G. (1988), 'Servicing the Public Debt: The Role of Expectations', American Economic Review, 78 (4): 647-661.

DE GRAUWE, P., (2011), The Governance of a Fragile Eurozone, mimeo, Leuven: University of Leuven.

GROS, D. & MAYER, (2011), Debt Reduction without Default, CEPS Policy Briefs,

Plenum der Okonomen, (2011), Stellungnahme zur EU-Schuldenkrise,

SINN, H.W. (2010), 'Hans-Werner Sinn: Wir sehen unser Geld nicht wieder', Interview with, 24 April 2010. griechenland-hilfen/wir-sehen-unser-geld-nicht-wieder.html


1 These interest rates are of course hypothetical ones. The interest rate on the outstanding debt of these countries today is different. The point is that if the EFSF were to apply these interest rates on the debt would tend to converge to these rates. Thus in table 1 we look at the long run solvency requirement under these two interest rate scenarios.

Table des illustrations

Légende Table 1: Primary surplus needed to stabilize debt ratio
Fichier image/jpeg, 48k


Paul De Grauwe (Ph.D, Johns Hopkins) is professor of international economics at the University of Leuven (KULeuven, Belgium) and holds honorary doctorates from the universities of S. Gallen (Switzerland), Turku (Finland), and Genoa (Italy). He was a member of the Belgian parliament from 1991 to 2003. He is a research fellow at the Centre for European Policy Studies in Brussels. His research interests are international monetary relations, monetary integration, theory and empirical analysis of the foreign-exchange markets, and open-economy macroeconomics. His books include The Economics of Monetary Union (Oxford), International Money. Post-war Trends and Theories (Oxford), and The exchange rate in a behavioural finance framework (Princeton). He collaborated with Philippe Van Parijs in setting up the "Rethinking Belgium" inititative.

© Presses universitaires de Louvain, 2011

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