AN UNPALATABLE SOLUTION : EUROBONDS COULD RESTORE CONFIDENCE, BUT AT A PRICE / THE ECONOMIST ( A MUST READ )

Economics focus

An unpalatable solution

Eurobonds could restore confidence, but at a cost


Aug 20th 2011
from the print edition

WITH alarming speed, Europe’s debt crisis has spread this summer from small countries such as Greece on the rim of the single-currency area to large economies such as Italy at its heart. The European Central Bank (ECB) has restored calm in Italian and Spanish government-bond markets for the moment by making big purchases of their debt. But such bond-buying is a temporary palliative. Many are now calling for a more fundamental solution to the crisis: the issue of “Eurobonds” in order to provide a fiscal underpinning to the shaky monetary union.


These Eurobonds are not to be confused with their namesakes invented in the early 1960s, when bankers severed the link between currency and country of issuance by helping international borrowers sell dollar-denominated bonds in London. What advocates of new-style Eurobonds have in mind for the euro area would be even more far-reaching: they wish to sever the link between the creditworthiness of a country and its cost of borrowing. The 17 member states of the single-currency area would be able to borrow in bonds issued by a European debt agency. These would be jointly guaranteed by all euro-area countries and thus underwritten in particular by the most creditworthy of them—above all, Germany, because of its economic clout and top-notch credit rating.


An underlying rationale for Eurobonds is that the public finances of the euro area as a whole look quite respectable, at least compared with those of other big rich economies. The IMF envisages that general government debt will reach 88% of the single-currency zone’s GDP this year. This is lower than America’s 98% and not much higher than Britain’s 83%. The euro area’s projected budget deficit will be a bit above 4% of GDP, better than America’s 10% and Britain’s 8.5%. Neither America—despite the recent downgrade of its debt by a rating agency—nor Britain has been subject to a debilitating loss of confidence. This suggests that pooling debt could indeed put an end to the euro crisis.

The successive waves of market attacks on countries have exposed an inherent fragility of a monetary union of states in which each stands behind its own debt but with the usual escape routes of devaluation and inflation no longer available. If investors lose confidence in a country’s fiscal prospects, their fear can become self-fulfilling by pushing up bond yields to unsustainable levels. The ECB can soothe markets by buying bonds, but beyond a certain point such purchases threaten its independence. By pooling risk, Eurobonds could be a more durable counter to such destabilising liquidity crises, argues Paul De Grauwe, an economist at the Catholic University of Leuven, in Belgium.


Another reason to introduce Eurobonds is that the existing defences drawn up to contain the crisis are starting to look too flimsy. The European Financial Stability Facility (EFSF), the rescue fund set up last year, is due to have €440 billion ($634 billion) of resources this autumn. Given its existing commitments to Greece, Ireland and Portugal, this would be barely enough to support Spain and insufficient for Italy if they were locked out of markets for any length of time. The obvious answer is to increase its size, but the fund has an inherent weakness. Unlike jointly underwritten Eurobonds, the national guarantees backing the EFSF puts each state on the line for only a share of it, broadly in line with its weight in the euro-area economy. This means that if France were to lose its top credit rating—the latest fear in the markets—the EFSF would lose a big chunk of its lending capacity (or its AAA rating).


Until now the countries that call the shots in the euro area—those with strong public finances, notably Germany—have viewed Eurobonds with horror. They have two main objections. First, the pooling of public debt in the 17 member states would raise the interest rates paid by the most creditworthy while lowering them in countries with weaker fiscal positions. The annual bill to German taxpayers of the additional borrowing costs could eventually reach 1.9% of German GDP, according to Kai Carstensen of the Ifo Institute for Economic Research in Munich. Second, Eurobonds would remove the pressure on improvident governments to put their public finances in order. Would Italy, for example, have pushed through its recent austerity budget had it not been pushed by the markets?


Blue and red-hot


Proponents of Eurobonds have an ingenious answer to both these objections. A policy proposal published last year by Bruegel, a think-tank, said that for each country they should be limited to 60% of GDP (the maximum ratio of debt to GDP first intended for the monetary union). Together with a liquidity premium that should arise from creating a much bigger market, in Eurobonds, than the national sovereign-debt markets, this limit would curtail the feared rise in borrowing costs. Countries would retain national responsibility for debt above the 60% threshold, which the authors dubbed “red” (as opposed to the “blue” Eurobonds). This would create an incentive for them to behave prudently, since borrowing costs on red bonds would be higher.


But the idea has two snags. First, by dividing sovereign debt into tranches, the enhanced safety of the blue bonds would come at the expense of the red ones—which could become red-hot for risk-averse investors. Vulnerable countries could find themselves in an even trickier position if investors demanded higher yields on this portion. Second, the proposal assumes that the 60% limit could be maintained. In a future debt crisis, it might not be.


Eurobonds would be a big sacrifice for the creditworthy nations of the euro area. The question for Germany in particular is whether this is a price worth paying to save the euro. The question for the other members of the monetary union is whether they can tolerate the much greater centralisation of fiscal policy that Germans would demand, as a bulwark against renewed budgetary indiscipline, in exchange for agreeing to Eurobonds.