The Eurobond
Proposals, Comments, and Speeches
Erik Jones
Professor of European Studies
SAIS Bologna Center
Director
Bologna Institute for Policy Research
25 May 2012
The Eurobond:
Proposals, Comments, Speeches
Erik Jones
This packet contains materials that I wrote during the period from February 2010 to April 2012.
Most of this material centers on the idea to create a common eurobond with limited drawing
rights. Originally, this idea was intended to strengthen fiscal discipline within the eurozone by
creating market incentives for highly indebted countries to borrow less. Over time, it has
developed as arguably the ‘best’ solution for responding to Europe’s sovereign debt crisis. This
intellectual history is important. Right now, the strongest opposition to the eurobond proposal
comes from those who think it gives highly indebted countries a free ride. Once you read
through this packet, it will be easy to see why such arguments are mistaken.
The first piece is a eurobond proposal that I drafted for ISPI in Milan in February 2010.
When the proposal came out, it emerged alongside a related proposal by Belgian prime minister
Yves Leterme to create a European Debt Agency. And, I later discovered, this proposal echoed
the arguments made by John Springford in a September 2009 opinion piece in the Wall Street
Journal. Of course all of that was eclipsed by the ‘Blue Bond’ proposal issued by Breugel in
April 2010 and updated in March 2011 – which has emerged as the focal point for the eurobond
debate.
The second piece in the packet reiterates the eurobond proposal and begins to shift the
debate toward market stabilization. I drafted that policy memorandum for Opex, which is the
economics arm of the Spanish Alternativas think tank. The question-and-answer structure of the
memorandum reflects the growing level of confusion and controversy that surrounded the
eurobond from the outset.
The next two pieces were published as editorials to defend the eurobond against
mounting criticism that emerged once the idea was launched politically in December 2010 by
Giulio Tremonti and Jean Claude Juncker. The fifth piece criticizes the March 2011 European
Council decision to focus on competitiveness in reforming European macroeconomic
governance.
The remaining pieces reiterate and strengthen the arguments made from the outset. My
talk at the ‘Festival of Europe’ conference in Florence last May tries to summarize the debate
about eurobonds (and includes references to much of the wider literature). The ‘keynote address’
I gave in Rutgers to a meeting of financial services professionals was an attempt to make these
issues comprehensible to an American audience. The two-part series I did for E!Sharp tried to
explain why the reform debate keeps moving around in circles and the op-ed with Dan Kelemen
for USA Today gives a more optimistic take. The comment for ISPI suggests how Germany
could be brought around to support the proposal. The op-eds for Foreign Affairs and
Eurointelligence focus on the flight to safety. Finally, the conference paper on five lessons from
the crisis and the policy brief I did for the Swedish Institute for European Policy Studies tie it all
together.
Clearly there is no end to this discussion and my contribution has been only a small one.
Nevertheless, I hope that this collection will be of use and look forward to any comments that it
may generate.
Bologna, 25 May 2012
Erik Jones
N. 180 - MARCH 2010
A Eurobond Proposal to Promote Stability
and Liquidity while Preventing Moral Hazard*
The current crisis in Greek
sovereign debt markets has
made two things clear. First,
any default by the Greek
government would be bad
for the eurozone as a whole
because it would hurt the
balance sheets of large
banks that are already
struggling to raise capital
and because it would
threaten the liquidity of bond
markets for countries that
may be in a similar situation.
Hence a timely bailout of the
Greek government would do
a lot to shore up the stability
and liquidity of European
financial markets. Nevertheless, and this is the
second point, no-one is
particularly eager to (be
seen to) bail out the Greeks.
Of course everyone is eager
to prevent another major
financial crisis but the idea of
pumping money into a
country
that
has
so
obviously lived beyond its
means while at the same
time cooking the books and
conniving with banks to
cover its tracks is hard to
swallow. Even under the most
generous of circumstances,
such an action would be
seen to create a “moral
hazard” – encouraging future
governments in Greece and
elsewhere to engage
similar behavior.
Abstract
in
The current situation in
Greece presents precisely
the sort damned-if-you-do,
damned-if-you-don’t dilemma
that the Maastricht Treaty
and the Stability and Growth
Pact were designed to
prevent. The multilateral surveillance, excessive deficits,
and early warning procedures were meant to spot
and correct these situations
in a timely manner; ESA 95
and the newly empowered
Eurostat were meant to
ensure that fiscal accounting
was easy for all to read; the
escalating ladder of sanctions
provided the incentives for
corrective action; and the no
bailout clause showed that
there was no net on the
other side of the precipice.
Unfortunately, however, few
economic commentators recognized that the Greek
situation was a real possibility.
Instead they worried that the
provisions
for
macroeconomic policy coordination
would leave too little room
for fiscal stimulus or policy
flexibility. Hence it is hardly
surprising that politicians
would use this concern to
set the stability and growth
No-one is particularly eager to
bail out the Greeks. Of course
everyone would like to prevent
another major financial crisis but
the idea of pumping money into
a country that has so obviously
lived beyond its means while
providing incorrect information
and conniving with banks to
cover its tracks is hard to
swallow. Even under the most
generous of circumstances,
such an action would be seen to
create a “moral hazard” –
encouraging future governments
in Greece and elsewhere to
engage in similar behaviour.
The solution could be a dual
bond structure for government
financing (including Eurobonds).
This would not eliminate the
Greek crisis but would help
mitigate its systemic importance.
Erik Jones is Professor of European
Studies at the SAIS Bologna Center
of the Johns Hopkins University and
author of, inter alia, The Politics of
Economic and Monetary Union,
Rowman & Littlefield, 2002.
(*) Further institutional, juridical and technical details on this proposal will be provided in a future ISPI publication.
2
pact aside at the first sign of
inconvenience. The Greek
situation is the natural outcome of this lack of
restraint1.
The question is where to go
from here. Two ideas that
have been floated are a
European stability fund to
shore up the financial system
and a common issue “Eurobond” to ensure that adequate
liquidity is available to all
member states2. These ideas
have tight synergies and
they could even be run
together. They also share
the same problem: moral
hazard. As Otmar Issing
insisted in criticizing such
proposals: «a common bond
is no cure for a lack of fiscal
discipline; on the contrary, it
would tend to encourage
countries to continue on their
wrong fiscal course»3. Still
the alternatives seem even
more unpalatable. The International Monetary Fund could
be called in to give a Greek
bailout the veneer of international respectability or Greece
could be pushed out of (invited
to take a holiday from) the
eurozone altogether4.
1
J. MATTHES, Why the IMF
should be involved in solving
imminent fiscal debt crises in
Eurozone countries, in «VoxEU»,
February 27, 2010.
2
D. GROS - S. MICOSSI, A bondissuing stability fund could rescue
Europe, in «Europe’s World»,
Spring 2009; P. DE GRAUWE - W.
MOESEN, Gains for All: A proposal
for a common Eurobond, CEPS
Commentary, April 3, 2009.
3
O. ISSING, Why a common
eurozone bond isn’t such a good
idea, in «Europe’s World», Summer
2009.
4
J. MATTHES, cit.; M. FELDSTEIN,
Let Greece take a eurozone
ISPI - Policy Brief
Clearly, what we need is the
best of both worlds – a
proposal that can provide
liquidity in a crisis but with
the teeth to ensure that
governments
have
an
incentive to keep their fiscal
situation under control. Such
a proposal should also offer
advantages to all parties,
both those countries that are
likely to wind up in difficulty
and those who are more
likely to do the bailing out.
Finally, the proposal should
not rely on a nuclear option
that lacks credibility because
it is too painful or embarrassing to enforce.
Eurobonds for Growth
and Stability
The eurozone needs a
common sovereign bond
issue to provide liquidity and
to avoid market speculation
(or a flight to security) from
resulting in cross-country
financing strains5. Member
state governments would
authorize bond issues for
which they would meet the
servicing requirements. Nevertheless, the bonds would
come from a central issuing
authority and would be both
indistinguishable and interchangeable in secondary
markets – one bond would
be much as another (of the
same coupon and maturity)
no matter which country
“holiday”, in «Financial Times»,
February 16, 2010.
5
M.G. ATTINASI - C. CHECHERITA
- C. NICKEL, What explains the
surge in euro-area sovereign
spreads during the financial crisis
of 2007-2009?, in «VoxEU»,
January 11, 2010.
authorized its issuance. In
other words, all eurobonds
with the same characteristics
would attract the same
ratings.
To avoid moral hazard,
participating
governments
would have limits on the
volume of bonds they can
authorize both globally and
in any given year. Specifically,
they would be constrained
from
authorizing
bonds
worth more than 60 percent
of their growth domestic
product or – after an initial
transition period – from
authorizing a net increase in
their total eurobond responsibilities worth more
than 3 percent of their gross
domestic product on an
annual basis. In this sense,
eurobonds would only be
available for responsible
borrowing.
“Excessive” borrowing, as
defined by the Maastricht
Treaty, would have to take
place
through
national
sovereign bond issues which
would be characteristically
different both from common
issue eurobonds and across
countries – and so attract a
different rating and price
from one country to the next.
Hence the first incentive to
engage in responsible borrowing would be the price
differential. Responsible borrowing would be cheaper;
excessive borrowing would
be more expensive.
The major advantage of this
arrangement would be the
heightened transparency that
it would provide both in
terms of financial markets
and in terms of the countries
3
ISPI - Policy Brief
themselves. Market participants would know exactly
not
only
how
much
“excessive” borrowing a
country was engaged in but
also which of a country’s
debt instruments are most
susceptible to the risk of
sovereign default. Moreover,
the countries that choose to
participate in the common
bond issuance would have
to accept much closer
scrutiny of their national
statistics and fiscal accounts
– just as firms that trade
publicly
on
the
stock
exchange agree to stricter
reporting requirements. If a
country was shown to be
cooking the books, its
authorization privileges could
be suspended, forcing it to
rely on more expensive
forms of borrowing until it
could earn the right to
authorize common issue
eurobonds again.
In extremis, this dual bond
arrangement suggests a
natural procedure for organizing a country’s orderly
default. The first stage would
be to renegotiate the terms
of country-specific obligations
– meaning those used for
any excessive borrowing –
followed if necessary by a
suspension of debt servicing
payments on the common
issue bonds (which could
continue to roll-over unaffected by any countryspecific financial situation).
Here it is true that the other
member states would be
required to pick up the
defaulting country’s debt
servicing obligations. However, this would only be
temporary, it would represent
far less of a financial
exposure
than
actively
bailing the country out, and it
could always be repaid with
interest once the crisis has
passed and the country’s
financial situation is on more
stable footing.
Deeper Markets,
Cheaper Liquidity
The incentives constraining
fiscal policy under this
proposal
are
easy
to
summarize: countries face a
higher price for excessive
borrowing; they run the risk
of losing their authorization
privileges; and they can
imagine what it will look like
to experience an orderly
(and yet still humiliating and
painful)
default.
These
incentives do not include an
unbelievable nuclear option;
there is no need to expel a
country from the eurozone,
to call in the IMF, or,
alternatively, to bail them
out. The structure of the
system also shores up the
procedures of the rest of the
eurozone. For example, the
European Central Bank is no
longer held responsible for
certifying all sovereign debt
instruments as collateral in
open market operations or,
reciprocally, for triggering a
sovereign debt crisis once
eligibility for collateral use in
open market operations is
withdrawn. Hence, on the
disciplinary side, it is a
credible arrangement all the
way down.
But
what
about
the
incentives for otherwise
responsible countries to
participate? These are fairly
straightforward as well. To
begin with, the common
issue eurobond offers a
deeper and more liquid
market than any country –
even Germany – can
generate for itself. Hence to
the extent that liquidity
trades at a discount, it
should offer lower borrowing
costs for all countries
(including Germany) as well.
Moreover, because it is
larger than any national
market, this eurobond market
would make it possible for
countries to export savings
across the eurozone without
accepting an implicit sovereign risk. This would make
it easier for Germany to
continue to run its export-led
growth
model
without
exposing its banking system
to the need to take on
unwanted exposure. A deeper
eurobond market would
make it more attractive for
countries outside the eurozone
to diversify their reserve
holdings into euros as well.
Indeed, since this common
issue eurobond would be
limited in scope to what we
can
characterize
as
responsible fiscal borrowing,
it might prove even more
attractive than the ever
expanding
market
for
government paper in the
United States.
Getting There from Here
If we had this dual bond
structure for government
financing, the current crisis
in Greece would be less
pressing and more manageable. It would be less
4
pressing because not all
Greek debt would come up
for refinancing in nationally
specific sovereign bonds.
Much of it would come up as
eurobonds instead. This would
not eliminate the crisis in
Greek public financing, but it
would mitigate its systemic
importance because in effect,
investors could fly to safety
from one set of Greek
obligations to another. This
would benefit both Greece
and the investors who hold
Greek obligations. Meanwhile,
the crisis would be more
manageable because we
could know better how to
structure a reorganization of
Greek finances transparently,
making it clear to all who is
exposed to losses and who
is not.
The trick is to get there from
here. It is possible to imagine
two alternatives. One is to
wait for this crisis to pass,
taking the time to organize
the institutions for issuing
and overseeing the common
issue eurobonds and for
preparing national fiscal
authorities (and their treasury
operations) for the necessary
transition. That may prove
the most rational way
forward. However, time is
not on our side. Hence it
could be possible to imagine
a more speedy process,
which sets up the institutions
for
eurobond
issuance
quickly so that the resources
they promise can soon be
put into place. This would
allow the member states to
begin refinancing Greek
sovereign obligations with
common issue eurobonds
almost immediately, stabilizing
ISPI - Policy Brief
financial markets by pooling
those obligations with issues
authorized by other member
states.
Technically
this
would not be a bailout.
Practically, it would take
much of the urgency away.
Not only would we eliminate
the current crisis, but we
would create the incentives
to avoid the next.
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© ISPI 2010
OPEX MEMORANDUM No. 147/2010
AUTHOR: ERIK JONES, Professor of European Studies of the SAIS Bologna Centre of
the John Hopkins University. He is also a collaborator of Opex.
TO: OPEX DATE: 21/07/2010
SUBJECT: A MARKET ALTERNATIVE TO FISCAL DISCIPLINE IN EUROPE; A PROPOSAL
FOR A EUROBOND FACILITY
Panel: Economía Internacional
Coordinator: Manuel de la Rocha Vázquez
www.falternativas.org/opex
Depósito Legal: M-54881-2008
ISSN: 1989-2845
Director: Nicolás Sartorius
Subdirector: Vicente Palacio
Coordinadores de Área: Mario Esteban (Asia-Pacífico); Rafael Bustos (Magreb-Oriente Medio); Raquel Montes
(Unión Europea); Manuel de la Rocha Vázquez (Economía Internacional y África Subsahariana); Vicente Palacio
(Relaciones Transatlánticas); Paulina Correa (Seguridad y Defensa); Kattya Cascante (Cooperación al desarrollo);
Érika M. Rodríguez Pinzón (América Latina).
Opex Memorandum No. 147/2010: A market alternative to fiscal discipline in Europe; a proposal for a Eurobond facility
Why there is a need for a Eurobond Facility?
The ongoing reform of European macroeconomic governance is making great strides in
improving both multilateral surveillance and fiscal policy coordination. The members of
the Task Force headed by European Council President Herman Van Rompuy should be
congratulated for the speed and diligence with which they are guiding this reform effort.
Nevertheless, the proposal they are developing, based on enhancing the enforcement
mechanisms, suffers from the same genetic weakness as the old Stability and Growth
Pact and the excessive deficits procedure that underpins it. When faced with a crisis
situation where a large and powerful country has to choose between obeying the rules
or making politically unacceptable fiscal adjustment, it will always be cheaper and
easier to break the rules. Similarly, EU member countries may easily ignore their
European commitments when the calculation of costs and benefits for doing so points in
that direction. That is why France and Germany suspended the excessive deficits
procedure in 2003; that is why 24 of 27 European Union member states find
themselves within the excessive deficits procedure today.
What the European Union needs is a system for fiscal discipline that can remain credible
in times of crisis. This should be a system that allows countries to borrow in moments
of extreme economic weakness, but that encourages them to do so in moderation,
setting incentives for them to bring their debt back down to sustainable levels once the
crisis has passed. Most important, it should be a system where the cost of defection is
always higher than the cost of playing by the rules – not just for smaller countries that
can be punished by their larger neighbours, but even for the most powerful of European
Union member states, France and Germany included.
A powerful proposal that would address many of those problems would be the creation
of a limited access common Eurobond Facility, through which member states would
have limited borrowing rights.
Such a Facility has already been put forward by experts. Yet, drawing on the best
arguments made in each of the proposals, this Memo seeks to make a strong case for
the Spanish Government (which could be an important beneficiary) to advance it in
official EU forums.
What would be the main features of the Eurobond Facility?
Eurobonds would have to be issued by a common authority and supported by the wider
architecture of European macroeconomic governance. The precise institutional design
is less important than the principles upon which such an authority would operate. The
most important features of the proposed Eurobond Facility are the following:
•
The bonds would be denominated in Euros and could be issued at different fixed
maturities in line with the portfolio requirements for treasury operations.
•
The bonds would be undifferentiated and no individual bond could be associated
with a particular member state. The implication here is that every bond will be
backed by every member state in a manner similar to the pro rata guarantees
provided to the European financial mechanism that was created to fund the
European Union’s response to the sovereign debt crisis.
•
Member States must commit to honour their common Eurobond obligations
before any other credit liability.
1
Opex Memorandum No. 147/2010: A market alternative to fiscal discipline in Europe; a proposal for a Eurobond facility
•
Member state access to bond issues would be limited as a share of their income.
The most obvious ceiling would be the 60 percent debt-to-GDP per country
threshold set in the Maastricht Treaty, however it would also be possible to
introduce intermediate thresholds at lower levels with a graduating scale of
charges associated with higher borrowing rates, up to the ceiling of 60 percent.
The characteristics described combine to form a very large, uniform, and low risk
market capable of rivalling or even surpassing the market for United States Treasury
paper in terms of depth and liquidity.
What would be the advantages for Member States that participate in the
Eurobond Facility?
The principal advantages come from the price and stability and that such a Eurobond
would offer.
•
For most Member States, the Eurobond Facility would allow them to borrow
funds at a lower cost than the current price they pay in the market;
•
Eurobonds would be an attractive and safe investment for many non-European
countries which would decide to diversify their foreign currency reserves, thus
balancing the US as the only reserve currency in the world. In turn, this
attractiveness would increase the depth and liquidity of the Eurobond market as
compared with existing national bonds, further lowering the price of credit and
increasing the incentives for Member States to participate;
•
The benefits from the Eurobond are also linked to the stronger discipline it will
impose on those countries participating in it, which would reduce the risk of
defaulting, thus compromising the stability of the whole Eurozone;
•
Ultimately, the issue of Eurobonds a the EU level would be an step forward in the
path to closer European integration and a key pillar of the European economic
governance.
How would a Eurobond Facility force Member States to maintain more fiscal
discipline?
Eurobonds would create strong positive incentives for governments to borrow
responsibly:
•
Member States would have to qualify to participate, primarily by meeting
rigorous standards for fiscal accounting and budgetary transparency just as
firms accept when they list on a stock exchange;
•
Member states would have to open their fiscal accounts to close scrutiny to
qualify for new borrowing and again like firms belonging to a stock exchange,
they would risk suspension of their borrowing privileges should they fail to
maintain transparent accounts;
•
The amount Member states could borrow would be strictly limited in proportion
to their income and, like homeowners, they could face escalating premiums as
they move close to their maximum borrowing threshold to cover the increasing
risks that even higher levels of responsible borrowing entails;
2
Opex Memorandum No. 147/2010: A market alternative to fiscal discipline in Europe; a proposal for a Eurobond facility
•
A Member States’ participation could be suspended – in the sense of suspending
the right to raise new money through the common Eurobonds until certain
conditions are met – and it can also be revoked. If and when a country would be
suspended all new issues will be blocked and the country’s position within the
facility will be wound up as existing bonds reach maturation.
In summary, participation by the Member States in the common Eurobonds would be
both a commitment and a privilege. This combination creates both credible incentives
and credible sanctions. Moreover, by varying the period of suspension from the facility,
it is possible to graduate the sanctions very precisely to coincide with any problems as
they occur.
What would be the implications of the Eurobond Facility for national bonds?
A common Eurobond Facility would also leave open the possibility for governments to
borrow in extremis. Once their right of issue is exhausted, governments can always use
national bonds instead of common Eurobonds to raise funds on the market. However,
these national bonds will be considerably more expensive to issue than common
Eurobonds because:
•
National bonds will have a weaker claim to repayment – member states will have
to commit to service common Eurobonds first;
•
National bonds will come in smaller issues with thinner markets – the common
Eurobonds will be issued in relatively large volumes by every member state, the
national bonds will be issued in small volumes and will differ from one member
state to the next;
•
National bonds will have less institutional support to maintain liquid markets –
the European Central Bank (ECB) will obviously accept common Eurobonds as
collateral in central banking operations, but it will not be constrained to accept
national bonds unless they meet fixed rating criteria.
At the same time, national bonds would be subject to greater market discipline and will
be more expensive than common bonds as a source of funding. This is much like credit
card debt when compared to mortgage debt – the governments that issue them will
face a powerful incentive to pay them off and so bring their net borrowing back down to
responsible levels. Two additional implications should be mentioned as well:
•
First, national bonds would carry a visibly higher risk of default in terms of
payment moratoria, haircuts, term extensions, etc. and so investors in these
bonds will have a incentive to know they risks they are undertaking;
•
Second, countries would be able to default on their national bonds without
raising the risk of default across their whole debt profile, which implies that the
collateral damage to the banking system of a national fiscal crisis will be less
extensive.
Hence, national bonds would become an important source of information about when a
member states’ debt is becoming too big without at the same time resulting in that
member state becoming ‘too big to fail’.
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Opex Memorandum No. 147/2010: A market alternative to fiscal discipline in Europe; a proposal for a Eurobond facility
Which countries would be allowed to join the Eurobond Facility?
Participation in the Eurobond Facility should be voluntary and membership should be
open to any Member State that is willing and able to meet the reporting requirements
and to accept the repayment obligations.
Voluntary participation is important for two reasons:
•
First, some member states may only be able to join on the basis of constitutional
amendment and popular referendum. In those countries, political leaders will
have to make the case membership and choose an appropriate time for joining.
As the experience of Sweden and the eurozone has demonstrated, legal
obligations do not improve the prospects of membership. On the contrary, legal
requirements may force the pace of decision-making and instead result in
curious legal anomalies (like Sweden’s non-participation in the eurozone) and
popular distrust and resentment;
•
Second, voluntary commitments are stronger commitments because they ensure
that the debate about participation is grounded in national self-interest and
because they offer greater transparency and accountability at the national level.
Making membership open to non-eurozone Member States follows established
precedent for institutional arrangements designed to support the function of the euro;
the Trans-European Automated Real-time Gross settlement Express Transfer system
(TARGET and now TARGET2) allows non-eurozone member states to join as well. As in
TARGET, the principal distinction is that non-eurozone member state have to accept any
exchange rate risk and settlement requirements attached to working in euros.
Moreover, the advantages of allowing non-eurozone Member States to join are
considerable.
•
Participation in the Eurobond Facility would strengthen incentives for noneurozone countries to improve their fiscal accounting and consolidate their
budgetary positions;
•
It would allow governments to benefit from a lower cost of financing for
responsible borrowing without spreading the low interest rate structure across
the society as a whole in an inappropriate or pro-cyclical manner (as happened
in Latvia);
•
It would help non-eurozone member states better manage or restrict their
foreign currency debt exposure (as in Hungary).
•
Finally, non-eurozone participation in a Eurobond Facility would reinforce the
process of convergence on eurozone membership by creating an intermediate
institutional step from which the advantages of full membership are stronger
because only adoption of the euro can eliminate any remaining exchange rate
risk.
Voluntary and open participation in a Eurobond Facility would not only stabilize the
functioning of the eurozone; it would strengthen the process of monetary integration as
a whole.
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Opex Memorandum No. 147/2010: A market alternative to fiscal discipline in Europe; a proposal for a Eurobond facility
What would be the implications for Member States of leaving, or being
suspended, from the Eurobond Facility?
Member states could be suspended or kicked-out of the Eurobond Facility, thus losing
the benefits they obtain from it. Yet, it will always be cheaper to stay in the Eurobond
Facility than to break the rules, even for the largest and most powerful member states.
The logic here is not unlike the arguments used to explain why countries do not exit the
Eurozone.
•
The transition costs for moving from treasury operations based on common
Eurobonds to national bonds, both within the government and across the
banking system would be significant;
•
The country’s borrowing costs after the transition would be considerably higher;
and,
•
The symbolic implications both for the individual member state and for the
European integration project as a whole would be both obvious and negative.
In other words, defecting from the system would always be more expensive than
complying with the obligations of membership. The discipline of the system would be
much more credible as a result.
What are the principal objections to a Eurobond Facility and from whom?
Apart from some experts, high profile political figures like Belgian Prime Minister Yves
Leterme and European Council President Herman Van Rompuy have made similar
proposals as well. Each time, however, they have encountered an immovable obstacle
in German Chancellor Angela Merkel and her government. The argument the Germans
make is two-fold:
•
First, such a Eurobond would violate the no-bailout principle according to which
neither member states, nor European institutions may assume responsibility for
one-another’s debts;
•
Second, such a proposal would raise borrowing costs for Germany, which is
already the first contributor to EU expenses, and there is no willingness on the
part of the German people to shoulder this additional burden.
The first argument is more concerned with legality than principle. If the principle
behind the no bailout clause is to prevent moral hazard in the conduct of government
finances, then this proposal meets that goal better than the original Treaty language.
None of the Treaty provisions succeeded in preventing Greece from reaching an
unsustainable financial situation and none of them prevented the other European Union
Member States from coming to Greece’s assistance.
The second argument about relative costs is more difficult to dismiss, particularly when
German government debt is trading at a significant premium (high price, low yield) to
most other member states. Nevertheless, it is important to remember the context.
German government debt is expensive in the market and so cheap for the German
government because Europe is in an economic crisis. During the pre-crisis period after
the start of the single currency, the difference across countries was much less
significant. In that pre-crisis setting, the much deeper markets available to a common
Eurobond would actually work to Germany’s benefit.
5
Opex Memorandum No. 147/2010: A market alternative to fiscal discipline in Europe; a proposal for a Eurobond facility
Germany would benefit from lower interest rates during periods of crisis as well. The
comparison across countries misses an essential component. At the moment, the prices
attached to national bonds reflect the entire volume of each country’s debt. With a
common Eurobond, the only responsible share of borrowing will be reflected in
Eurobond prices and the excessive borrowing will be reflected in national bond markets.
So long as Germany continues to borrow responsibly, its financing needs will be met by
Eurobonds that will be as much a safe haven in the future as German bunds are today.
Germany will continue to benefit from favourable financing rates even as the rest of
Europe will see the incentives for fiscal discipline enhanced.
6
09/03/2011
Why German opposition to the comm…
16.12.2010
GREEK DEBATE
Germany is unfit for
the euro
By: J oerg Bibow
2 1 .0 4 .1 0
Portents of the
Greek Rescue
By: Barry E ic hengreen
1 5 .0 4 .1 0
Finally a deal, but I
am still sceptical
By: Wolfgang M ünc hau
1 3 .0 4 .1 0
Why Greece will
default
By: Wolfgang M ünc hau
0 7 .0 4 .1 0
Why an IMF solution
is most likely
By: L aurenc e Boone
WHY GERMAN OPPOSITION TO THE COMMON
EUROBOND PROPOSAL IS MISTAKEN
By: P aul D e G rauwe
1 1 .0 3 .1 0
Greek
Competitiveness Is
Not the Issue, Fiscal
Discipline Is
By: E rik J ones
0 4 .0 3 .1 0
Europe in Dire
Straits – don’t be
Brothers in A rms.
By: H enrik E nderlein
0 2 .0 3 .1 0
How should the
Eurozone handle
Greece?
By: D aniela Sc hwarzer
and Sebas tian D ullien
0 1 .0 3 .1 0
The Euro A rea's
political constraints
By: Wolfgang M ünc hau
1 6 .0 2 .1 0
Password:
By: Erik Jones
There are four things we all
want to happen as this crisis
in European sovereign debt
markets develops. We want
borrowers in Greece, Ireland,
and elsewhere to learn to
live within their means. We
want lenders to learn to
price risk appropriately and
to share in losses when they occur. We want
governments and banks to be able to meet
their day-to-day requirements. And we want
the euro to remain a common currency without
the member states having to sacrifice their
fiscal sovereignty. Only a common eurobond
with limited drawing rights and senior status
like that proposed by Giulio Tremonti and JeanClaude Juncker can meet these objectives.
2 4 .0 3 .1 0
The Greek crisis and
the future of the
Eurozone
LOGIN
Username:
Much of the German opposition to a eurobond
comes from the notion that less frugal
countries would take advantage of common
bonds to borrow beyond their means. That is
why it is important to have limited drawing
rights. The current system forces the
Germans to bail out countries when they
cannot pay. A common bond with limited
drawing rights would only ask the Germans to
put their creditworthiness on the line for other
countries when those can pay. At the same
time, there is a sharp contrast between the
cost of borrowing with a common bond and
the cost of borrowing in a national bond that
is on top of their rights in the common issue.
If we use the Tremonti-Juncker proposal as an
illustration, debt raised in common eurobonds
up to 40 percent of GDP would be very cheap
to finance; the debt raised in national bonds
beyond that threshold would be very
expensive. There is a strong market incentive
for countries not to borrow beyond their
means.
Lenders would face clear incentives and
consequences as well. The challenge is to
help investors to differentiate between debt
which is more risky and debt which is more
secure. A common eurobond with limited
drawing rights and senior status would provide
the solution. Investors would know that any
common eurobond is much like any other
insofar as debtors would ensure that it is
serviced first. National bonds would have a
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political.
The de cision to
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rate rise is
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1/3
09/03/2011
Why German opposition to the comm…
lower standing and would suffer earlier losses.
In the Tremonti-Juncker proposal, conversion
from national bonds to eurobonds would come
at a cost as well. Hence, investors would
know that national bonds have higher risk
attached and because they would stand to
lose first.
Meanwhile it is important to note that
excessive borrowing and excessive lending are
only a small fraction of the activity in bond
markets. Governments routinely recycle debt
that has matured with new bond issues and
banks rely on government securities for their
treasury operations. Under the current system
whole countries are cut off when their
sovereign debt markets run into trouble as
national governments struggle to roll over their
debt and as banks find themselves subject to
widespread losses on their most liquid assets.
A common eurobond would limit this dynamic
by creating a distinction between the rollover
of responsible lending and any excessive
increase in borrowing. At the same time it
would ensure that national banking systems
across the eurozone relied on the same
securities in their treasury operations and so
eliminate an unnecessary source of
counterparty risk.
problems
25.06.2010
For two ye ars now,
le ading policy m ak e rs,
a ca de m ics a nd
busine ssm e n have be e n
m e e ting for discussions
in the Global Econom ic
Sym posium to provide
concre te solutions for the
m ost pre ssing global
gove rnance issue s the
world will be facing this
ce ntury. He re is the
re sult of the se
discussions: a re pository
of concre te policy
proposals.
Finally, a common eurobond would only
reiterate and reinforce the commitments made
at Maastricht in 1991 and Amsterdam in 1997.
Governments would agree to avoid excessive
deficits (that is, borrowing beyond their
drawing rights) in the short term and they
would strive to achieve fiscal balance over the
medium-to-long term. There is nothing in this
that implies a transfer from north to south or
from Germany to the rest. Moreover, there is
nothing to prevent countries from pursuing
radically different versions of the welfare
state. A common eurobond does not imply a
redistributive fiscal union. On the contrary, it
ensures that such redistribution does not have
to take place.
By differentiating between responsible and
irresponsible borrowing, a eurobond creates a
market incentive for fiscal probity. By
distinguishing between senior (European) and
junior (national) debt, a eurobond gives clear
signals to the markets on how to price risk.
By making it easier for governments to rollover existing debt while still making it harder
for them to borrow irresponsibly, a eurobond
would stabilize both debt markets and interbank lending.
The German people are reluctant to accept a
common eurobond. That is because they
believe they operate only on one side of the
relationship. The reality is that Germans are on
both sides of the trade. They may not sell the
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2/3
09/03/2011
Why German opposition to the comm…
bonds but they buy them; hence they risk
suffering losses and ultimately might risk a
bailout themselves. A common eurobond with
limited drawing rights would limit their exposure
and not increase it. Everyone in the markets
would know where they would risk losses and
where they would be bailed out. Such
certainty is essential if the euro is to survive
and prosper.
Erik Jones is Professor for European Studies at
the Johns Hopkins University.
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It is high time for Berlin to rethink its dogged opposition to common European debt
obligations, writes Erik Jones
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March-A pril 2011
Europe : Just abo ut rights?
Ba rgaining powe r - and m o ne y
End of the Arabia n night?
Cartoon: Mike Mosedale
When Luxembourg Prime Minister Jean-Claude Juncker and Italian Finance Minister Giulio Tremonti proposed the creation of
common “eurobonds” just prior to the December 2010 European Council, their suggestion received a frosty reception.
Opponents of the proposal denounced the idea as an attempt to introduce a transfer union – moving money from one
group of countries to another – through the back door. Not only would such a common bond facility raise interest rates on
responsible borrow ers, the argument ran, but it would also make it easier for less responsible governments to spend their
w ay into trouble.
What the situation requires, opponents of the eurobond concluded, is more fiscal discipline supported by a permanent
facility for crisis management. Moreover, such a facility should support the stability of the European financial system, leaving
individual governments to clean up the messes they make on their ow n.
This criticism of the eurobond has a broad resonance with voters wary of footing the bill for other countries’ financial
mistakes. As an intuitive proposition, what could be worse than underwriting another country’s public debt? Yet such
criticism (and such intuition) ignores crucial features of the actual proposal and so misses the point.
A eurobond facility like the one proposed by Juncker and Tremonti would ensure that responsible borrowers alw ays pay the
lowest possible rate of interest while creating powerful market incentives to curb excessive borrow ing. More important, it
w ould shore up the stability of the European banking system while at the same time forcing private-sector investors to set
bond prices that are more in line with attendant risks.
In this way, a eurobond would better protect taxpayers from having to support yet another major bailout. And should
governments insist on behaving irresponsibly, a common eurobond w ould eliminate any systemic justification for other
countries – or the European Central Bank (ECB) – to step in.
The advantages of a eurobond of this kind w ould stem from three features: conditional participation, limited drawing rights,
and senior status. Moreover, each of these could be fine-tuned to make the effects of a eurobond stronger or w eaker.
Start with the notion of conditional participation. Countries w ould not have a right to issue common eurobonds any more
than they have a right to join the euro. Hence participation w ould be subject to qualification – with criteria like those that
firms face when listing on the stock exchange or issuing corporate bonds.
Countries would be required to meet rigid accounting standards that would ensure a higher level of transparency and they
w ould have to accept more intrusive oversight from the European Union’s accounting watchdog, Eurostat. Of course,
governments could resist this intrusion. But then they w ould give up the advantages of issuing eurobonds either as a first
instance or in refinancing existing debt.
The limited drawing rights w ould ensure that borrow ing was not excessive. Juncker and Tremonti proposed a limit is of 40
percent of gross domestic product (GDP). Other proposals use the Maastricht Treaty’s public debt ceiling of 60 percent of
GDP.
Whatever the constraint, the implication is the same. Borrow ing below the limit would take place cheaply in eurobonds.
Borrow ing above the limit w ould require states to issue more costly national obligations. This w ould create an incentive to
limit borrowing in the marketplace, where excessive debt would be increasingly expensive to finance.
The senior status of eurobonds over strictly national obligations would mean that, in the event of a crisis, the eurobonds
w ould alw ays be paid off first. This preference given to the eurobonds would reinforce the incentives to rein in government
borrow ing through three subtle yet discrete effects.
The first effect is transparency. At the moment, all of a country’s debt is much the same. Hence when Greece experienced a
crisis in its bond market, all investors in Greek bonds were equally affected.
But if Greece had issued a mix of eurobonds and national obligations, only those investors exposed to national obligations
w ould have been under duress. More important, those investors would have know n the higher risks they w ere taking w ell
before the crisis occurred – giving them the opportunity to price in that risk before the fact.
A second effect operates through bank balance sheets. Currently banks use government bonds as collateral to borrow cash
from the European System of Central Banks – the national central banks that are part of the eurozone. In normal times, this
means that the market for sovereign debts is very deep and government bond prices reflect that fact.
Once sovereign debt markets come under stress, however, the market suddenly dries up. Banks are reluctant to sell what
they hold, for fear of taking the write-down on those assets, and they are also reluctant to buy more bonds and so increase
their exposure. Prices in government bond markets suddenly become very volatile as a result.
This explains w hy the ECB took the decision to begin making purchases in sovereign debt markets – to dampen those
volatile price movements. It also explains w hy the ECB had to accept Greek bonds as collateral irrespective of their risk
rating – otherw ise it w ould have been cutting off access to liquidity (meaning money) for Greek banks. A eurobond w ould
resolve both dilemmas by creating a separate category of assets for use as collateral with central banks.
Moreover, the same assets would be used by all banks across the eurozone. Not only would eurobond markets be less
vulnerable to distress, but the eurobonds themselves w ould have greater liquidity (they could be more easily converted into
money) than any European sovereign debt instrument currently in existence. The cost of borrowing in eurobonds w ould be
comparatively lower as a result.
The third effect of giving repayment preference (or seniority) to eurobonds is that it w ould limit the systemic implications of
sovereign debt restructuring. Should a government need to restructure its obligations, it w ould put all the cost of that
exercise onto the strictly national part of its debt.
However, since private investors w ould know of that possibility from the start, either they, their creditors or their regulators
w ould build their exposure to such obligations into their models for value at risk. Meanwhile, the banking system as a whole
w ould have no reason to overexpose itself to risky sovereign debt through the process of routine treasury operations as
central banking collateral. Finally, there would be no reason for the ECB to relax its collateral rules or to buy government
obligations in secondary markets.
A eurobond w ith conditional participation, limited drawing rights and senior status would be anything but a blank cheque.
On the contrary, it would be a powerful instrument for restructuring incentives in the market. Governments would save
money by opening their accounts and reining in their spending; they would pay extra for borrowing that is excessive; and
their creditors would have to accept the consequences of any risks.
Moreover, these incentives would operate w ithout any necessary political deliberation. The redesigned stability and growth
pact, intended to instill fiscal discipline on eurozone countries, would still require a decision by the EU Council in order to
sanction a profligate member state; under a eurobond those sanctions w ould be automatic. The pact also has lengthy
procedures for encouraging action; under the eurobond regime like the one described here, the encouragement would be
immediate and continuous.
Opponents of the Juncker-Tremonti proposal should look more closely at the advantages such an arrangement would offer.
It would create a deeper and more liquid market where responsible borrowing is amply rewarded through low interest
rates. It w ould make it unnecessary for the ECB to w eaken its balance sheet or to intervene directly in the marketplace. And
it would prevent sovereign debt restructuring from triggering a pan-European banking crisis.
These advantages are going to be hard to sell to voters – both in Germany and elsew here – w ho are intuitively averse to
the idea of having common bonds or fiscal instruments.
Nevertheless, it is time for Europe’s leaders to explain to their electorates why the proposed eurobond is in everyone’s best
interest. European integration has often lurched forw ard in times of crisis and the EU has emerged much stronger as a
result. The present crisis should not be any different.
Copyright E!Sharp magazine
Why Europe Needs Eurobonds(?)
Erik Jones
SAIS Bologna Center
(ejones@jhubc.it)
Remarks prepared for
Festival of Europe
Conference on ‘State of the Union’
Florence, 9-10 May 2011
Page 1 of 9
Why Europe Needs Eurobonds(?)
Erik Jones
SAIS Bologna Center
Good morning. It is both an honor and a privilege to join a panel with
such distinguished participants. I would like to thank the organizers for
including me in such an impressive event. I would also like to thank
them for giving me a topic that has so much in-built support from my copanelists. Our first speaker, Paul De Grauwe, is rightly credited with
restarting the debate on eurobonds in an influential paper that he wrote
with Wim Moesen in April 2009.1 For those of you who are interested
in a recent synthesis, I would recommend De Grauwe’s latest essay on
economic governance in a fragile eurozone.2 As part of that debate,
Mario Monti has been a consistent advocate of Eurobonds as a source of
solidarity and market discipline;3 Lorenzo Bini-Smaghi threw his weight
behind the idea in a speech he made at the IMT in Luca last March;4 and
Zolt Darvas has reinforced calls made by his Bruegel colleagues,
Jacques Delpla and Jakob von Wiezsäcker to introduce eurobonds as
well.5 Hence my goal from their perspective is primarily to give due
weight to their insights and contributions.
Of course the organizers have been careful to include some more
skeptical voices on the panel. I think that is why they put the question
mark in the title. Yves Mersch has described the eurobond proposal as
both ‘unhelpful’ and ‘premature’, explaining that ‘if you want to
Europeanize debt then you have to Europeanize tax collection’ and
pointing out that it would be more useful to focus attention on necessary
structural reforms.6 As if that were not explicit enough, our moderator,
Giancarlo Corsetti, has joined with an impressive array of authors in a
recent CESifo report to argue that the emphasis in the debate should be
on crisis response and – and I quote – ‘under no circumstances should
the eurozone move to Eurobonds as advocated by some European
Page 2 of 9
politicians and commentators’ because such ‘Eurobonds [would] do
nothing but strengthen incentives for opportunistic behavior on the part
of debtors and creditors.’7 My goal in this context is simply to suggest
that there are ways to design the Eurobonds that mitigate such
objections.
The starting point is not the eurobond proposal itself but the challenges
that the proposal is meant to address:
First, European fiscal policy coordination has not resulted in sufficient
discipline or even an adequate level of transparency in fiscal accounting
practices. This was true long before the current crisis and implicates
France and Germany as well as Portugal and Greece. Moreover, there is
little evidence to suggest that the recent reforms to the procedures for
European macroeconomic governance – the ‘European semester’ and the
‘Euro-plus Pact’ are going to be enough to make a difference.
Second, the rapid pace of nominal interest rate convergence prior to
monetary union and the low nominal interest rate differentials charged
during the first years of the euro suggest that sovereign debt markets in
Europe have significant potential to mis-price underlying default risk.
Moreover, this is not simply a function of poor information; it derives
from the interaction between financial market integration and monetary
union – hence it is likely to recur should politicians succeed in restoring
market confidence.
Third, the cost of imposing discipline in European sovereign debt
markets greatly exceeds the danger of moral hazard at any given point in
time. Although there are clear incentives to ‘teach’ market actors not to
underestimate sovereign default risk in the future (and sovereign
borrowers not to overestimate their access to the markets), the impact of
restructuring sovereign debt in the eurozone would be considerable.
Moreover, the difference between benefit and cost increases
Page 3 of 9
dramatically as member countries get deeper into trouble – which means
that some form of bailout under the current arrangements is almost
inevitable no matter how much it may be unpopular with one or another
member state electorates. The difficult decisions taken with respect to
Greece just this weekend reflect that fact.
So the challenge is to discipline the member states while stabilizing
financial markets and avoiding moral hazard: Governments should
borrow responsibly, financial actors should pay attention to risk, and
both borrowers and lenders should be accountable for their decisions. I
am sure that there is no-one on this panel who would refuse to sign up to
this agenda. The question is whether a common eurobond provides the
best instrument for achieving those shared objectives.
Certainly a bond that allows a country like Greece to borrow as much as
or more relative to annual output than a country like Germany without
paying higher interest rates until it is too late would not provide an
acceptable solution. That is what got us into this mess in the first place –
as Giancarlo Corsetti and his colleagues are correct to insist. Therefore
it is important that any eurobond proposal come with ‘strict
conditionality’: governments who want to raise resources with such an
instrument should accept tight restrictions on their borrowing. The
eurobond proposal put forward by Jean-Claude Juncker and Giulio
Tremonti last December sets the limit at 40 percent of GDP. But that is
likely to be too restrictive because too many countries would find
significant needs unmet. The Maastricht Treaty provides a higher
threshold for responsible borrowing – at 60 percent of GDP. This seems
more realistic. For those worried about such a high threshold, it would
be possible to charge increasing premia on debt issued ever closer to that
limit. This is consistent with the spirit of the original De GrauweMoesen plan and with the synthetic proposal that De Grauwe has made
in the more recent publication I mentioned.
Page 4 of 9
But the real incentive to avoid excessive indebtedness comes when a
government needs to borrow beyond the maximum limit. Such
borrowing would not be available through common eurobonds, it would
have to be made using strictly national debt instruments, and it would
come at a significant market premium because it would provide a clear
signal to the markets of a government’s excessive indebtedness; to
reinforce that signal, we could also require that borrowing in national
debt instruments above the threshold for financing through eurobonds
would be ‘junior’ in terms of repayment to the ‘senior’ common debt
instruments. This is in line with the Delpla-von Weizsäcker plan.
Additional advantages come from the ‘strict conditionality’ for
participation. Governments that choose to issue the eurobonds could
face much more intrusive auditing of their accounts, just like firms that
list on a public stock exchange. They could have much stricter reporting
and financial planning requirements, going beyond even the ‘European
semester’. And they could face a real administrative sanction in the
form of restricted access to common eurobond financing should they
refuse to comply with policy recommendations related to fiscal
consolidation. Moreover, the strength of the proposal lies in the fact that
governments would have to accept such conditionality voluntarily in
order to get access to common financing instruments. Mr Mersch
believes we should focus on structural reforms – and he is right. But to
do so we need larger carrots in addition to larger sticks. A common
eurobond offers both measures.
This brings us to the market pricing of risk. Part of this story has
already been addressed through the limits on borrowing, the improved
market signaling, and the higher requirements for transparency. At this
point we should also introduce a structural dimension. Sovereign debt is
used in liquidity operations between private sector financial institutions
and the correspondent institutions of the European System of Central
Banks. More simply, banks use sovereign debt as collateral when they
Page 5 of 9
need to get access to cash. In turn, this means that there is always some
demand for sovereign debt instruments. Bank treasurers responsible for
negotiating interest rate swap contracts were very aware of that fact and
they took advantage of the solid demand for sovereign debt instruments
across the eurozone in designing and implementing their convergence
trading strategies in the 1990s. The notional value of these swaps
greatly exceeded the volume of sovereign debt instruments in
circulation. And bank treasurers I have spoken with are convinced that
it was the trade in derivatives rather than the trade in sovereign bonds
that brought about the convergence of nominal interest rates. By
implication, the derivatives markets and sovereign debt markets are
tightly inter-connected.
There is considerable direct exposure in the financial system to
sovereign debt instruments as well – particularly on the banking books
of private sector financial institutions, where assets are supposed to be
held to term and so, absent a credit event, are not marked to market.
Paradoxically, when these banks come under stress and so require
emergency liquidity from the European System of Central Banks, they
tend to increase the size of their banking books and so increase their
exposure to sovereign debt instruments as well. By the same token, the
European Central Bank has little choice but to accept distressed
sovereign debt instruments as collateral for bank liquidity operations.
The decision of the ECB’s governing council last May to lift any rating
requirement for the use of Greek sovereign debt as collateral is one
illustration; the decision to lift ratings requirements for Ireland this
March is another.
The solution to all these concerns is to make common Eurobonds
eligible for banks to hold on their banking books to use as collateral for
liquidity but to apply strict limits on the eligibility for any other type of
sovereign bond. Here again, the eurobond would provide a clear signal
to the markets – meaning not only bond traders but bank treasurers and
Page 6 of 9
central bankers as well. In turn, that signal will help them better to price
in associated risk.
This brings me to the final point about moral hazard and bailouts. Right
now it is hard to imagine how the eurozone can easily afford a sovereign
default. This is the point that many commentators have made repeatedly
over the past few weeks. Any credit event would force bank treasurers
holding distressed sovereign debt instruments to mark those assets to
market and so absorb a significant capital loss. The correspondent
institutions of the European System of Central Banks would have to
absorb capital losses due to their exposure to distressed sovereign debt
instruments as well – and the ECB may have to call for new capital from
its members as a result. That is why the pressure to avoid a restructuring
is so intense and it is an open question whether so-called ‘soft’ forms of
restructuring like a maturity extension would be enough to dodge the
bullet. Standard & Poor’s made it clear this past weekend that any soft
restructuring would constitute default. A common eurobond could
resolve this dilemma and so make it easier for countries to engage in an
orderly restructuring. The ‘senior’ eurobonds would continue to rollover even if the national bonds used for excessive borrowing were
brought into technical default. In turn this would make it more likely
that private sector actors could participate in the losses without any
adverse systemic implications; they could take the hit without
threatening to bring the whole financial system grinding to a halt. Most
important of all, private sector investors would be well-aware of their
exposure to this possibility before they made the investments in the first
place.
As things stand now, there is simply too much systemic risk for
politicians to insist on an orderly restructuring of sovereign borrowing in
countries like Greece and Ireland. The only recourse is to bail those
countries out – and to keep renegotiating the bailout packages until the
markets can be convinced that a crisis has been averted. Unfortunately,
Page 7 of 9
that is at best a short-term solution and it has significant medium-tolong-term implications. If it fails, the resulting crisis will be harder to
manage; if it succeeds, the next crisis will be harder to avoid.
Of course there are significant problems with the eurobond proposal –
not least those associated with its implementation. Daniel Gros has
written persuasively about the difficulty associated with introducing new
instruments that have seniority into a pool of debt that is nearing
default.8 I think these implementation issues are worthy of discussion
and have a few ideas about where that discussion should start.
Nevertheless, Mr Mersch is right to insist that we consider ‘first things
first’ and so it is worth reasserting the basic objectives.
If we agree that countries should be more disciplined and transparent in
their fiscal policies; that markets should be more efficient and effective
in pricing in risk; and that moral hazard should be avoided so that
stability can be maintained without unpopular bailouts; then we must
first decide what is the best route to achieve those objectives. Even
reformed and reinforced, the current architecture for European
macroeconomic governance offers no guarantee of discipline. Given the
market opportunities associated with financial integration and monetary
union, a crisis resolution mechanism will not improve market pricing of
sovereign default risk. And nothing proposed so far promises to deal
with the moral hazard emerging alongside the fragility of Europe’s
integration financial system.
No matter how difficult it may be to implement, a common eurobond
offers the prospect of resolving these dilemmas. Hence the first step is
to choose whether to embrace that solution or to engineer an equally
promising alternative. Thank you for your attention.
Page 8 of 9
Notes
1. http://www.ceps.eu/book/gains-all-proposal-common-eurobond
2.
http://www.econ.kuleuven.be/ew/academic/intecon/Degrauwe/PDG-papers/Discussion_papers/G
overnance-fragile-eurozone_s.pdf
3.
http://www.ilsole24ore.com/art/commenti-e-idee/2010-12-22/eurobond-interesse-tedesco-23250
9.shtml?uuid=AYmTi1tC
4. http://www.ecb.int/press/key/date/2011/html/sp110311.en.html
5. http://ideas.repec.org/p/mkg/wpaper/1002.html
6. http://imarketnews.com/node/23761
7. http://www.voxeu.com/index.php?q=node/6199
8. http://www.voxeu.org/index.php?q=node/5891
Page 9 of 9
Keynote Address
EU-Business Forum on Financial Services
Thursday, 2 June 2011
New Brunswick, New Jersey
Erik Jones
Professor of European Studies
SAIS Bologna Center
and
Director
Bologna Institute for Policy Research
Page 1 of 13
Keynote Address
Good afternoon and many thanks for allowing me to interrupt your
lunch at the close of such an interesting morning conference. It is a
real privilege to address this group and to follow the conversation that
was started by esteemed colleagues from the private sector, the think
tank world, and academe. I am particularly pleased to see a
representative of the German government. The worlds of business,
research, and policymaking should intertwine more often in such
productive ways.
If I were to give a proper title for my remarks other than ‘keynote
address’, I would probably call the give the talk some hackneyed
name like ‘Hobson’s Choice’, ‘Scylla and Charybdis’, ‘Between a
Rock and a Hard Place’, or ‘The Devil and the Deep Blue Sea’.
Anyone of those cliches would capture the basic message which is
that Europeans confront a clutch of problems with no easy or obvious
solutions. Worse, as these problems have become ever more tightly
tangled together, the stakes have continued to rise.
Hence we now face alternatives that were once considered completely
unrealistic and yet must be accepted as legitimate prospects. Here I
am talking about the possibility of a sovereign default in Europe, the
collapse of one or more national banking systems, the exit of one or
more countries from the eurozone, and the breakup of the euro as a
common currency.
Please understand that I do not welcome these possibilities and I am
not eager to engage in fearmongering or doom-saying. On the
contrary, I have spent most of my professional life explaining why I
believe that the European Union’s economic and monetary union is
much stronger than most analysts ever imagined it could be, how it is
very unlikely to fail or even to splinter, why the eurozone should be
larger and not smaller, and how any government would have to be
crazy to try and restore its national currency.
Page 2 of 13
Nevertheless, I have to admit that Europe’s political, economic, and
financial leaders have backed themselves into a corner by refusing to
take decisive action early on as this situation developed. Along the
way, they have managed to frighten each other, the markets, and their
own people. As a consequence they have nurtured opposition to
institutional reforms that could not only resolve the crisis but also
prevent it from recurring.
This indictment is sweeping and I should point out that academics,
journalists, and policy analysts – in other words, people like me –
share in the responsibility for the mess we find ourselves in today.
Our contributing role is to rely too heavily on theory and too little on
data or experience. As a community, we tend to speak in terms of
standard concepts and models – fitting the world into abstract
packages that we already think we understand. This tendency has not
been fruitful for the policy debate. On the contrary, we have managed
not only to mis-diagnose the problem but also to prescribe solutions
that have made the situation worse. In doing so, we have failed our
core ambition to inform effective policy; the world is not a better
place for our efforts.
Of course I say ‘we’ but that is really just a false modesty. They were
wrong and I was right all along. And if only they had listened to me,
you would be enjoying your lunch while we talked about more
cheerful thinks like global warming or the upcoming Republican
primaries. Now let me explain why. My story is structured in five
parts. For those of you who like to count, I should caution that each
part is longer than the one preceding it.
First, the problem – if that is what we really want to call it – is not the
single currency. It is financial market integration. And ‘the problem’
is that financial market integration worked better than we could have
imagined. Think about it, the goal of financial market integration is to
help channel capital from places where it is less productive to places
where it is more productive. In plain English, that means that money
should flow where it can find the highest rate of return. When this
Page 3 of 13
process started in Europe in the early 1990s, the standard deviation
across bid yields on ten-year sovereign bonds in the countries that
would later form the eurozone was close to 5 percentage points.
Between 1993 and 1998, that variation fell to just 1 percentage point.
And when the euro started in 1999 it was down to less than one-half
of one percent.
It didn’t take huge volumes of capital flowing across countries to
compress interest rates this way. As one prominent European bank
treasurer who was active during the period explained it to me, much
of this convergence was achieved through trading in interest rate swap
contracts between banks working within the same national markets.
And while the notional values of these contracts swelled dramatically,
the actual payments made were much smaller and the net payments
much smaller still.
Second, interest rate convergence in Europe’s integrated financial
marketplace increased the significance of very small differences in
rates of return. The resulting ‘hunt for yield’ was a question of
volume. There is no big surprise there. Nevertheless it had
implications that were not fully appreciated before the fact. The most
important implication is that you tend to get a lot more bad lending in
markets where interest rates fall dramatically than where they remain
relatively stable – even if the quantity of potential lending available in
both countries increases by equal measure.
One of my colleagues, Filippo Taddei, has an elegant formal model
that uses information asymmetries to explain why this is the case. In
his model, banks flush with cash look to book out loans. Where they
have already saturated the market – by which I mean, where they have
already loaned out money to everyone willing to borrow money at the
prevailing market rate – then there are likely to be few takers for fresh
loans. The dodgy investors willing to take a risk on loans at that rate
have already been weeded out either by scrupulous bankers or by
inexorable market forces.
Page 4 of 13
Where interest rates have fallen dramatically, by contrast, there will
be many who suddenly want to borrow. Unfortunately, many of these
new customers will not be able to repay the money they borrow. The
banks in Taddei’s model cannot tell the difference between good
potential customers and bad ones – this is the information asymmetry.
They will weed out some of the dodgy customers, but many more will
slip through the cracks. The implication is that the growth in lending
results in an increase in bad assets, even where lending standards
remain unchanged. A good illustration of this would be Sean
Fitzpatrick’s rapid expansion of the Anglo-Irish bank. Fitzpatrick
grew his bank on the principle of quick decision-making. He would
charge slightly higher rates of interest than his competitors but he
would get you the loan quicker – sometimes even the same day. As
interest rates declined across the Irish market, this business practice
made it easy for Fitzpatrick to outgrow his competitors. They grew
along with the expansion of the market, but he grew faster because he
responded more quickly and so led the curve. It also meant that
Fitzpatrick wound up with an increasingly problematic asset book. Of
course we could blame Fitzpatrick’s low lending standards for his
predicament, but that would not be entirely accurate. Fitzpatrick
knew his market and his customers, and he did business with some of
the best names in Ireland. Even if Fitzpatrick’s standards were
relatively high, the odds were stacked against him and so it was
inevitable that he would accumulate bad debts. This stacking of the
odds or ‘adverse selection bias’ is the essential finding of Taddei’s
analysis.
The third step in the story is the growing variation across countries in
the balance between savings and investment. Some countries will
save more than they invest and export the difference to other countries
that will invest more than they save. The countries that have
historically had low interest rates will become the international
lenders; the countries where interest rates were high will borrow.
Again that was always the goal of international financial integration –
to break the cross-country correlation between savings and
investment.
Page 5 of 13
The measure of this difference in roles across countries – net savers
lending money on the one hand and net investors borrowing money on
the other hand – shows up in the flow of goods and services and so is
captured in the balance on current accounts. If a country saves more
than it invests, it must be exporting more than it consumes and if a
country invests more than it saves, it must be absorbing more imports
than exports. Put another way, when the capital account is in surplus
because money is flowing into the country from abroad, then the
current account must show an offsetting deficit for the country’s
international payments position to balance.
This change in current account performance does not necessarily
happen immediately but it will eventually show up during the process
of financial market integration and nominal interest rate convergence;
it is the balance of payments expression of the hunt for yield across
countries; it is the elimination of the Feldstein-Horioka puzzle. Hence
if we take the standard deviation across countries of current account
balances as a percentage of gross domestic product we will find that it
fluctuates between three and three-and-a-half percentage points for
the future eurozone countries between 1991 and 1998. Between 1998
and 2000, that variation almost doubled to more than six percentage
points where it stayed until the middle of the last decade; between
2005 and 2007, it jumped again from six to eight percentage points.
What this means in practical terms is that some countries – like
Greece, Portugal, and Spain ran up increasingly large deficits while
others like Austria, Germany, and the Netherlands ran large surpluses.
The point to keep in mind, is that these changes in relative current
account positions had very little to do with relative cost
competitiveness – at least for the deficit countries. They were driven
by capital flows and not the price elasticity of demand for any given
country’s goods and services. You can see this immediately when
looking at the correlation, timing, and magnitude of the changes
involved. Let me give you an example. Between 1997 and 2001,
Greece’s real effective exchange rate relative to the fifteen West
Page 6 of 13
European member states of the European Union depreciated by seven
percent. In other words, the Greece became more competitive and not
less during the five year period. Meanwhile, the country’s current
account deficit increased from just under two percent of gross
domestic product to between eleven and twelve percent of gross
domestic product. Greece became competitive but the impact of its
increased net borrowing more than overwhelmed any trade effects.
The situation in Austria and Germany reveals the scale of the contrast.
Austria’s real effective exchange rate depreciated by four percent and
Germany’s real effective exchange rate depreciated by six percent
between 1997 and 2001. In other words, both countries gained
competitiveness, Austria less than Germany and Germany less than
Greece. The change in current account performance nevertheless,
went the other way around. Austria’s current account deficit
contracted from 2.3 percent of GDP to just under 0.8 percent, and
Germany’s current account deficit decreased from 0.5 percent of GDP
to very close to balance.
We can go deeper into this competitiveness discussion during the
question and answer period. My point is that it is ancillary to the
problem we face now and I am happy to give you the data to explain
why I believe that to be the case.
For the moment, though, I’d like to move to the fourth step in the
problem. This step is going to be very familiar to those of you
working in U.S. financial markets because it looks a lot like the
liquidity glut that Federal Reserve Chairman Ben Bernancke has
complained about coming from countries in Asia and the Middle East
to the United States. The combination of low interest rates, adverse
selection, and huge lending volumes led to asset bubbles that
manifested differently from one part of the eurozone to the next. The
bubble formed in government paper in Greece, real estate in Spain
and Ireland, and consumer credit in Portugal.
These were obviously not the only countries to experience asset
Page 7 of 13
bubbles. House prices also rose dramatically in the Netherlands and
the UK, for example, not to mention the countries of Central and
Eastern Europe or the Baltic States. Not all of the bubbles that
formed resulted in crises – hence, the Dutch housing market came in
for a relatively soft landing. And not every country that experienced
bubbles experienced them in all categories of assets. Italy’s housing
is expensive, and the cost has risen significantly with the greater
accessibility and lower cost of home mortgages, but I would not
describe it as a bubble.
So my point is only that the combination of factors emerging out of
financial market integration was one source of asset bubbles that were
also being experienced elsewhere for other reasons. The fact that it is
one source, however, is an important concession. If you have one
source of a problem that manifests differently in different countries,
then you also have a potential source of correlation. If for whatever
reason the effects of financial market integration – the reduction in
interest rates and the change in the volume or direction of
international capital flows – were to be thrown into reverse, then the
different bubbles in different parts of the eurozone would suddenly
have to deflate and the adverse selection in lending practices within
those countries where interest rates fell significantly would suddenly
appear in sharp relief.
This point about implicit correlation was made in 2002 by a PierreOlivier Gourinchas in his comments on a paper about financial market
integration published by Brookings. Gourinchas made it clear then
that the Europeans had created a system where countries like Greece,
Ireland, Spain and Portugal could find themselves suddenly without
access to international credit. Since their capital accounts would lurch
into balance, their current account positions would have to balance as
well. The net effects of such a shut-down are all around us. You can
see it in the rapid rise in unemployment and housing defaults – even
in countries like Ireland and Spain where it is very painful and
difficult to go through personal bankruptcy. You can see it in the
simmering popular discontent as well. The current Greek government
Page 8 of 13
was elected to escape austerity and not to impose it. The current Irish
government was elected primarily to throw the other bums out.
But it is the fifth part of my story that is the most worrying because it
connects the process of financial market integration to the wider
patterns of European macroeconomic governance. You should note at
this point that I have not talked much about fiscal discipline or
excessive government borrowing. I talked a bit about the bubble in
Greek government paper, but most of the conversation has not been
about government debts or deficits. That is not a professional bias.
On the contrary, I came to this story because I work on
macroeconomic governance. In 2002 and 2003, I wrote a series of
papers warning about the real potential for excessive borrowing
should European governments relax the rules for fiscal discipline –
known collectively as the ‘stability and growth pact’ – and should
smaller countries like Greece choose to take advantage of the
increased creditworthiness and relaxed current account constraints.
Instead, the French and German governments colluded to hold the
excessive deficit procedure at the heart of the stability and growth
pact ‘in abeyance’. This could be a big ‘I told you so’ moment for
me. But the fact of the matter is, I got it wrong. Greece is the
exception. So, for that matter, is Hungary. Countries like Ireland,
Latvia, Portugal, and Spain are closer to the rule.
You see there really is no choice between defaulting on your debts
and remaining in the single currency. If a country – like Greece –
tries to leave the euro in order to default, it will only make its
situation worse and not better. So even if small countries do take
advantage of their enhanced creditworthiness to run up huge debts and
deficits, ultimately they realize that they will have to pay it all back.
That is why successive Greek governments have reluctantly admitted
the need for austerity. They know as well as everyone else that they
cannot keep borrowing forever. I know there are some doubters on
this point – particularly at Moody’s where they have just downgraded
Greek sovereign obligations to a level that corresponds with roughly a
fifty percent chance of default. But I think it is a fair bet to say that
Page 9 of 13
the Greeks would much rather pay back their debts than either leave
the eurozone or default.
Where my story intersects with macroeconomic governance is not
through excessive debts and deficits. Rather it is through the
extraordinary mechanisms that member state governments and
European institutions are willing to go in order to prevent damage
from occurring to systemically important banks or to national banking
systems writ large. The Dutch government’s nationalization of Fortis
Netherlands is one example, the Belgian government’s rushed bailout
of Fortis holding is another. Then there are the spate of bank recapitalizations that started in Britain and spread across the Continent
(apart from Italy, where Silvio Berlusconi and Giulio Tremonti
shoved UniCredit into the arms of Muammar Ghaddafi and his Libyan
sovereign wealth fund). We could also list the ECB’s decisions to
suspend the tightening of its collateral rules in September 2008; the
relaxation of any rating requirement for Greece in May 2010 or
Ireland in March of this year; and the decision to intervene directly in
secondary sovereign debt markets.
These decisions were all taken for the same fundamental reason: to
shore up systemically important banks or national banking systems.
And they all contributed to the same basic phenomenon: national
governments became more indebted even as the European System of
Central Banks became more heavily exposed to sovereign debt. This
was fine so long as the markets remained confident in the ability of
national governments and European institutions to manage the
situation. It stopped being acceptable once that confidence began to
evaporate and Europe’s ability to agree on a solution and then
implement it effectively came into doubt.
This is where the Hobson’s Choice part of the conversation becomes
apparent – and so I promise that I am working toward a conclusion.
A Hobson’s Choice is a choice with zero degrees of freedom. I worry
that we are backing into that situation right now. The European
Central Bank cannot continue to increase its exposure to sovereign
Page 10 of 13
debt indefinitely and it cannot accept the consequences should one or
another sovereign entities go into default. Hence its only choice is to
find some way to limit its exposure without experiencing a ‘credit
event’. That is why the ECB is so reluctant to accept any re-profiling
in Greece. And it is also why it is so worried about further contagion
from Greece to Ireland or Portugal, where it faces a very similar
situation.
The governments of the highly indebted countries cannot accept to
pay the interest that would be charged in the market for their debt and
yet they cannot risk the consequences of a default for their domestic
banking systems either – because they cannot see any alternative to
the public sector as a source of banking capital. So if they want to
keep their banks alive, they have to maintain access to credit markets
and somehow lower the cost of borrowing. The question is whether
this will be easier inside or outside the single currency. So long as the
ESCB remains committed to providing liquidity to distressed national
banking systems, the answer is clearly ‘in’. Should the ECB restrict
access to liquidity, the balance could shift to ‘out’.
The governments of the net creditor countries have problems of their
own. Their own banks are exposed to the consequences of financial
market integration and require fresh injections of capital as well.
They have to worry that central banking activities will start a round of
inflation that could eat into the real value of their savings. And they
have all the political problems associated with making sure they get
their money back. A comment made by the Luxembourg Central
Banker, Yves Mersch, last May helps to put their situation into
context. He insisted that the fundamental principle of the market
economy is that you pay back your debts. He might have added that
you also must accept the consequences of your decisions. That is why
the creditor countries are so eager to see Greece meet its obligations
or – at a minimum – the private sector absorb any losses.
The trick is to find some formula to satisfy all three positions at once.
We have to lower the risk associated with central banking activities
Page 11 of 13
without jeopardizing the stability of systemically important banks or
national banking systems. We have to lower the debt service
requirements for highly indebted countries so that they can afford to
recapitalize their domestic banks while at the same time paying back
their debts. And we have to create a framework that prevents this
situation from recurring by avoiding moral hazard. This framework
cannot eliminate risk and so it must channel it in such a manner as to
clarify the relationship between risk and return. Most important, it
must ensure that there is a transparent and equitable distribution of the
burdens associated with any loss.
This is a tall order and it is where I will leave you to ponder over your
desert. As I mentioned at the outset, there is an institutional solution
that can resolve this problem. That is the creation of a eurobond with
limited drawing rights. This solution flies under a number of different
flags, it has been proposed by several think tanks, and it has attracted
support from government leaders, central bankers, and the European
Parliament. Moreover, it is a solution that works alongside and
strengthens the financial market integration that we wanted, that
worked better than we expected, and that got us into this mess in the
first place.
I would be happy to go into the mechanics of the proposal but your
coffee is probably getting cold and I have already gone on a bit too
long. The basic point is that Europeans are either going to have to
look at the bright side of introducing a common eurobond or they are
going to have to confront as series of ever more unpalatable
alternatives: sovereign debt restructuring, banking system crisis,
eurozone exit, or breakup of the euro.
The bright side is pretty bright. We can organize a system to make
sure that countries like Greece pay back their debts in full an on time.
Even if that part doesn’t work, we can at least create the conditions
for an orderly restructuring that does not bring down the Greek
banking system as a whole. We can insulate the European System of
Central Banks from unnecessary losses on its existing assets and we
Page 12 of 13
can prevent it from having to loosen its collateral rules again in the
future. Finally, we can make it easier for net lending countries to
recognize and appreciate the risks they are assuming when sending
their money abroad.
The arguments against the creation of a eurobond are mistaken if not
misleading. Such an instrument would not imply a transfer from rich
to poor or from boom to bust. That is what we do through financial
market integration in the present system – and with consequences that
are now readily apparent. A common eurobond would not raise the
cost of sovereign borrowing in the creditor countries either – because
borrowing costs are relative, because it would be the single must
liquid and creditworthy asset in the eurozone, and because it would
offer a real alternative to dollar denominated obligations at a time
when the United States is uniquely under challenge.
Of course Europeans do not all agree on this eurobond proposal. But
they do not agree on any workable alternative either. Moreover, it is
not something that they can sweep under the carpet – as the recent
show-down between the IMF , the ECB and the ratings agencies
makes apparent. Europe is caught between a rock and a hard place, it
must sail between Scylla and Charybdis to confront either the Devil or
the deep blue sea. Bluntly, Europeans are being asked to face a
Hobson’s Choice, which is a choice that is not a choice. It is time for
Europeans to start thinking outside the box.
Many thanks for your attention.
Page 13 of 13
Muddling through the sovereign debt crisis (1)
In the first part of a two-part analysis on Europe’s sovereign debt crisis, Erik Jones
cautions against the extreme scenarios being advanced by leading commentators
A heavy burden to carry: Greek Prime Minister George Papandreou is under intense scrutiny. Photo:
Wikimedia Commons
Newspaper columnists like the Financial Times' Wolfgang Munchau (FT, 5 and 12 June) and economics
commentators like Nouriel Roubini (FT, 13 June) would have us believe that Europe will either emerge
from the current sovereign debt crisis as a much more united political and economic union or it will
fracture as one or more of the peripheral countries like Greece, Ireland, and Portugal are forced out of
the euro. Although there are strong arguments to be made either way, the most likely scenario is less
dramatic. Europe is neither going to unify nor founder in the wake of this crisis; instead it will continue to
muddle through.
The extreme views
The points made my Munchau and Roubini (among many others) are worth taking seriously. Munchau
claims that there is no way to avoid a crisis that does not lead somehow toward common European fiscal
institutions. Greece cannot pay back its debts unless it can convince the markets to accept a reasonable
rate of interest; the markets will only reduce the rate of interest they charge to Greece if there is some
external guarantee from some other more credit-worthy country - like Germany - that money lent will
come back; Germany will only extend that guarantee if it has assurances that the Greeks will pay their
taxes; and Greece will only provide those assurances if other countries - including Germany – offer similar
guarantees as well.
Following the logic of this chain of reasoning, Germany will ultimately face the choice between some basic
level of fiscal federalism in Europe or an unstructured sovereign debt default in Greece that could bring
the German banking system down as well. The technical requirements for amending the European
treaties are easily met and so it is plausible to assume that the Germans will prefer closer European
Union to another Lehman-Brothers type of experience.
Roubini is less sanguine in his assessment of the prospects for political union and correspondingly more
pessimistic about the reasonableness of the Germans. Hence the likelihood is high that Greece will face a
sovereign default that could not only damage its domestic banking system but also leave it locked out of
credit markets for an extended period of time. The alternative of ever tighter austerity is only marginally
more attractive because it means very slow growth in output and incomes for the Greek economy as a
whole. Meanwhile, the country suffers from a lack of international competitiveness that cannot be
rectified so long as its prices and wages are denominated in euros. Hence Roubini and others argue that
it would be easier to accept the inevitable and exit the monetary union: this would do no more damage
than an unstructured default and it at least offers the prospect of shortening the period of price and
wage adjustments that must be achieved under any circumstances.
The more realistic scenario
Both perspectives are right and both perspectives are wrong. They are right insofar as they rest on an
accurate diagnosis of the market conundrum. Greece can pay its debts but not the cost of servicing them,
and those servicing costs are more likely to go up than to go down. This is why the ratings agencies
continue to downgrade Greece; it explains how the ratings downgrades feed back into a negative selffulfilling prophecy as well. The lower the rating becomes, the more market confidence in Greece
deteriorates, and the less market participants want to trade in Greek sovereign debt. They are right to
be pessimistic about popular attitudes in Germany toward a fiscal union as well. The Germans are united
in rejecting what they view as a 'transfer union' from North to South - and they are hardly alone in that
sentiment. The Austrians, the Dutch, the Finns, the Swedes, and the Slovaks all reject such a possibility
as well. More important, such transfers tend to erode political union within countries like Belgium, Italy,
and Spain. Hence it is hard to imagine how they could promote political unification at the European level.
Where the extreme views are wrong is in their assessment of what a default would entail and how much
effort is necessary to organize a bailout. Here the European Central Bank has an important story to tell.
ECB members like Lorenzo Bini-Smaghi have been consistent in maintaining that any sovereign default
would have unacceptable consequences. The direct effect would be to wipe out the capital of the
affected country's own banking system; it would likely make a big dent in the capital of the ECB as well.
And indirectly it would impose losses across Europe and North America, further cutting into bank capital
at a time when financial institutions are struggling to meet higher requirements for solvency. This would
have a chilling effect on confidence in inter-bank markets with long-term implications that are impossible
to anticipate. In other words, sovereign debt markets for countries like Greece, Ireland, and Portugal are
simply too big to fail.
The solution is simply to bail out both those governments that are in trouble and the banks that hold
their debt. Ideally, this would be done without creating a 'credit event' - a change in the ratings or
related characteristics of sovereign bonds that would implicate technical definitions of default used in
derivatives contracts and for prudential oversight. This is essentially what has happened in the
successive Greek bailouts, in the European Financial Stability Facility (EFSF), through various changes in
ECB collateral rules, and through the ECB's direct purchase of sovereign bonds in secondary markets. It
is also what should take place in the planned European Stability Mechanism (ESM). The only debate is
about whether the private sector should share in any losses resulting from sovereign debt restructuring
and whether such losses would constitute a credit event. The German government says that the banks
should pay at least as much as taxpayers; the ECB and the ratings agencies insist that this would be
tantamount to default. It was always far easier to imagine Germany backing down on this issue than
jumping from the threat of default to the construction of common fiscal institutions. That is in fact what
we got with the most recent round of proposals. And that is what muddling through is all about.
06/07/2011
Erik Jones
Comments
A nna Pichoir
Sounds lik e we are all going to m uddle through on a le viatha n vassa l a nd survive as be st we ca n. Don't e x pe ct
m iracle s e x ce pt te ctonic change s according to Christine Lagarde , the ne w dire ctor of IMF.
08/07/2011
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Muddling through the sovereign debt crisis (2)
Erik Jones concludes his analysis by calling for the creation of eurobonds
The name is Bond, Eurobond: Italy’s economy and finance minister, Giulio Tremonti, is one of many
experts calling for this new instrument. Photo: Wikimedia Commons
Muddling through may not be very dramatic and yet it is fraught with risk - which is why writers like
Wolfgang Munchau and Nouriel Roubini look hard for some alternative. Europe will face moments of high
tension, with severe consequences should European politicians fail to organize an appropriate response.
As the ratings agencies continue their relentless downgrades of European sovereign borrowers and
warnings of impending default, the pressure will only continue to mount. Nevertheless, the balance of
forces is likely to prevent movement toward the extremes of political unification or disintegration.
European integration has gone far enough to be too difficult to reverse, and yet Europe's citizens are
unwilling to see it progress very much further.
Implications
The economic implications of muddling through are important. In the short term, muddling through will
fuel volatility in financial markets - particularly as key institutions come into conflict with one another at
the international level and member state governments face ever more heated opposition at home. The
tension between the Council of Economic and Finance Ministers (ECOFIN Council) over private sector
participation is one example; the possibility of an unfavourable ruling on the legality of the first Greek
bailout by the German Constitutional Court is another.
The bottom line is that things could still go very wrong. Negotiations over the precise details of the
different bailout agreements could founder. Popular unrest either in the peripheral countries or in the
core could undermine necessary reforms. A further slowdown in the United States economy could chip
away at market confidence. Violence could spread across North Africa and into the more volatile regions
of the Arab world. In other words, just about any strong shock could tip Europe's current strategy for
dealing with the sovereign debt crisis out of balance.
In the medium-to-longer term, muddling through will strengthen the divergence between Europe's core
and its periphery, even as it reduces the pace of economic activity overall. Growth in core Europe will
slow as a result of the crisis; growth in the periphery will weaken even further. Meanwhile, the
heightened sense that European financial markets could go badly very quickly weakens confidence in the
European economy as a whole. The consequences are all around us. They can be found in volatility of
sovereign debt prices and in the decline in producer confidence in April and May this year. The risks
associated with tragic miscalculation dominate the headlines and they also create caution in the board
room. This not only slows the pace of investment but also hinders the prospects for future growth.
Imagining a Better World
Things do not have to be so fragile. Indeed, there is a proposal floating around that could offer a solution
to the sovereign debt problem. This is the proposal for a common European sovereign debt obligation - a
Eurobond - that would be jointly issued in order to ensure market confidence but would also provide only
limited drawing rights for participating countries to avoid abuse. This proposal was floated most
prominently by Giulio Tremonti in an editorial he co-authored with Jean-Claude Juncker last December. In
various and subtly different guises, the idea has attracted support from Lorenzo Bini-Smaghi at the ECB
and from the European Parliament as well. And it has reemerged most recently in a letter signed by Guy
Verhofstadt, Giulio Amato, and a list of other European economic and political heavyweights. Best of all, it
does not require excessive European unification in order to function. There is no need for a common fiscal
authority and no implicit requirement for north-south transfers. Indeed, the proposal is not so different
from the bonds issued by the European Financial Stability Facility (EFSF) and the European Stability
Mechanism (ESM).
A common eurobond simply offers a more equitable, stable, and transparent mechanism for doing much
the same refinancing that is already in existence. Hence if muddling through is the most realistic
prospect, there is at least one plausible and superior alternative. Moreover, this alternative is much
closer to muddling through than either a dramatic step forward in the process of European integration or
an even more dramatic unstructured sovereign default. The question now is whether Europe's heads
of state and government have the courage to go down that route.
09/07/2011
Erik Jones
Comments
Share |
31 August 2011
1 September 2011
Framing the Eurobond
Erik Jones(*)
German opposition to the Eurobond proposal is intense. Whether you poll public opinion or survey editorials in the popular newspapers, the answer is always the same. The German people do not want to
be responsible for the debts of the Greeks, Irish, Portuguese, Spanish, or the Italians. They do not want
to run the risk that they could have to pay back the loans taken out by countries that appear to have
borrowed irresponsibly. And they do not believe their parliamentarians should be allowed to make a
decision that would be too painful to reverse. Joining the single currency was bad enough; Germany will
not join a European ‘debt union’.
This position is as clear as it is irrational – at least from the perspective of those who support the Eurobond proposal. To begin with, the original idea of having a Eurobond was to create market incentives
for highly indebted countries to rein in their spending. The proposal sketched by Italian Economics Minister Giulio Tremonti and Luxembourg Prime Minister Jean-Claude Junker in a December 2010 editorial
in the Financial Times offers good illustration. Countries would only be allowed to borrow cheaply in
Eurobonds up to a certain share of their gross domestic product (GDP), they would get access to such
borrowing under strict conditions, and they would commit to servicing those obligations first. Any additional borrowing would be much more expensive because it would be much riskier for investors. Hence
there is an incentive for countries to stay within the limits.
More to the point, Germany is already exposed to significant losses in the event of a default by
Europe’s highly indebted countries, both directly and indirectly. In direct terms, German banks are the
source of much of the lending at risk. German pension funds are heavily investing in now questionable
sovereign debt as well. And Germany is a principal stakeholder in the European Central Bank, which
holds the largest exposure of all. Indirectly, the German financial system is dependent on banks in other
European countries for its funding; if those other banks take losses, German banks will have difficulties
too.
Finally, the introduction of Eurobonds should lower the risk of default. Right now the highly indebted
countries are struggling because they cannot get access to private capital at affordable interest rates.
Greece, Ireland, and Portugal have already been pushed out of the market; Spain and Italy are paying
dearly to stay in. The more these countries have to pay for their borrowing, the more likely they are to
be forced to write down the principal of their debts. Greece spent most of the summer trying to avoid
this outcome; now it appears to be inevitable. Market speculators are betting that other countries will
soon follow. And that market speculation results in higher interest rates that in turn make some sort of
default more likely.
In other words, German opposition to the Eurobond proposal is irrational from the perspective of Eurobond-supporters because the introduction of Eurobonds will increase fiscal discipline in highly indebted
countries, shield Germany from losses on the borrowing that has already taken place, and weaken the
The opinions expressed herein are strictly personal and do not necessarily reflect the position of ISPI.
(*) Erik Jones, Professor of European Studies and Director Bologna Institute for Policy Research Paul H. Nitze School of
Advanced International Studies (SAIS), Bologna Center, The Johns Hopkins University.
2
ISPI - Commentary
influence of speculation in the marketplace. But being irrational from one perspective does not make
the German position irrational full stop. On the contrary, German opponents of the Eurobond say they
fear such an instrument will force them to accept risks in the future; they would rather simply take their
losses now than face that uncertain fate. For supporters of Eurobonds, the losses now appear large
and the risks in the future appear smaller; for the Germans themselves the weights are the other way
around.
This distinction between opponents and proponents of the Eurobond proposal may seem irrational but it
is not. On the contrary, it is a fairly standard problem in behavioral economics – as demonstrated by
Daniel Kahneman and Amos Tversky in their Nobel prize-winning research on ‘prospect theory’. [Only
Kahneman received the prize in 2002 because the Nobel committee will not recognize scholars postmortem; Tversky passed away in 1996.]
Kahneman and Tversky showed that people respond differently to losses and gains, even when the
expected value of the outcomes is precisely the same. The idea is simple. When confronted with uncertainty about the risks involved, people will tend to exaggerate losses. In the Eurobond example, the
Germans can raise any number of questions. How can we be sure that access to the bonds will be
limited? What mechanism will be used to make sure that the highly indebted countries pay back their
Eurobonds first? What will happen if investors take fright and stop refinancing these Eurobonds? Such
questions give rise to uncertainty which only increases over time. As a consequence, the perceived risk
that the Germans will have to cover losses on Eurobonds issued on behalf of Greece, Ireland, Portugal,
etc., increases disproportionately. And psychological opposition to the Eurobond proposal increases as
well. The Germans would rather cut their losses today than face the prospect of such exposure in an
uncertain future.
For proponents of the Eurobond, the calculus works the other way around. Faced with precisely the
same level of uncertainty, they focus on the concrete advantages in the present and pay less attention
to the implications of future conditions. Here we should return to the point about fiscal discipline. Right
now it is relatively easy for supporters of Eurobonds to discount the implications of constrained access
to cheap bond financing. The most important point is to reduce the cost of debt servicing in the present.
That is the immediate gain. The market discipline they will face in future public finances can be dealt
with later.
The other insight from ‘prospect theory’ is that the emotions surrounding the fear of loss are stronger
than those surrounding the prospect of gain. That explains why the Germans are so much more passionate in rejecting Eurobonds than anyone else is about supporting the proposal. It explains why the
Germans are easier to mobilize and more vocal in expressing their opinions as well. Editors can sell
more newspapers running against Eurobonds in Germany than writing in favor of them in Greece, Ireland, or Spain.
Turning this situation around will be a challenge. To begin with, European politicians will have to reframe the German debate to emphasize the gains to Germany from the introduction of Eurobonds and
to minimize the uncertainty surrounding potential future losses. This will require concrete concessions
from highly indebted countries about their willingness to control spending in the future. The recent move
to introduce formal constraints on debts and deficits into national legislation is part of this re-framing
effort. Such constraints may not make much sense for a Keynesian economist, but they offer critical
psychological support.
A more difficult part of the re-framing will be to convince the German people that the introduction of
Eurobonds will result in gains. This will require concessions as well. What the Germans want to hear is
that the highly indebted countries will fulfil their obligations. They want to see real evidence that existing
sovereign debt will be paid back in full and on time. Such re-framing of the argument excludes the possibility for any restructuring – because restructuring means that creditors experience a loss and not a
gain. Only a firm commitment to repay can change the terms of the debate.
3
ISPI - Commentary
Fortunately, the Eurobond proposals floated by Tremonti and others
can meet both sides of this re-framing effort. They create a market
discipline that is consistent with formal debt and deficit requirements
and they lower the cost of debt servicing enough to make it possible for
highly indebted countries to meet their obligations in full. The trick now
is for European politicians to strengthen this message. They can
change the terms of the debate. And once they do, they will discover
that even staunch German opposition can be overcome after all.
La ricerca ISPI analizza le
dinamiche politiche, strategiche ed economiche del
sistema internazionale con
il duplice obiettivo di informare e di orientare le scelte
di policy.
I risultati della ricerca vengono divulgati attraverso
pubblicazioni ed eventi,
focalizzati su tematiche di
particolare interesse per
l’Italia e le sue relazioni
internazionali.
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dell’ISPI sono realizzate
anche grazie al sostegno
della Fondazione Cariplo.
ISPI
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Via Clerici, 5
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© ISPI 2011
Searching for the Regional Political and Economic Governance
Principles for a Common Currency
Erik Jones
Bologna Institute for Policy Research
SAIS Bologna Center
Nuffield College, Oxford
(ejones@jhubc.it)
comment prepared for
Enhancing the Institutional Framework for the Euro
Euro 50 Group and European University Institute
Brussels, Belgium
23 January 2012
Five Principles for Europe’s Monetary Union
This comment is does not develop a single line of thought. Rather it makes five quick observations
that might be used as the basis for discussion. These observations touch on old arguments in the
study of optimum currency areas and monetary integration. Nevertheless, the current crisis casts
them in new light.
1.
Macroeconomic imbalances across countries arise from capital market flows and not
divergences in competitiveness.
The variation across countries in sovereign bond yields at the long end of the maturity spectrum
diminished markedly in the decade prior to the launch of Europe’s economic and monetary union.
The standard deviation across ten-year bond yields for the twelve original euro participants
(including Greece) fell from a high of 4.86 percentage points in 1993 to just 0.49 percentage points
in 1999. Meanwhile, the variation across countries in current account balances expressed as a
percentage of gross domestic product (GDP) increased, albeit with a lag. The standard deviation
across national current account balances for the same twelve countries was 3.07 percentage points
in 1996 and 6.21 percentage points in 2000. See Exhibit 1A.
The theoretical mechanism behind this negative correlation relies on the negative influence
of nominal interest rates on investment, consumption, and perhaps even government spending.
When interest rates are high, they tend to depress activity; when they are low, activity tends to
increase. Yet as investment, consumption or government spending expand under the influence of
rapidly declining nominal interest rates, they tend to outstrip domestic output and so cause imports
to grow at a faster pace than exports. A negative balance on the country’s current account is the
result. Greece is a good example. In 1994, Greece has a modest current account surplus worth 1
percent of GDP and nominal long term interest rates of 20.7 percent. These interest rates were
already declining from a 1992 high of 24 percent; by 2000 long-term nominal interest rates had
fallen to just 6.1 percent. The Greek current account deficit in 2000 was worth just over 12 percent
of GDP. See Exhibit 1B.
Nominal interest rate convergence is not the only variable that correlates with changes in
current account performance; movements in the real effective exchange rate correlate as well.
Looking across countries, Germany experienced an improvement in its real effective exchange rates
during the period from 2000 to 2007; Germany also managed to run up a significant cumulative
current account surplus over the same period. By contrast, the peripheral countries of the eurozone
– meaning Portugal, Ireland, Italy, Greece, and Spain – show a deterioration in their real effective
exchange rates and an accumulation of current account deficits. See Exhibit 1C.
This correlation between real effective exchange rates and current account balances lies at
the heart of the claim that macroeconomic imbalances are the result of divergent price
1
developments. The theoretical mechanism supporting this claim rests on the notion that as prices
increase in one country relative to its major trading partners, its exports will lose market share and
its imports will increase. In turn, this will have negative consequences for manufacturing
employment.
Given this theoretical mechanism, the data for export market shares and manufacturing
employment present significant anomalies. Looking at the eighteen years from 2001 to 2007, both
Germany and the eurozone periphery lost market share – but Germany lost more. See Exhibit 1D.
Germany also lost significantly more manufacturing employment over the same period. See
Exhibit 1E. Of course the selection of the base year is important. The 1990s were difficult for
Germany and many German manufacturing jobs were lost in the aftermath of unification.
Nevertheless, German manufacturing shed jobs during the single currency as well; meanwhile, the
peripheral countries of the eurozone added manufacturing employment. This data is inconsistent
with the idea that changes in price competitiveness can explain macroeconomic imbalances.
If capital flows from Germany to the eurozone periphery lie at the heart of European
macroeconomic imbalances, then these data for export market shares and manufacturing
employment are no longer inconsistent with the causal mechanism. Lower interest rates reduce the
cost of capital and so enhance the cost-competitiveness of exports from the periphery; higher rates
of investment should strengthen productivity growth to compensate for higher costs as well. The
claim here is not that all of the capital flowing in peripheral countries was used wisely; rather it is
that effective use of capital inflows could explain how peripheral countries were able to sustain
both their export market share and their manufacturing employment.
2
2.
Divergences in cost competitiveness are the result of macroeconomic imbalances despite the
positive influence of monetary integration.
The decomposition of real effective exchange rate movements into components reflecting
movements in the nominal effective exchange rate, relative GDP price deflators, and the relative
ratio of total nominal wages to nominal GDP (also known as relative ‘real’ unit labor costs), makes
it possible to trace different areas of influence. It also makes it easier to make inter-temporal
comparisons. See Exhibit 2. Four factors stand out:
•
•
•
•
first, monetary integration resulted in lower levels of relative GDP price inflation across the
eurozone periphery with the possible exception of Spain;
second, relative real unit labor costs increased after monetary union only in Ireland and Italy
– which is unsurprising given how much the governments of these countries sought to
compress relative wage growth during the run up to membership in the euro;
third, movements in the nominal effective exchange rate tended to be offset by even larger
movements in relative GDP price inflation except in larger countries like Italy and Spain –
and only Italy saw any benefit from this increase in competitiveness in terms of the current
account; and,
fourth, German performance under monetary union stands out primarily for its exceptionally
low GDP price inflation combined with its low real unit labor costs – the peripheral
countries are much closer to the European average.
The mechanism underlying this divergence in performance is closely related to the link
between capital flows and current account performance. In the capital receiving countries, activity
outstrips domestic output and so puts upward pressure on wages and prices. This should tend to
increase the relative performance of the GDP price deflator but may not lead to a change in relative
real unit labor costs if the influence on the aggregate for nominal wages and nominal GDP is
roughly the same. In the capital sending country, the effect is the opposite. Domestic consumption,
investment and government spending should run below domestic output, putting downward
pressure on wages and prices. The net effect across sending and receiving countries will be a
cumulative price competitive divergence over time.
The conclusion to this point is that the peripheral countries have good reason to worry about
their relative cost competitiveness. Adverse movements in relative prices did not do too much
damage to export market shares or manufacturing employment prior to the crisis. But having
benefitted from easy access to foreign lending, these countries are in poor shape to compete without
relatively low capital costs. The situation would be worse without the euro – particularly if
countries like Ireland and Italy cannot repeat the huge wage compression they used to prepare for
membership in the single currency. Relative cost competitiveness remains a challenge nonetheless.
3
3.
You can force countries to borrow more easily than you can force them to lend.
The relationship between lenders and borrowers has a complicated ethics and power dynamic – and
the ‘intuitions’ that predominate in a modern market economy are not always appropriate. A bank
cannot put money into the pocket of a consumer; by contrast, foreign banks can deposit money
freely into domestic banks. This contrast is significant. When a domestic bank attracts foreign
deposits, it has no incentive to seek offsetting foreign assets. On the contrary, it has domestic
clients who would be eager to use the money if only the bank could offer a more affordable lending
rate. The surge in foreign deposits facilitates this transformation. As the supply of loanable funds
increases in the domestic banking system under the influence of foreign depositors, the price of
lending for domestic uses should be expected to decline.
Banks are not the only channel for foreign capital. Sovereign debt markets operate as well.
When foreign investors bid up the price of domestic sovereign debt, they price-out domestic
investors. The composition of sovereign debt holders changes from domestic to foreign, and the
composition of domestic investments changes from high yielding sovereign debt to a mix of lower
yielding sovereign debt and other domestic assets. Again this effectively increases the supply of
loanable funds on the market, which lowers the cost of borrowing and so expands the demand for
the funds made available. Even a country like Italy, with both a relatively conservative domestic
banking system and household savings many times greater than government borrowing, is not
immune to the influence of this mechanism. Hence during the run-up to monetary union, the
decline in nominal interest rates took place as foreign investors bought up an increasing share of the
Italy’s public debt. In 1990, Italy’s long-term nominal interest rates were 13.5 percent and foreign
holdings of Italian sovereign debt accounted for just 5.3 percent of the total; by 1998, Italian longterm nominal interest rates had fallen to 4.9 percent and foreign holdings of Italian sovereign debt
accounted for 25.2 percent of the total.
A country’s hold over its foreign lenders is virtually nonexistent. All a foreign investor
needs to do is sell their bond holdings or close their accounts. The domestic government cannot
compel foreigners to purchase its debt instruments and domestic banks can all too easily find
themselves cut off from international capital markets. Both consequences are evident in Greece,
Ireland, and Portugal. They show early signs in Spain and Italy as well. And while it is true that
the European Central Banks provision of three-year liquidity has prevented a liquidity crisis in the
European banking system, it is still not evident that it has encouraged increased cross-border
lending.
4
4.
The flight-to-safety should not be allowed to move geographically.
The asymmetry in the relative power of borrowers and lending shows up at both the domestic and
the international levels. Germany cannot stop financial actors from moving their money into its
banks and government assets; the peripheral countries of Europe are hard pressed to keep domestic
savings at home. This is the defining feature of the flight to safety in Europe; the pattern is
geographic. Faced with uncertainty, investors send their money somewhere safe. Moreover, their
actions are self-reinforcing. As capital flight raises borrowing costs on the periphery, clearing
houses increase the charges they impose when accepting peripheral country assets as collateral and
ratings agencies reconsider the creditworthiness of peripheral country borrowers.
This pattern is different from the flight-to-quality observed in the United States. U.S.
investors tend to move across asset classes rather than geographic boundaries; the flow of funds is
from equity to fixed income and government-backed paper and not from one state to the next.
Moreover, financial institutions in the U.S. rely on the same high quality assets for their banking
transactions. Hence even a marginal decline in the creditworthiness of the U.S. government, like
that imposed last August when Standard & Poor’s removed its triple-A rating, has little impact on
the usefulness of U.S. government paper as the preferred shelter from unwanted risk.
The difference between the European and U.S. patterns is important because of the link
between government finances and national banking systems in eurozone member states.
Governments tend to market the bulk of their debt to banks domiciled within their country and
banks tend to hold disproportionate amounts of their home country’s sovereign debt. Moreover,
governments have to issue debt if they need to shore up the domestic banking system and the
domestic banking system tends to suffer whenever there is a fall in the price of the home country’s
debt. The implication is that the European flight to safety is doubly destabilizing because it
undermines national banking systems while at the same time hobbling member state governments.
This is why European countries are so prone to country-specific liquidity shocks. It is also why
even countries that do not borrow hugely from abroad – like Italy – remain vulnerable. Italy’s
cumulative current account deficit is only a small fraction of the country’s GDP and yet both
sovereign debt markets and the country’s major banks have experienced acute moments of crisis.
5
5.
Neither integrated labor markets nor a federal fiscal system necessarily insulate against a
country-specific liquidity shock.
U.S. regional economies are less vulnerable to asymmetric shocks but they are not immune. The
experience of the Southwest region in the 1980s is a good illustration. The decade started with a
Mexican debt crisis that crippled many Texas banks – only to be followed by a decline in world oil
prices and a collapse of the savings and loans industry. The impact of these events were
concentrated in the Southwest region and the effects were not the same in, for example, New
England. Hence while Southwest income per capita was increasing relative to the U.S. average
during the 1970s, it suddenly declined at the end of that decade; New England income moved in the
opposite direction. See Exhibit 5A. The same is true for employment. A gap in employment rates
opened up in the 1980s with the Southwest trailing New England. Both effects – the income gap
and the employment gap – are persistent up to the present. See Exhibit 5B.
The influence of the federal transfer system has not been to eliminate the difference. On the
contrary, transfers per capita are higher than the US average in New England, where both income
per capita and employment are superior. Indeed, transfers per capita in New England actually
increased shortly after the region experience a positive per capita income shock. By contrast,
transfers per capita to the Southwest region are even lower relative to the US average than per
capita income throughout the period. See Exhibit 5C.
Population flows have not helped to eliminate the gap between New England and the
Southwest either. Rather than flowing toward the region with higher income and employment,
population growth has concentrated in the Southwest. See Exhibit 5D. Much of this growth may
be due to immigration from outside the country and particularly from Latin America; some is still
likely to be the result of internal migration from other parts of the U.S. North, like the Great Lakes
region. Whatever the origin, the effect of labor flows has been reinforcing rather than
countervailing.
A better design for federal transfers might improve the situation in the Southwest and the
introduction of active labor market policies might result in more efficient matching of Southwest
labor and New England job prospects. The point is not that Europe could not benefit from
optimally designed systems. Rather it is that the systems operating in the United States are far from
optimal in terms of stabilizing regional economic performance in the face of asymmetric shocks
and, ultimately, promoting income and employment convergence across regions. Europe does not
have to emulate U.S. institutional design to achieve U.S. levels of performance. Indeed, attempting
to replicate U.S. federal fiscal institutions or labor market policies may have significant unintended
consequences.
6
Concluding Remarks
The current crisis in European sovereign debt markets was caused by financial market integration
and not by the creation of the single currency. If anything, the existence of the single currency and
the European System of Central Banks helped to insulate European countries from some of the
worst effects of the economic and financial shock that originated in the United States. This should
lead us to consider how we might capture the benefits of financial market integration while
avoiding the unintended risks that international capital flows tend to create.
The answer should allow for the emergence of macroeconomic imbalances but it should
encourage productive investment and discourage the formation of asset market bubbles. Moreover,
the answer should channel the flight to safety across asset classes rather than geographic space.
Such an answer does not require a great leap forward in European integration. But it does depend
upon some mechanism for severing the unhealthy interdependence at the national level between
government fiscal accounts and the bank balance sheets.
The creation of a shared sovereign debt obligation would meet many of these objectives.
Appropriately structured conditionality for participation in the sovereign credit club could take care
of the rest. This is not a solution for the current crisis. But it should prevent the next.
7
9.00
Exhibit 1A: Interest Rate Convergence and Macroeconomic Imbalances
8.00
7.00
Stan
ndard Deviation ((Percent)
6.00
Long‐term Interest Rates
5 00
5.00
4.00
Current Account Balances
3.00
2.00
1.00
0.00
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
Year
2001
2002
2003
2004
2005
2006
2007
2008
2009
AMECO Database
30
4
Exhibit 1B: Long‐term Interest Rates and Current Account Balances in Greece
2
25
‐2
20
‐4
15
‐6
‐8
10
‐10
‐12
5
‐14
0
‐16
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
Year
Long‐term Interest Rates
Current Account Balance
AMECO Database
Current Account Balancce as Percent GDP
ent
Long‐term Nominal Interrest Rate as Perce
0
Exhibit 1C: REER Movements and Current Account Performance, 2000‐2007
REER
Curr Acct
28.8
14 0
14.0
11.1
8.8
Germanyy
Ireland
10.8
6.2
Greece
Spain
p
Italyy
Portugal
g
‐6.5
‐12.3
‐13.0
‐44.5
‐63.2
‐85.1
Source: Ameco Database
110
Exhibit 1D: Relative Performance in World Export Market Share
105
100
Index, 1991
1=100
95
90
85
80
75
70
65
60
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
Year
Germany
PIIGS
AMECO dataset (AXGT)
11000
Exhibit 1E: Employment in Manufacturing
10500
10000
9500
Thousan
nds
9000
8500
8000
7500
7000
6500
6000
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
Year
PIIGS
Germany
AMECO Database
2007
Exhibit 2: The Decomposition of Real Effective Exchange Rates
Greece
Germany
1991-2000
1991-2000
2000-2007
2000-2007
52.9
6.3
4.3
5.3
2.5
REER
NEER
16.7
GDP Def
8.8
RULC
REER
-7.3
NEER
-9.1
Italy
2000-2007
1991-2000
3.8
GDP Def
REER
NEER
GDP Def
RULC
-16.1
-25.3
-26.0
Portugal
1991-2000
Spain
2000-2007
1991-2000
22.4
21.3
REER
1.9
8.9
1.9
NEER
-10.0
4.6
GDP Def
REER
-0.2
RULC
2000-2007
13.9 13.0
11.1
6.2
RULC
-10.9
-4.4
-5.2
5.1
3.8
2.0
6.6
NEER
2000-2007
11.5
10.8
15.3
3.5
REER
RULC
-38.6
Ireland
14.0
GDP Def
2.4 0.5
-5.7
-12.3
1991-2000
7.6
0.7
NEER
-13.0
-26.1
GDP Def
RULC
-0.8
-3.8
120%
Exhibit 5A: Salary and Wage Payments per Employee, Relative to US Average
115%
110%
105%
100%
95%
90%
85%
1969
1974
1979
1984
1989
1994
1999
2004
2009
Year
New England
Southwest
Bureau of Economic Analysis
65%
Exhibit 5B: Population Share in Employment
60%
55%
50%
45%
40%
1969
1974
1979
1984
1989
1994
Year
New England
1999
2004
Bureau of Economic Analysis
Southwest
2009
125%
Exhibit 5C: Per Capita Income and Transfers Relative to the U.S. Average
120%
115%
110%
105%
100%
1969
1974
1979
1984
1989
1994
1999
2004
95%
90%
85%
80%
75%
Year
New England Income
New England Transfers
Bureau of Economic Analysis
Southwest Income
Southwest Transfers
2009
40,000,000
Exhibit 5D: Population in New England and the Southwest
35,000,000
30,000,000
25,000,000
20,000,000
15,000,000
10,000,000
1969
1974
1979
1984
1989
Year
New England
1994
1999
2004
Bureau of Economic Analysis
Southwest
2009
European Policy Analysis
April . ISSUE 2012:4e p a
Erik Jones*
Eurobonds, Flight to Quality, and TARGET2
Imbalances
Abstract
This brief shows how the introduction of eurobonds may provide an effective if still partial solution
to some of the fundamental problems that have been raised during the sovereign debt crisis in the
eurozone. In a five part analysis, it shows how the structure of European banking collateral and the
geographic flight to quality across European financial markets have strong negative interactions in
sovereign debt markets. The brief also considers the advantages and disadvantages that eurobonds
would present as a potential solution to this underlying dynamic. The brief concludes by focusing
on the challenges associated with implementation of any eurobond proposal. Although it makes
some possible suggestions, the most important message from this analysis is that implementation
should be the focus for debate. The time has come for Europe’s political leaders to take a decision
about whether to pursue eurobonds in principle.
Introduction
The debate over whether member states that have
adopted the euro as a common currency should issue
common sovereign debt instruments (or eurobonds) has
receded into the background. The European Commission
published its green paper to solicit comments on three
different versions of what it renamed the ‘stability
bond’ proposal on 23 November 2011 and then never
followed up.1 German political opposition to the idea
was categorical, at least within much of the country’s
economics establishment and among the governing
parties of the center-right.2 Moreover, the Germans were
hardly alone. The Dutch, the Finns, and the Slovaks
were only among the most prominent in joining German
opposition to the eurobond proposal.
*
1
2
Opposition to eurobonds is unlikely to soften in the near
future. Although many commentators suggest that some
manner of commonly issued and jointly underwritten
sovereign debt instrument will come about eventually,
even ardent supporters of the proposal, like Luxembourg
Finance Minister Jean-Claude Juncker and Italian Prime
Minister Mario Monti, admit that the moment is not ripe.
Meanwhile popular discussion about the eurozone crisis
has moved onto more technical matters. Some of these
issues are relatively easy to grasp, like concern expressed
about the size and composition of the European Central
Bank’s (ECB) balance sheet. The ECB has accumulated
large stocks of sovereign debt both as collateral against
loans given to banks and through the direct purchase
Erik Jones is Professor of European Studies at Johns Hopkins SAIS, Director of Bologna Institute for Policy
Research and Senior Research Fellow at Nuffield College, Oxford.
‘Green Paper on the Feasibility of Introducing Stability Bonds.’ Brussels: European Commission,
COM(2011) 818 final, 23 November 2011.
The position taken by the former chief economist of the European Central Bank, Otmar Issing, is illustrative.
See Otmar Issing, ‘Why a Common Eurobond Isn’t Such a Good Idea,’ Europe’s World (Summer 2009).
More recently, Issing has been quoted as saying that a common eurobond represents the greatest threat to the
stability of the eurozone. See the Eurointelligence daily briefing of 30 March 2012 at
www.eurointelligence.com.
Swedish Institute for European Policy Studies
www.sieps.se
EUROPEAN POLICY ANALYSIS 2012:4 . PAGE 1
of government debt securities as part of the securities
markets program. Others are more complicated, like the
debate that has erupted over TARGET2 imbalances – or
the relative positions of different national central banks in
the real-time gross settlement system that is used to make
financial payments across countries within the eurozone.
No matter how obscure such issues may seem, however,
they are vitally important. The president of the German
central bank (or Bundesbank), Jens Weidmann, created
a minor scandal when the German daily Frankfurter
Allgemeine Zeitung (FAZ) leaked a letter he wrote to ECB
President Mario Draghi to complain about the growth and
deterioration in the ECB’s balance sheet and about the
exposure of the Bundesbank to the rest of the eurozone
through TARGET2 transfers.3
Weidmann’s letter was followed closely by comments
from former ECB Executive Board member Jürgen
Stark, who argued that Europe’s monetary policy makers
risked undermining the stability of the euro through their
aggressive extension of credit to banks under the longterm refinancing operations (LTROs) undertaken in
December 2011 and February 2012.4 These refinancing
operations provided unlimited amounts of liquidity at
very low rates of interest for periods of up to three years.
In this way, the ECB fulfilled its role as lender of last
resort – channelling roughly €1 trillion in new funds
into the European banking system. Stark’s concern was
that the collateral received in exchange for this lending
exposed the ECB to potentially unacceptable losses.
Draghi responded to both criticisms directly in his 8
March press conference but he could not silence the
debate.5 Even Weidmann’s own attempts to minimize
the significance of the controversy in an open letter to
the FAZ on 13 March did little to ease concerns.6 Hence
Draghi returned to these themes more forcefully in his 26
March speech to the Association of German Banks.7
Such debates appear divorced from the idea of having
European governments issue common debt instruments
and yet they are not. To a large extent, the expansion of
3
4
7
5
6
the ECB’s balance sheet, the emergence of significant
TARGET2 imbalances, and the necessity for the ECB to
make extraordinary amounts of credit through the LTROs
all stem from the fact that national governments in the
eurozone issue national sovereign debt. The purpose of
this brief is to suggest how the introduction of eurobonds
might provide an effective if still only partial response to
these more recent concerns.
The brief has five sections. The first explains how the
collateral available to national banking systems and the
geographic pattern of the flight to quality have influenced
the current sovereign debt crisis. The second reintroduces
the debate about eurobonds, focusing on the question
of market discipline. The third examines some of the
criticisms of the eurobond proposal related to moral
hazard. The fourth connects this eurobond debate back
to the problems of collateral and the flight to quality. The
fifth sections concludes with policy recommendations
related to the implementation of eurobonds.
Two problems
The argument about the potential utility of eurobonds
hinges on two elements in the financial architecture of the
eurozone: banking collateral and the flight to quality. The
point about banking collateral touches on the relationship
between national governments and their domestic banks;
national governments and national banking systems are
closely interdependent. Domestic banks offer a captive
market for sovereign debt by helping to float new issues
and by creating an active secondary market. Meanwhile,
sovereign debt offers an essentially ‘risk-free’ asset to
facilitate day-to-day banking operations by providing
collateral for use in obtaining liquidity from central banks
or for clearing transactions either bilaterally or with
central clearing houses. However, this interdependence
has negative as well as positive implications. When
a country’s domestic banks get into trouble, the
governments lose access to the markets; when sovereign
debt markets get into trouble, the domestic banks suffer
disproportionate losses; and when sovereign debt markets
get into trouble because the banks are already in trouble
to begin with, the problems are self-reinforcing. This third
‘Die Bundesbank fordert von der EZB bessere Sicherheiten,’ Frankfurter Allgemeine Zeitung
(29 February 2012).
Ambrose Evans-Pritchard, ‘Germany’s Monetary Doyen Slams ECB’s “Shocking” Balance Sheet,’ The
Telegraph (8 March 2012).
http://www.ecb.int/press/pressconf/2012/html/is120308.en.html.
http://www.bundesbank.de/download/presse/publikationen/20120315.TARGET2_balances.pdf
http://www.ecb.int/press/key/date/2012/html/sp120326_1.en.html.
PAGE 2 . EUROPEAN POLICY ANALYSIS 2012:4
scenario where both the banks and the governments are in
trouble at the same time is essentially what has happened
to the countries of the eurozone periphery.
The Greek case offers a good example of the negative
interdependence between banks and governments. When
private sector investors were forced to accept a reduction
in the value of the Greek bonds they were holding, the
impact fell disproportionately on the Greek banking sector.
As ECB President Mario Draghi explained during his 4
April 2012 press conference, private sector involvement
in the Greek debt restructuring not only ‘wiped out’ the
capital of the Greek banks but also left them without
collateral to use in routine banking operations. Hence it
was necessary to arrange a special recapitalization of the
Greek banks in order to ensure that at least some of them
survived the process.8
The flight to quality is what investors do with their money
when faced with a sudden change in the risk environment.
They liquidate investments that they perceive to be
excessively risky and move the liquidity (or money) into
investments that have a lower risk profile. This reaction
describes the mechanism behind the crisis. It also
explains why Europe is distinctive when compared with
other large money unions like the United States.
In the United States, the flight to quality runs across asset
classes. When investors in the United States take fright,
they sell equity to buy fixed income; when the fright is
extreme, they move up the fixed-income quality ladder
until they end up holding large stocks of U.S. government
bonds.
The flight to quality in Europe operates across asset
classes as well, but it is also geographic. Frightened
European investors sell their positions in the more risky
or peripheral countries and increase their holdings in
stable core economies like Germany. At the extreme,
domestic investors from within the peripheral countries
join the capital flight and take their money abroad. This
geographic dimension of the flight to quality is what has
damaged the economies on the periphery. As the money
flowed out of the peripheral countries, their economies
ground to a halt.9
These two different features of Europe’s financial
architecture work closely together. The geographic flight
to quality damages both public finances and national
banking systems, and any weakness in either public
finances or national banking systems is enough to trigger a
flight to quality. There is no fixed pattern to this dynamic.
Whether the weakness of government finances triggers
a capital flight that damages the banking system, as in
Greece, or the weakness of the banking system triggers
a capital flight that damages public finances, as in Spain,
the consequences are the same and both the banks and the
governments end up in trouble. Hence the challenge is to
solve both structural problems at once.
There are two ways to manage the collateral problem. One
is to place tight standards on eligibility rules; the other is
to improve the quality of the collateral that is available.
The first solution is difficult to enforce because of the
inherent differences in the quality of assets in different
markets. The last time the ECB made a concerted effort to
strengthen its collateral rules was just prior to the collapse
of Lehman Brothers; the ECB soon found itself loosening
restrictions on available collateral instead in order to make
sure that banks across the eurozone had ample access to
liquidity.10 The same tendency can be seen in the ECB’s
treatment of Greece, Ireland, and Portugal. Each time the
national governments of these countries experienced a
downgrade that could wipe out the eligibility of its debt as
collateral, the ECB has made an exception to its collateral
requirements so that the national banking systems of
those countries could remain solvent.11 The difficulty
involved in enforcing collateral rules will not go away
easily. The fact that the ECB signalled its intention to
tighten its eligibility criteria is no guarantee that it will
not find it necessary to loosen them up again.12
http://www.ecb.int/press/pressconf/2012/html/is120404.en.html.
Silvia Merler and Jean Pisani-Ferri, ‘Sudden Stops in the Euro Area,’ Bruegel Policy Contribution 2012/06
(March 2012).
10
See Erik Jones, ‘Reconsidering the Role of Ideas in Times of Crisis,’ in Leila Simona Talani (ed.) The Global
Crash: Towards a New Global Financial Regime? (London: Palgrave, 2010) pp. 64-66.
11
See press releases from the ECB website (www.ecb.int) for 3 May 2010 (Greece), 31 March 2011 (Ireland),
and 7 July 2011 (Portugal).
12
Ralph Atkins, ‘ECB Tightens Banks’ Use of Assets as Collateral,’ Financial Times (23 March 2012). Draghi
sought to minimize the significance of this change in his 4 April 2012 press conference.
http://www.ecb.int/press/pressconf/2012/html/is120404.en.html.
8
9
EUROPEAN POLICY ANALYSIS 2012:4 . PAGE 3
Improving the quality of collateral available is also
difficult. Banks use sovereign debt as collateral because it
is the closest thing available to a ‘risk-free’ asset. Hence
the challenge is either to come up with a risk-free asset
that does not depend upon the national government or to
make sovereign debt less risky. This problem cannot be
addressed within national boundaries. Either the banks
will have to rely on assets from other countries, or other
countries will have to absorb some of the risk of sovereign
debt. This is essentially the problem that the ECB faces
with those countries whose banks are in distress today.
Such banks have been allowed to issue bonds with
government backing as part of European Union (EU) and
International Monetary Fund (IMF) assistance packages.
In turn, the banks have been using these governmentbacked bonds as collateral in seeking liquidity from their
national central banks. The question is whether other
central banks should accept such bonds as collateral as
well. On 23 March 2012, the ECB surprised the markets
by suggesting that national central banks should approach
the matter on a case-by-case basis rather than being
expected to share the risks that such bonds necessarily
entail.13
The flight to quality problem has only one solution. If
the goal is to allow investors to move across asset classes
and risk ratings without encouraging them to move across
geographic boundaries, then the only way forward is to
create a relatively ‘risk-free’ asset that circulates in all
jurisdictions. Alternatively, some countries’ risk-free
assets will always be less risky than others and investors
seeking quality will have to move money across national
boundaries to take advantage of the difference.
A solution to all of this is to create a sovereign debt
instrument that is less risky than existing government
bonds and that can flow freely from one country to
the next (so that domestic capital can stay put). This is
essentially what eurobonds could offer. If European
governments issued jointly underwritten eurobonds
rather than relying exclusively on national sovereign debt
instruments, then the flight to quality in Europe would not
have to move geographically even if it continued to flow
across asset classes (as in the United States). If European
governments issued jointly underwritten common
sovereign debt obligations, then governments could gain
access to financing from wider markets and banks could
rely on assets for collateral that did not depend on their
home state.
The payoff for restructuring the flight to quality and
improving the quality of existing collateral is considerable.
If the flight to quality in Europe did not move across
countries, there would be less pressure on TARGET2
imbalances to finance sudden gaps in international
payments; if governments could rely on pan-European
sources of financing, there would be less pressure on
the ECB to shore up domestic sovereign debt markets
through direct purchases of distressed sovereign debt;
and if the aggregate balance sheets of national banking
systems were not heavily exposed to losses on holdings of
national sovereign debt instruments, there would be less
pressure on the ECB to loosen its own collateral rules and
provide additional liquidity to banks.
The existence of jointly underwritten common sovereign
debt instruments like eurobonds would not solve all
of Europe’s financial problems. The United States
also experienced the crisis – including intra-district
imbalances in financial flows across the Federal Reserve
System – despite the widespread use of U.S. Treasury
bonds.14 Nevertheless, by releasing some of the pressure,
eurobonds would help stabilize the European financial
system. Even if that is not the end of the problem, it is
still a good start.
The problem is convincing a reluctant public – most of
whom view eurobonds as a way for less creditworthy
governments to escape market discipline at the expense
of their more creditworthy neighbours. While economic
conditions are good, the weaker countries will take
advantage of low interest rates to borrow excessively;
when economic conditions worsen, the weaker countries
will default. In the worst case scenario, Europe’s most
creditworthy nations will end up absorbing the losses.
The irony, of course, is that this worst case scenario is
precisely what happened in the absence of eurobonds;
indeed, excessive borrowing is that danger that eurobonds
were meant to address.
Eurobonds as market discipline
Here it is useful to clear up some lexical confusion.
Sovereign debt instruments denominated in euros have
been around for a long time and the idea of allowing
See Draghi at http://www.ecb.int/press/pressconf/2012/html/is120404.en.html.
See the 6 March 2012 blog post by Michiel Bijlsma and Jasper Lukkezen of Bruegel
(http://www.bruegel.org/blog/detail/article/696-target-2-of-the-ecb-vs-interdistrict-settlement-account-of-thefederal-reserve/).
13
14
PAGE 4 . EUROPEAN POLICY ANALYSIS 2012:4
European institutions to issue their own obligations dates
back to the European Commission presidency of Jacques
Delors. Both of these things – debt denominated in euros
and obligations issued by European institutions – are
called eurobonds. Moreover, prominent politicians like
former Italian Prime Minister and European Commission
President Romano Prodi continue to make proposals to
deepen the market for euro-denominated obligations and
to expand the issue of debt by European institutions. But
such eurobonds are not what the debate is about.
The ‘eurobonds’ proposal at the heart of more recent
controversy centers around the idea of having national
governments issue common and jointly underwritten
sovereign debt obligations. Such bonds will be
denominated in euros and they will most likely be
issued by a European institution. But what makes them
distinctive is that they will be used to finance the member
states individually and yet they will be backed by the
member states collectively. That is what it means to say
they are common and jointly underwritten sovereign debt
obligations.
There is another distinguishing feature. The member
states will have only limited access to sovereign debt
financing through eurobonds. The reason is to discipline
member state indebtedness – much in the same way that
credit cards or current account overdrafts have limits.
Here it is useful to consider that the original ambition
was not to resolve the current sovereign debt crisis; it
was to prevent such a crisis from occurring. Governments
had already shown little restraint in their borrowing,
European institutions did not enforce their own rules and
regulations, and market participants failed to price in much
of a difference in the cost of borrowing from one country
to the next. Hence, the goal of the eurobond proposal was
to change the structure of sovereign debt markets in order
to enhance market discipline. Unsurprisingly, given this
emphasis on market mechanisms, the first proposal to
create eurobonds with limited access was introduced on
the opinion pages of the Wall Street Journal.15
The idea underpinning the proposal is straightforward
and uncontroversial: governments should have limits on
what they can borrow responsibly and they should be
discouraged from borrowing ‘excessively’. The challenge
is to get the markets to distinguish between responsible
and excessive borrowing. There are two basic techniques;
15
16
one focuses on the borrower and the other focuses on the
borrowing itself.
The strategy embedded in the Maastricht Treaty that set
the framework for monetary integration focuses on the
borrower. Governments are enjoined not to run excessive
deficits and they are sanctioned if they fail to comply.
Experience has shown, however, that this strategy was
unsuccessful for both political and economic reasons.
Politically, the Council of Economic and Finance
Ministers (Ecofin Council) proved both unable and
unwilling to impose sanctions on offending governments.
The February 2001 reprimand of the Irish government for
failing to rein in its economy was rescinded; the February
2002 decision to ignore excessive deficits in Germany and
Portugal turned out to be unjustified; and the November
2003 decision to hold the excessive deficits procedure for
France and Germany ‘in abeyance’ was unlawful.16 More
recently, the debate about Spanish compliance (or noncompliance) with the new fiscal compact demonstrated
that borrowers will resist restraint and lenders are
reluctant to impose it. Economically, the markets have
showed little interest in differentiating between different
countries’ sovereign debts until suddenly the spreads
between the most- and least creditworthy countries
widened dramatically, precipitating the current crisis.
The problem with focussing on the borrower is that
it offers an all-or-nothing set of alternatives. The risk
rating of a country influences all of its public debt. The
price structure will change across different maturities,
but within any given maturity both responsible and
irresponsible borrowing are treated the same. Moreover,
any default on one set of obligations constitutes a credit
event for all the rest. This creates an important dynamic
in how markets perceive national creditworthiness. The
entire stock of a country’s outstanding debt is affected
once a country’s solvency or liquidity is called into
question. Long-term institutional investors that thought
they had purchased virtually risk-free assets when a
government appeared to be borrowing responsibly could
find themselves taking substantial losses on those assets
should the government’s financial position suddenly
change. This is the dynamic that has affected banks in
countries like Ireland and Spain.
The eurobond proposal originally published in the
Wall Street Journal offered an alternative approach
John Springford, ‘A Bonding Exercise for the Euroland,’ Wall Street Journal (7 September 2009).
See Erik Jones, ‘The Politics of Europe 2004: Solidarity and Integration,’ Industrial Relations Journal 36:6
(December 2005) p. 450.
EUROPEAN POLICY ANALYSIS 2012:4 . PAGE 5
to differentiating between responsible and excessive
borrowing – one that focuses not on the borrower but
on the debt. The reason for introducing eurobonds is to
create a clear threshold between one type of borrowing
and the other. It achieves this distinction by altering the
structure of guarantees attached to the debt instruments.
All participating countries would underwrite each-other’s
responsible borrowing by issuing a common series of
obligations, and each country would be able to borrow
with these obligations up to a fixed threshold of their
gross domestic product (GDP). Any borrowing beyond
that threshold would not be jointly underwritten and so
the guarantees would vary from state to state. Given the
different guarantees attached to the debt, the markets
would charge a low price for the jointly underwritten
bonds and a higher price for the nationally-specific bonds.
Moreover, by eliminating this sudden transformation
in the risk-rating of supposedly ‘risk-free’ assets, the
eurobond proposal promised to mitigate the onset of any
sovereign debt crisis.
The threshold effect is only one element in the debate
and the eurobond proposals that evolved during the
early months of 2010, included a number of different
dimensions of distinctiveness between responsible
borrowing and excessive borrowing.17 In turn, each
of these distinguishing features reinforced the price
difference between eurobonds and national bonds, thus
strengthening the market disincentive for countries to
get excessively into debt. Some of these features are
primarily structural. In this sense, they are also implicit
in the original proposal. The eurobonds would trade in
larger markets than country-specific bonds, and so they
would be more liquid. Some of the features are primarily
regulatory, in the sense that they depend upon other rules.
The eurobonds could be designated as more ‘senior’,
giving them a higher status in terms of repayment. Finally,
some of the features are structural and yet also subject
to regulatory reinforcement. For example, the eurobonds
would make good collateral for clearing or for banking
transactions because they would come with strong multinational guarantees. It would also be possible to write
collateral rules to strengthen this position by imposing
large haircuts on national debt used as collateral or by
making national bonds ineligible. This would make
eurobonds not only more liquid and more senior, but
also more useful for the banking community. Moreover,
the combination of liquidity, seniority, and utility,
should command a significant premium in the markets
– reinforcing the price difference between relatively
inexpensive eurobonds and relatively more expensive
national obligations.
Finally, the eurobond proposals emphasized the
importance of certification as a means of controlling
the borrower as well as the borrowing. Governments
would not qualify automatically to participate in the
common funding pool. They would have to demonstrate
an ability to manage their finances, they would have to
accept more intrusive auditing, and they would have to
demonstrate the capacity to meet their collective debt
servicing requirements. Of course, the original proposal
for Europe’s single currency contained a number of
similar criteria. The difference is that access to eurobond
financing is an ongoing matter for governments and so
the incentives for following the rules of membership
would be constant; a government would have as much
interest in retaining certification to raise funds through
common eurobonds as they would in qualifying to issue
such bonds in the first place. By contrast, accession to the
eurozone was a one-off transformation. It was very hard
for many of the candidate countries to meet the criteria
for convergence in order to qualify for entry into the
eurozone. As the Greek case shows, however, it would be
even harder to see them leave.
The problem with these original eurobond proposals
lay in their implementation: it would be difficult to
introduce new senior eurobonds alongside existing
national obligations; it would be challenging to enforce
the thresholds on borrowing; and it would be hard to get
both the ratings agencies and the wider community of
market participants to buy into this new arrangement.18
Moreover, these complexities only increase in the context
of an ongoing sovereign debt crisis – when trading in
the markets is relatively thin, investors are nervous, and
any added complexity is likely to push capital out of the
European marketplace altogether.
The most widely cited of these proposals is Jacques Delpla and Jakob von Weizsäcker, ‘The Blue Bond
Proposal,’ Bruegel Policy Brief 2010/03 (May 2010). See also Erik Jones, ‘A Eurobond Proposal to Promote
Stability and Liquidity while Preventing Moral Hazard,’ ISPI Policy Brief no. 180 (March 2010). For an early
overview of proposals, see Guillermo De La Dehesa, ‘Eurobonds: Concepts and Implications,’ (Brussels:
European Parliament, March 2011).
18
For further discussion of some of these issues, see Jacques Delpla and Jakob von Weizsäcker, ‘Eurobonds:
The Blue Bond Concept and Its Implications,’ Bruegel Policy Contribution 2011/02 (March 2011).
17
PAGE 6 . EUROPEAN POLICY ANALYSIS 2012:4
Recognition of these implementation concerns led to a
second round of debates about potential intermediate
solutions – including a shared debt management agency,
a common European bailout facility, or a European
redemption pact.19 Governments could issue all of their
debt through an agency that they guaranteed directly; they
could create a strong firewall to help those countries that get
in trouble with their own debt management; or they could
create a fund to finance all existing excessive borrowing
against the promise that governments would not return
to further irresponsible behaviour. Such intermediate
proposals did alleviate some of the complexity of
implementing eurobonds but only by increasing the
complexity of their design. These proposals also blurred
the market’s ability to perceive the distinction between
responsible and excessive borrowing and so weakened the
benefits to be had from strengthening market discipline.
In short, they offered advantages in the context of the
ongoing crisis but at the expense of preventing the next
one. The problems of close interdependence between
national governments and their domestic banking systems
and arising from the geographic flight to quality remain
unaddressed.
Moral hazard, borrowing costs,
and loss provision
The intermediate proposals for eurobonds also failed to
address the most potent criticisms of the original proposal
to encourage member states to issue common, jointly
underwritten sovereign debt instruments: Opponents of
the proposals expressed concern that eurobonds would
increase moral hazard by allowing less creditworthy
participants to borrow more cheaply; they worried that
eurobonds would create conditional liabilities for more
creditworthy borrowers that would lead to lower ratings
and higher borrowing costs on even the most responsible
participants; and they feared that the withdrawal of
individual participants or the spectacular collapse of the
system would leave the strongest countries in Europe to
cover any losses. In other words, although the original
eurobond proposal was designed to increase market
discipline, nothing in either the proposal or its intermediate
alternatives addressed the concerns that define a large part
of public opinion today. Therefore, it is worth considering
the logic of these positions more carefully.
The concern about moral hazard returns the focus
for market discipline to the borrower and not the
borrowing. The argument is that eurbonds will create
perverse incentives. By lowering the cost of responsible
borrowing, eurobonds effectively release resources to
service excessive deficits. They also shift the focus for
political discipline from the imposition of sanctions to the
enforcement of the borrowing thresholds. And yet since
European politicians have shown themselves incapable of
imposing sanctions, there is little reason to assume that
they will be more effective in imposing restrictions on
common debt issuance. Finally, eurobonds take pressure
off of governments in need of politically painful and yet
economically necessary reforms. Without the threat of
crisis, such governments are more likely to delay making
structural adjustments.20
The concern about conditional liabilities also focuses
attention on borrowers. The problem is that while national
governments have individual credit ratings, the pool of
eurobonds as a whole would be jointly underwritten.
Hence the ratings agencies would be justified in looking
at the potential losses that any one country could face in
the event of a breakdown within the system when making
assessments of a country’s creditworthiness. The extent
of any likely breakdown is an important factor as well. At
a minimum, the stronger countries would have to be able
to take on the debt servicing requirements of the weakest.
Given that this would effectively increase liabilities for
the strongest participants, it should be expected to raise
their borrowing costs and put downward pressure on their
credit ratings. The German ministry of finance estimates
that participation in such a system would cost Germany
billions of euros.21 While the liabilities are conditional,
the costs to Germany are real. Even if the eurobonds work
perfectly as a commonly issued and jointly underwritten
sovereign debt instrument, Germany would pay a price
for its exposure to the system.
The concern about loss provision stems from the
possibility that the system will not work perfectly. The
question is who will pick up the costs if the eurobond
arrangement fails. This is where moral hazard and
conditional liabilities come together to create a fear that
unscrupulous governments will repudiate their obligations
See Alexander Duering and Abhishek Singhania, ‘A Modest Eurobond Proposal,’ Deutsche Bank Fixed
Income Special Report (25 August 2011); Hans-Joachim Dübel, ‘Partial Sovereign Bond Insurance by the Eurozone: A More Efficient Alternative to the Blue (Euro-) Bonds,’ CEPS Policy Brief No. 252 (August
2011); Bofinger, Peter, et al. ‘A European Redemption Pact,’ VoxEU (9 November 2011).
20
See Duering and Singhania, ‘A Modest Eurobond Proposal,’ (2011) above. See also ‘Eurobonds: Moral
Hazard Ahead,’ Financial Times (23 November 2011).
21
‘Euro Bonds Would Cost Germany Billions,’ Spiegel Online International (22 August 2011)
http://www.spiegel.de/international/germany/0,1518,781524,00.html.
19
EUROPEAN POLICY ANALYSIS 2012:4 . PAGE 7
to the system, thus leaving governments that respect their
obligations to carry more than their fair share.
These concerns are compelling. They also appear to
be happening even without eurobonds. Indeed that is
why Jens Weidmann expressed alarm about Germany’s
TARGET2 position. Although he claims in his 13 March
letter that he does not believe the eurozone will come
apart, the only reason for collateralizing TARGET2
imbalances is to have some asset in place to absorb the
losses should one or more countries pull out of the system.
The concern about conditional liabilities is evident today
as well. This is why Jürgen Stark expressed skepticism
about the size of the ECB’s balance sheet and why he is so
critical of the assets the ECB accepts as collateral. Finally,
such concerns explain why the preponderance of German
public opinion is so critical of the governments on the
eurozone periphery. Here it is useful to cite a speech Stark
made while he was still an ECB Board Member: 22
In my view solving the current sovereign debt crisis
is primarily in the hands of governments. Its root
cause lies in lax fiscal policy rules and associated
deteriorating public finances in some euro area countries.
Stability criteria were violated, fiscal rules ignored and
statistics tweaked. Growth dividends were not used for
necessary consolidation in good times. In the same vein,
competitiveness positions worsened in many euro area
countries, due to a lack of structural reforms.
This is a near perfect illustration of moral hazard.23
Full circle
Yet if the worst fears of the eurobond’s opponents are
already evident, it is worth considering how they came
to pass. Many parts of the story are already evident.
National governments took advantage of the system and
European institutions failed to enforce the rules. Yet such
features are ubiquitous. They are as easily found in any of
the possible alternatives. Countries outside the eurozone
– like Iceland or Hungary – have also been affected.
Meanwhile countries like Ireland, Portugal, Spain, Italy,
and Greece are more different than they are similar.
Somehow the problem is structural and not national; if
the question is what caused the crisis, original sin is not
the answer.
A better analysis looks at the problems of geographic
capital movements and collateral rules. Only rather
22
23
than focussing on distress and uncertainty, it looks at
opportunity and return. During the run-up to monetary
union, investors at the core of the eurozone sought
opportunities on the periphery and the most creditworthy
banks looked for relatively risk-free assets that offered a
higher rate of return. This is why long run interest rates
across sovereign debt obligations converged so sharply
across European countries during the late 1990s; it is why
cross border deposits expanded in the smaller, peripheral
markets; and it is why the economies of the eurozone
periphery experienced relatively high rates of debtfuelled growth.
The result of the process can be seen in the prolonged
period of tight interest rate differentials during the first
decade of monetary integration and the large cross-border
exposures of the national banking systems and sovereign
debt markets that built up over the same period. Indeed,
it is this prior outward flow of capital from the core to
the periphery that explains the depth of the crisis once
the flow moved in reverse. Geographic capital flows and
collateral rules played as important a role in setting the
stage for the current crisis as they did in bringing down
the curtain.
There is little reason to believe that the cycle will not
repeat itself. The impact of capital market integration
in times of economic stability is to move savings from
countries with relatively low rates of return and scarce
opportunities for investment to countries with relatively
higher rates of return and more abundant opportunities
for investment. The flows during the next cycle do not
need to be as great as they were the last time; all that
matters is that the stock of cross border exposure builds
up over time. The impact of capital market integration in
times of economic uncertainty is a rapid unwinding of
these accumulated positions. As large amounts of funds
flow suddenly back to countries with surplus savings and
relatively few opportunities for investment, the net effect
will be to slow economic performance across the area of
integrated capital markets as a whole.
The difference between a eurozone with eurobonds and a
eurozone without them is not to be found in the quality of
political leadership or its willingness to abide by solemn
commitments. Rather it is found in the structure of
market incentives and the costs of violating the rules. The
strength of the eurobond proposal is that it provides more
http://www.ecb.int/press/key/date/2011/html/sp111202.en.html.
Stark’s analysis is obviously inaccurate. Neither Ireland nor Spain had fiscal problems before the crisis. Their
problems were more closely related to the growth of private debt. The governments only got into trouble once
the private debtors needed to be bailed out.
PAGE 8 . EUROPEAN POLICY ANALYSIS 2012:4
opportunities for continuous enforcement than the allor-nothing alternatives offered in the current system. It
creates incentives for countries to allow for more intrusive
monitoring and it reduces incentives for banks or other
financial actors to attempt to arbitrage price differentials
within a pan-European framework of rules. Of course such
a system will be prone to manipulation, but so is the status
quo. On balance, however, the structure of incentives in a
eurozone containing eurobonds will bring more stability
to the system rather than encouraging oscillations. So
long as governments depend upon national obligations,
they are likely to suffer further turmoil.
Policy recommendations
No matter how attractive eurobonds might be as a proposal,
there are significant challenges to be tackled before they
can be implemented. Hence the basic recommendation is
that these implementation challenges should be placed
at the forefront of the debate. The time for considering
whether eurobonds are justified in principle has elapsed.
The European Commission’s green paper should have put
an end to that phase of discussion. Now the challenge is
to take it further.
The first step could be to harmonize and strengthen the
collateral available to banks across the eurozone. This
could be done by swapping out the banking books of the
pan-European banking system at par value, using jointly
underwritten sovereign debt instruments. For many of
the banks, this will insulate them from potential losses
like those experienced in Greece as part of private sector
involvement. The ECB’s exposure to sovereign debt
instruments – both outright and pledged – should be
swapped out as well. This will not increase the contingent
liabilities of the participating governments. It is already
evident from the ‘open sector involvement’ debate during
the second Greek bailout negotiations that these assets are
effectively ‘senior’ to those held in the private sector. By
swapping them out, the eurozone governments will only
make that seniority more explicit.
The next step could be to offer distressed countries the
opportunity to refinance their debt as it comes due in these
new eurobonds in exchange for intrusive auditing and
monitoring. This is already happening in those countries
that have requested official assistance; it could be made
available to all governments in the eurozone on the same
conditions. Governments in sound fiscal situations might
object that they do not require such supervision; but their
demonstration of solidarity would help mollify public
opinion in those countries most needing reform. In any
event, there would be cost advantages to participating in
jointly underwritten sovereign debt issuance, particularly
if collateral rules were shaped to privilege these assets for
use in obtaining bank liquidity or in clearing.
The remaining challenge will be to enforce the thresholds
for issuance, particularly for those countries most
indebted. The original eurobond proposal was designed
to prevent a crisis and not to solve one. Now that it is too
late to prevent a crisis, it is probably too soon to unleash
market discipline on distressed governments. That said,
there is no reason that governments cannot be coaxed back
into the markets at some point in the future. Therefore,
while it may be necessary to swap out a country’s entire
existing stock of debt with eurobonds in the short term, it
should be possible to refinance any excess borrowing with
strictly national sovereign debt instruments incrementally
once the government is able to re-enter the markets. That
is essentially what the European bailout mechanisms
intend. The financing they provide offers only temporary
relief from market pressures and should at some point be
paid back as the government regains market confidence.
There is no reason that the introduction of eurobonds
could not provide similar exceptional and temporary
relief.
In the final analysis, Europe will have to move to a system
that focuses on the borrowing and not the borrower. It
will need to stop the geographic flight to quality and it
will have to break the strong interdependence between
national banking systems and their domestic governments.
Otherwise Europe’s policymakers will continue to find
themselves periodically descending into crisis. They will
overstretch their monetary institutions and may even
undermine the eurozone as a whole. These questions are
all linked by the structure of the system. The eurozone as
a whole needs structural reform.
Eurobonds offer a partial if still effective solution. They
would make it easier to channel the flight to quality
across asset class without necessary forcing capital to
flow across national boundaries. They will disconnect
sovereign access to borrowing from the solvency and
liquidity of national banking systems. They will provide
strong guarantees for the assets held on the balance sheets
of European monetary institutions. And they will relieve
at least some of the pressure that has built up across the
European financial system.
Of course politicians must still address concerns about
moral hazard and abuse of the system. Those problems will
EUROPEAN POLICY ANALYSIS 2012:4 . PAGE 9
not go away and critics of the eurobond proposal are right
to point at that jointly underwritten and commonly issued
sovereign debt instruments are vulnerable. But the point
that should be stressed is that the current crisis is a result
of moral hazard under the existing system. Moreover,
by focusing on the borrower and not the borrowing, the
existing framework for reining in excessive deficits puts
governments in an unenviable all-or-nothing situation
PAGE 10 . EUROPEAN POLICY ANALYSIS 2012:4
where the incentives for ignoring the rules or refusing to
enforce them are very hard to ignore. Solemn declarations
and inverted decision making procedures are not enough
to reshape the structure of these incentives. Europe’s
political leaders must look for some more fundamental
solution. At least part of that solution will be found in the
eurobond proposal.
European Policy Analysis available in English
2012
2012:3epa
The Hungarian Constitution of 2012
and its Protection of Fundamental Rights
Authors: Joakim Nergelius
2012:2epa
The EU and Climate Treaty Negotiations
after the Durban Conference
Author: Katak Malla
2012:1epa
The EU’s Cooperation and Verification Mechanism:
Fighting Corruption in Bulgaria and Romania after EU
Accession
Authors: Milada Anna Vachudova and Aneta
Spendzharova
2011
2011:14epa
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2011:13epa
Euro Plus Pact: Between Global Competitiveness and
Local Social Concerns
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2011:12epa
The EU Strategies for New Climate Treaty Negotiations
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2011:8epa
Brussels Advocates Swedish Grey Wolves: On the
encounter between species protection according to
Union law and the Swedish wolf policy
Author: Jan Darpö
2011:7epa
A New Proportionality Test for Fundamental Rights
Authors: Anna-Sara Lind and Magnus Strand
2011:6epa
The European Treaty Amendment for the Creation
of a Financial Stability Mechanism
Author: Bruno de Witte
2011:5epa
Comment on the European Commission´s “Green
Paper towards adequate, sustainable and safe European
pension systems”
Author: Conny Olovsson
2011:1epa
How Small are the Regional Gaps? How Small is the
Impact of Cohesion Policy? A Commentary on the Fifth
Report on Cohesion Policy
Author: Daniel Tarschys
2010
2010:14epa
Mollifying Everyone, Pleasing No-one.
An Assessment of the EU Budget Review
Author: Iain Begg
2010:11epa
Social and Employment Policy in the EU
and in the Great Recession
Author: Giuseppe Bertola
2010:10epa
The Socio-Economic Asymmetries of European
Integration or Why the EU cannot be a “Social Market
Economy”
Author: Fritz W. Scharpf
2010:9epa
Strengthening the Institutional Underpinnings
of the Euro
Author: Stefan Gerlach
2010:6epa
The European External Action Service:
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Author: Christophe Hillion
2010:2epa
Rethinking How to Pay for Europe
Author: Iain Begg
2010:1epa
Internal and External EU Climate Objectives
and the Future of the EU Budget
Author: Jorge Núñez Ferrer
EUROPEAN POLICY ANALYSIS 2012:4 . PAGE 11
2009
2009:14epa
The Eastern Partnership: Time for an Eastern Policy of
the EU?
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2009:13epa
Out in the Cold? Flexible Integration and the Political
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2009:12epa
From Zero-Sum to Win-Win?
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2009:11epa
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and Ewa Rabinowicz
2009:10epa
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Author: Sideek Mohamed Seyad
2009:9epa
An EU Strategy for the Baltic Sea Region:
Good Intentions Meet Complex Challenges
Author: Rikard Bengtsson
2009:8epa
What to Expect in the 2009-14 European Parliament:
Return of the Grand Coalition?
Author: Simon Hix
2009:7epa
The 2009 Swedish EU Presidency:
The Setting, Priorities and Roles
Authors: Fredrik Langdal and Göran von Sydow
2009:5epa
When Lab Results are not Sufficient: On the Limitations
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Author: Karolina Zurek
2009:2epa
Democracy Promotion in a Transatlantic Perspective:
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Author: Anna Michalski
PAGE 12 . EUROPEAN POLICY ANALYSIS 2012:4
2009:1epa
Foreign Policy Challenges for the Obama Administration
Author: John K. Glenn
2008
2008:14epa
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Authors: Fredrik Langdal and Göran von Sydow
2008:11epa
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2008:8epa
The Potential Impact of the Lisbon Treaty
on European Union External Trade Policy
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2008:4epa
The Lisbon Treaty and EMU
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2008:3epa
The Lisbon Treaty and the Area of
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Author: Ester Herlin-Karnell
2008:2epa
A Better Budget for Europe:
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Author: Filipa Figueira
2008:1epa
The Future of the Common European Asylum System:
In Need of a More Comprehensive Burden-Sharing
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Author: Eiko Thielemann
For a full list of publications, see www.sieps.se.