EUROBONDS:
A CRUCIAL STEP TOWARDS POLITICAL
UNION
Paul De Grauwe
University of Leuven and CEPS
1
Introduction
• Euro zone is thrown in a deep and existential
crisis.
• This crisis has led to an increasing consensus that
political union is necessary to preserve euro zone
• At the same time, there appears to be little
willingness in Europe today to take drastic steps
towards a political union.
• Thus, if the euro is to be preserved, a strategy of
small steps towards more political integration
will be necessary.
2
• I will argue that a common Eurobond issue is
an important first step towards political union
• that can pacify financial markets and bring
back financial stability in the euro zone.
• In addition, the joint issue of Eurobonds can
also be used to provide a boost to economic
growth in the euro zone.
3
• I will also draw the attention to a number of
objections that have been raised against the
issue of joint Eurobonds.
• These objections have to be taken seriously.
• They have to be dealt within the design of the
Eurobonds.
4
The need of Eurobonds: political
• The crisis has degenerated into an existential
crisis of the euro zone.
• Investors now ask themselves the question of
whether the euro zone, as we know it today, will
survive.
• This lack of trust in the future of the euro zone
leads to endemic instability.
• It has the effect of transforming bad news about
one particular country into bad news for other
countries, and for the system as a whole.
5
• Crisis has been made worse by the decision of
the European Council of October and
December to make bondholders pay if future
governments ask for financial assistance.
• This decision has destabilized the government
bond markets in the eurozone and will
continue to do so because it makes them
vulnerable to self-fulfilling speculative attacks
• Very much like the ERM
6
• This vicious circle inherent in the endemic
instability must be halted.
• This can only happen if the member countries
are willing to design a mechanism that will
convince the market about the seriousness of
their commitments towards the euro zone.
• Solemn declarations by leaders of government
will not be sufficient. They are seen as “cheap
talk”.
7
• A common Eurobond is such a mechanism.
• By jointly issuing Eurobonds the participating
countries become jointly liable for the debt
they have issued together.
• This is a very visible and constraining
commitment that will convince the market
that member countries are serious about the
future of the euro.
8
• In addition, market participants will see it as a
first step on the road to political union.
• This will “pacify” the financial markets
because it takes away the existential fears that
destabilize them today.
• As a result, it will contribute towards restoring
stability in the euro zone.
9
Financial need for Eurobonds
• By creating a large bond market in the euro zone
that can compete with the dollar bond market, it
also creates a market with a lot of liquidity.
• This will make it attractive for outside investors
(e.g. from Asia) in search of diversification.
• This also increases attractiveness for AAAcountries in eurozone
10
Objections to Eurobonds
• The proposal of issuing common Eurobonds
has met stiff resistance in a number of
countries.
• This resistance is understandable.
• A common Eurobond creates a number of
serious problems that have to be addressed
11
Moral hazard
• Common Eurobond issue contains an implicit
insurance for the participating countries.
• Since countries are collectively responsible for
the joint debt issue, an incentive is created for
countries to rely on this implicit insurance and
to issue too much debt.
• This creates a lot of resistance in the other
countries that behave responsibly.
• This moral hazard risk should be resolved.
12
Low attractiveness for AAA-countries
• What are the benefits for AAA-countries?
• By joining a common bond mechanism that
will include countries enjoying less favourable
credit ratings, countries like German and the
Netherlands may actually have to pay a higher
interest rate on their debt.
13
The design of common Eurobonds
• Should take care of these objections
• This can be achieved by working both on the
quantities and the pricing of the Eurobonds
• A combination of
– Blue and red bonds (Bruegel): participation in
common eurobond limited to given % of GDP (blue
bond; senior); the rest is red bond (junior).
– Differential interest rates (De Grauwe and Moesen):
countries pay an interest rate related to fiscal
position
14
• Such a design minimizes moral hazard risk
• Makes it attractive for AAA-countries (they
face low average and marginal borrowing cost)
• and for lower rated countries (they face
relatively low average borrowing costs but
high marginal costs).
• This design gives the right incentives to low
rated countries
15
Optimal Design of eurobond
Interest rate
Interest rate
Low-rating country
AAA-country
MBC
ABC < MBC
ABC
ABC = MBC
60%
Debt ratio
60%
Debt ratio
ABC = average borrowing cost
MBC = marginal borrowing cost
16