Market pressures on ailing Euro-zone countries persist and the Merkels and Sarkozys struggle to find an answer. The latest hype gaining ground is the idea of Eurobonds. These would be jointly issued bonds by all Euro-zone (or even EU) governments to finance government debt by national (or sub-national) governments.

Ironically, I remember several interesting discussions with my Italian federalist friends who have always lobbied within JEF and UEF to support the introduction of Eurobonds – to allow the EU (budget) to run deficits primarily for EU-wide infrastructure projects. I have always (and continue to) oppose this idea because I think we do not need another layer of debt  in the EU while there is sufficient room for mobilising funds to invest in EU-wide infrastructure projects from the ineffective CAP and structural policy – and where necessary also from national coffers. While the financing mechanism for these Eurobonds would be the same, the current discussion is promoting Eurobonds on a very different level.

Eurobonds to solve the debt crisis

Eurobonds as advocated these days are seen as a tool to lower borrowing costs for peripheral Eurozone countries (Greece, Ireland etc.) who struggle with run-away interest rates on newly issued debt. They are practically cut off from the market, hence EU intervention mechanisms like the EFSF are now used to finance their debt. In some ways the EFSF is not so much different from the Eurobonds discussed today except the fact that the EFSF is primarily seen as a crisis intervention – and not a permanent – vehicle. Because (just like with the EFSF) Eurobond debt is guaranteed by countries like Germany or the Nordics borrowing is cheaper for such jointly guaranteed Eurobonds. So, why should we not issue Eurobonds for all EU countries, lowering borrowing costs for those in trouble and thereby help them out? – Because of moral hazard, you silly.

If deficit-prone countries can borrow at cheap rates again, what is their incentive to create sustainable public finances in the first place? Experience tells us that without tougher institutional provisions this is unlikely to happen: When (debt) interest rates decreased dramatically for countries like Italy or Greece after they joined the Euro in the early 2000s, their budgetary profligacy did not stop. Allowing them cheap access to new bonds is unlikely to change the picture. Unless it is done in a more intelligent way this time…

How to make Eurobonds work

The primary challenge is to prevent a repetition of what happened after the Euro introduction, i.e. letting countries accumulate even more debt because the interest on it is so cheap. However, if there were mechanisms to overcome this problem, then Eurobonds would be a helpful tool to potentially help Greece et al. out of the debt spiral they are in. How can this be done? – I believe this can be achieved through a number of (national) institutional provisions, which should be made a pre-requisite for anyone seeking Eurobonds. Such measures should include:

– a zero-deficit (balanced-budget) rule at national and sub-national level that is anchored in the constitution. Realistically, it would be phased in, just like Germany’s ‘Schuldenbremse';

– a rainy-day fund (Singapore-style?) that takes away from policy-makers at least 50% of budget surpluses and any privatisation proceeds. It may only be tapped under severe economic downturns;

– an independent adviser on national economic development who suggests the growth assumption underlying the national budget (this could e.g. be the EU Commission, OECD etc). Any surplus achieved during the financial year or revenue beyond the initial projection would be locked up;

– a mechanism of regular EU inspections to oversee the reliability of national public finances (maybe via a special cooperation between OLAF-like units and Eurostat);

– a maximum debt level financed through Eurobonds. This could conveniently be at 60% (following the Maastricht criteria) but I think it should be lower at maybe 30%;

– an initial list of state assets that are handed over to the rainy-day fund to be sold or privatised whenever the highest value can be obtained;

– a sustainable answer to government pension (and potentially health) obligations, ideally by at least prohibiting defined-benefits for government employees as well as serious pension ages in the public sector.

This list is long and more than demanding. But given that trust is weak following the mess we are in, these provisions should act as a strong commitment stick for every government that wants to seriously get out of the mess.


Comments

14 Comments so far

  1. Aymeric L on August 17, 2011 0:28

    If you respect a zero-deficit rule, how do you make debts at all? You don’t need any Eurobonds if the rule is zero-deficit. Your proposals are a bit inconsistent…

    And they tell a lot about the Germans’ aversion to indebtment, their trust in rules and experts, and their distrust in elections (electors) and politicians.

    I don’t want to insult your germanity, but don’t forget that debts make sense economically, wherever they serve to invest in projects that support growth. From the Middle age Italian republics to contemporary Germany, Europe’s development was always financed through debts. Of course, we have to come back to sustainable levels of indebtment now. Strict rules are needed.

    But in general, waiting until the purse is full before starting spending monney is good for Oma, but it doesn’t make sense at all in economical terms.

    As to the list of state assets to be privatised automatically in case of rainy-days… Well, we could generalise this logics and adopt a list of decisions to be made in case of recession, of war, or of natural disaster. Or a list of persons to put in office?

    But then, would we still need Wulff as president, or would R2D2 fit the bill?

    Long live the automatocracy !

  2. Jan on August 17, 2011 6:55

    Aymeric,

    criticising my argument because of the passport I have does not make your case stronger. I think national stereotypes have their place – at stand-up comedy.

    My argument is not inconsistent regarding zero-deficit rules and debts. Let me clarify: You are right that in an ideal world a zero-deficit rule in the first place would not allow any debt. However, we live in the real world and all Euro-zone countries have significant amounts of debt. Their level is so high that we have to live with them for a while and I think Eurobonds can help to lower their costs for a good number of countries. Hence, if we talk about introducing Eurobonds, then we need to establish their relationship to existing debt.

    Yes, ‘using’ debt can (could) make sense. But countries have varied in the debt they have obtained to achieve the same growth result. I have not seen Greece or Italy growing as fast as they should given the amount of debt they have accumulated after joining the Euro. Apparently debt always translate into growth…
    Given the level of wealth we have in most EU countries at present, I am not convinced that what we need is further (traditional) economic growth financed through debt. We need to focus on strengthening internal cohesion, potentially also loosening the grip of the state on citizens and businesses. This might be achieved means other than debt-financing.
    You are also right that many historic entities have financed their growth through debt. But many of these have also defaulted on their debt (repeatedly) – starting with the Italian republics. That is fine when you are responsible yourself for the consequences but it will not work when you rely on others to bail you out (as with the Eurobonds).

  3. Aymeric L on August 17, 2011 8:51

    Hey, that’s absolutely not what I said.

    Debt does not always translate into growth, and defaulting is not the answer.

    But forbidding deficits out of guilt is nonsense. Well used, debt-financing does support public investment, which does and will always play a role in economic growth. Loosening market rules can be a solution, sometimes, but it’s sometimes not.

    Now I apologise for my national “prejudices”, but I simply can’t ignore that most of your proposals are German, that you use the word Schuldenbremse, and you’re not so far from using the word Schuldensünder. I find it good when we, French, are told that our viewpoints are too French.

  4. Mark on August 17, 2011 8:54

    So Sarko and Angie are backing your first criterion then.
    I like this post, it straightforwardly sets out the argument and I think your response is progressive.
    I prefer a migration-policy response to your final point on pension costs, but suspect I’m among the few.
    Sort out the debts and we’ll still have a serious demographic issue to deal with, but that’s for another post…

  5. Jan on August 17, 2011 9:01

    Government invests into ‘the future’ every day with the money it spends on welfare, infrastructure etc. I need to be convinced that 1. there is not enough money already that can be better spent and 2. that the debt you are incurring pays off later on. Apparently, most people have lost faith into the ability of a number of governments to repay their debt (and so have I under current circumstances).
    Reality tells us that very few countries have shown over time that they were able to generate the relevant income to reduce their debt over time. Maybe you can give positive examples where this has happened over the last 30+ years following debt-based growth?

  6. Aymeric L on August 17, 2011 9:29

    Japan, the UK, South Korea, France, Switzerland, the USA, Germany, Canada, China, Brazil, India: http://www.gfmag.com/tools/global-database/economic-data/10403-total-debt-to-gdp.html#axzz1VGyJb4jS

    All these economies rely on debt. Most of them are considered reliable.

  7. Jan on August 17, 2011 9:33

    They are reliable until they are not reliable anymore… I guess.

    Germany alone has added substantial debt over the last 3 years but it is only back to pre-financial crisis GDP level now. This might have been worse of course without debt but I am still looking for countries who have successfully lowered their debt over a period of 10+ years.

  8. Aymeric L on August 17, 2011 9:47

    What for ?

    We’ve just had the worst crisis since 1929.

  9. Richard Laming on August 17, 2011 15:57

    Trying to write political rules for issues such as constitutional limits on borrowing is very difficult. The SGP failed because it was dependent on politicians, and we all know what they are prey to. Graham Bishop has proposed a market-based method of restricting borrowing: to require banks with sovereign loans to provide for greater capital to cover the risk of default. The capital requirement would increase as the public finances of the sovereign borrower got worse, thus increasing the costs of borrowing and forcing the sovereign borrower to change course. This would not require a change in the EU treaties. http://www.federalunion.org.uk/is-the-eurozone-working-lessons-from-the-greek-crisis/

  10. Stephen Little on August 17, 2011 19:49

    You don’t need any balanced budget requirements or strict tests. Simply by issuing blue bonds guaranteed under joint and several liability with the full faith and credit of by the EZ as per the Bruegel recommendation you solve the moral hazard dilemma.

    All “red bonds” are structurally subordinate (but should also be longer dated to prevent any de facto inversion of claims) to the blue bonds and countries can issue as many as they like, but as junior bonds will cost much more to issue thus restricting the number that can be sold and encouraging fiscal discipline.

    What’s more these Euro Euro Euro bonds (euro denominated eurozone global bonds) would be AAA thus not offending the Germans.

  11. Oliver on August 17, 2011 19:55

    There are some examples of countries that have managed to lower their debt in the last ten years: Belgium, Spain, Denmark, Sweden, Bulgaria.

    http://www.google.es/publicdata/explore?ds=ds22a34krhq5p_&met_y=gd_pc_gdp&idim=country:es&dl=es&hl=es&q=estad%C3%ADstica+deuda+p%C3%BAblica+espa%C3%B1a#ctype=l&strail=false&nselm=h&met_y=gd_pc_gdp&scale_y=lin&ind_y=false&rdim=country_group&idim=country:be:dk:se:es:bg&ifdim=country_group&hl=es&dl=es

    It was the decision of their democratically elected governments taking advantage of a good financial situation. The crisis, however, has cut that trend in some cases, which is understable. It is possible to write normal policies in the Constitution but it should be up to the people’s will (therefore through democratic elections) to decide what they want to expend the money into and they are the best to handle their present needs. Basically if you pretend to fix today the rules of tomorrow, you are taking away from democracy the decisions of daily life.

    If you start writing in the Constitution normal policy rules you will be a) advocating the Constitution not to be respected when circumstances come. Funnily ennough, the first countries not to respect the debt agreements were France and Germany and that proved that NO consequences would be of that (obviously, you need to be France or Germany to be safe, which shows in a crude way some parts of the bad nature of the EU). b)taken away normal policy decisions from whom will now better. Or is it that we know what would be best for the European in 20 years or themselves?

    What we are seeing right now is a market playing poker. They know governments will pay. If they don’t basically it would be a world they can’t survive in. But as long as they keep their bet and governments do not act in accordance, it is a way to make money easily. I cannot understand how it is possible that, without the situation of the real economy changing at all, the risk of many soveraign countries debt can change from week to week. Obviously that is not real economy but a casino where markets (whoever they are and I would be glad to meet them in person) put their best poker face.

  12. Jan on August 18, 2011 3:41

    Good debate, folks!

    @ Steve: The Bruegel proposal (http://www.bruegel.org/publications/publication-detail/publication/403-the-blue-bond-proposal/) isnt too far away from what I suggest here and their blue bonds are not really different from what I have in mind. However, I see problems in 2 points: I am not sure that the 60% debt/GDP is a fair long-term target but let’s leave it there. Secondly and more importantly, the ‘red bonds’ are nice – but they are exactly where the problem is today. You can push them out for a while – until markets loose confidence in you. And then we are at the same problem we face today. There is a limit to how much you can borrow – and it is hard to know when you reach it.

    @Richard: Completely agree that the SGP was subtoptimal. Precisely because it was too easy to overrule or ignore its provisions. Btw this has not only happened in terms of FR and DE breaking the 3% rule but by practically ALL member states in not saving up during the ‘good’ times.

    @Oliver: Great graph/link!
    You can see there that only BE, DK, BG and CH have really lowered their debt – and Switzerland has a debt brake/adjusted zero deficit rule. DK and BG have seen relatively high growth during that period so the really interesting case is Belgium.
    So yes, we find a few examples where politicians have behaved responsibly – without prior ‘conditioning’ but does that mean that they all will in the future?

    It is not anormal to restrict the leeway of (elected) politicians. We do that for interest rates – but we also do that in terms of federal structures, separation of powers, term limits etc. I do think there needs to be full flexibility in serious crises (like recently) but if we assume that most EU-15 countries grow at an average of somewhere around 1-2% per year on average, how is it sustainable to keep deficits in a year you grow at 2%?
    This may work fine for a while but it is not the casino but the underlying problem that makes you vulnerable. Yes, markets are a bit random and unpredictable for when they hit you. But with everything we know about Greek public finances now, we should probably be more surprised that they have not deserted the country earlier.

  13. Aymeric L on August 18, 2011 9:32

    I agree that there should be a ban on deficits in periods of minor growth, but not a general one.

    I wonder if a solution could be to oblige member states to have two budgets, one for functioning expenditures, and one for investment. The former would always have to be balanced, while member states would be able to finance their investments through debt. This is a solution applied to regional authorities in France and Germany, and it apparently helps containing debt to a reasonable level.
    Such an option has never been considered at EU level. Why? Is it considered irrelevant, or insufficient?

    In general, I find the idea of a golden rule justified democratically. But listing assets that would be automatically privatised in case of crisis is far too antidemocratic, rigid, and inefficient. Why automatically selling billion-worth state assets in times of crisis? This really makes no sense at all.

    We should better force states to reduce their indebtment in periods of growth, if necessary by selling their assets at that moment.

  14. Stephen Little on August 18, 2011 11:26

    The point of a blue/red distinction is that the EU doesn’t care if a country defaults on its subordinated debt. Life would go on much in the same way as if Sicily defaulted on its debt; moreover banks would (in all likelihood) have to set aside a great deal more capital on subordinated debt thus mitigating issues of contagion to banks.

    It would also be possible to start at say 100% of new debt with Greece/Ireland/Portugal and slowly draw down.

    Also as per P&R (below) the EZ would have a prior claim on tax revenues of the borrower

    http://www.bloomberg.com/news/2011-07-28/tax-trio-would-put-end-to-euro-arson-commentary-by-perotti-and-zingales.html

    Re RL’s comment: Perotti and Zingales suggest that all banks pay a tax on the credit spread (% of CDS) of the Sovereigns they own – thus better reflecting their risk. The issue I have with this is that if sovereign debt is on a trading book it is marked to market anyway and the interest rate risk (VaR)(and for lower rated bonds – credit risk) would be capitalised so why pay more tax.

    Secondly it would create an automatic mechanism which would increase volatility (banks would sell off bonds as the CDS spiked thus causing the CDS to spike higher and…). Finally it would treat sovereigns differently than corporate bonds and reduce demand.

    There is certainly a case for removing the risk free status of sovereign bonds (G7 bonds are currently risk weighted at zero).

    Above and beyond the technical details I have one major issue and that is that no one has voted for what will be the biggest transfer of sovereignty the world, to the best of my knowledge, has ever seen.

Name (required)

Email (required)

Website

Speak your mind