Euro bonds: Guide to the perplexed
Euro bond proposals are proliferating. Euro zone politicians will chew over the multiple variations on the theme of debt mutualisation at this month’s summit. Here’s our guide to everything you always wanted to know about Eurobills, redemptions bonds, red/blue bonds, deficit bonds etc but never dared ask.
This is the easiest and least controversial proposal, because it requires a relatively small transfer of risk, and little surrender of sovereignty. The idea, proposed by two French academics – Christian Hellwig and Thomas Philippon – just covers short-term debt.
Countries would issue short-term debt guaranteed by each other and capped at a given percentage of national GDP, probably 10 percent. Potential losses would be low as short-term debt is rarely restructured; and countries that ran up excessive deficits could be kicked off the programme, reducing moral hazard. Moreover, countries would still have to issue long-term debt, exposing them to market discipline. One problem is that euro zone governments may shy away from kicking a country off the programme for fear of triggering default.
Eurobills could be quickly implemented and wouldn’t require a change to the European treaty that prohibits countries from assuming each other’s liabilities. But they can’t solve the crisis on their own, as they would cover only a small portion of a government’s debt and only the short-term borrowings. Think of them as a first step on the very long road to a real common bond.
A second proposal, deficit bonds, is to mutualise only new debt. The idea is being explored by a quartet of senior officials including the ECB’s President Mario Draghi, according to Der Spiegel.
Deficit bonds would cover government spending over and above what national governments can raise from taxes. The quid pro quo would be that a central body would control how much is borrowed, and what it is used for. National governments would still have to look after the debt they ran up before the crisis. This combination of controlling future debts, and not transferring liability for historic ones, may make it more palatable in Germany.
But the idea would involve countries giving up the right to run up deficits, as member states would only be free to choose how to spend funds they could cover from their own revenue. A variation on this theme, which is designed to make it more palatable to deficit countries, would allow governments the freedom to run deficits up to 3 percent of GDP – with the new procedure kicking in only above that level.
A big problem with the idea is that states would still have to refinance their existing debts. If they couldn’t do this in the markets, they might need a debt restructuring or further bailouts. So deficit bonds won’t necessarily solve the crisis.
Red bond, blue bond
A third idea is to use euro bonds to finance debt up to a certain level – say 60 percent of GDP. Any remaining debt would have to be issued by states on their own.
Under the original concept, devised by think-tank Bruegel, the mutualised bonds are called “blue bonds” and the rest “red bonds”.
Governments would be subject to market discipline through the red bonds, restraining their ability to run up large deficits on their neighbours’ credit. Miscreant countries could also be sanctioned through fines or reductions in their common debt allowance. This proposal may require a treaty change, depending on how it is structured.
But this idea might not solve the crisis either because countries with high levels of debt may struggle to issue the red bonds. Italy alone would need to issue over 900 billion euros of subordinated national bonds. If highly indebted countries couldn’t issue red bonds, they might again need debt restructuring or further bailouts.
If the red bond, blue bond idea mutualises debt up to a certain level, the redemption fund idea mutualises it beyond a certain level. This concept, devised by Germany’s so-called wise men, would allow countries with debt equal to more than 60 percent of GDP to issue euro bonds for that excessive debt. They would then have to pay it down over 25 years.
The repayment schedule roughly mirrors commitments euro zone governments have already made to bring down their debt to 60 percent of GDP over the next 20 years. But the joint funding mechanism should lower interest costs, making the consolidation less painful. The moral hazard risk would be mitigated by countries’ agreement last year to pass a constitutional law to keep balanced budgets. They would also pledge collateral as security to deter them from defaulting on their peers – probably gold and foreign currency reserves equal to 20 percent of their borrowing under the pact.
Because the pact would be temporary and limited, it might not require a treaty change and should stand up to challenges in Germany’s constitutional court. However, it could prove controversial because it would hardwire a commitment to reduce debt rapidly, potentially prolonging the recession and committing taxpayers to years of austerity to repay past debt. Countries may also resent pledging their gold as part of the scheme.
What’s more, the plan might not solve the crisis because countries would still have to fund the rest of their debt, up to 60 percent of GDP, themselves. If they couldn’t, there might yet again need to be a debt restructuring or a further bailout.
Go all in
Why not go all in and get euro zone member states to issue all debt centrally, backed by each other through joint and several guarantees? Wouldn’t that solve the crisis? Maybe. But nobody is seriously proposing this as it could leave countries dangerously exposed to peers that borrow recklessly, unfettered by market discipline. Even strong countries such as Germany might then find their creditworthiness undermined.
For these reasons, going all in is inconceivable without a full political union. That would take years and may not be politically acceptable, even in countries that would benefit most.
European politicians will discuss euro bonds when they gather on June 28 and 29. But if markets are expecting a quick fix, they will be disappointed. Any policy that can be quickly pushed through won’t stop the crisis on its own. And the more radical proposals will take time and be politically difficult.