Blog Post

The euro’s last-chance saloon

Should Italy go flop, the most palatable solution would be a limited Eurobond up to 60 percent of GDP. This should be phased in through complete pooling of new issuances, in which a member state can participate till its share in the stock of Eurobonds reaches 60 percent of its GDP.

By: Date: September 4, 2011 Topic: Macroeconomic policy

A version of this column was published in Világgazdaság on 26 August 2011

The debate on pooling national debt issuances, ie introducing Eurobonds, has become inflamed. In addition to the fear of loss of national fiscal sovereignty, legal arguments and antipathy towards Eurobonds, there are three major arguments against them.

First, taxpayers in core countries would guarantee the debt of the whole euro area. A country in trouble may refuse to pay for its share, despite commitments.

Second, it would weaken fiscal discipline since, in the case complete pooling of bond issuances, there would be no national bonds and therefore markets would not be able discipline governments. There is little hope that even the reformed Stability and Growth Pact would keep countries on their toes.

Third, the yield on the Eurobond would be above the current German yields, so it would be more expensive for Germany to pay its debt.

However, the third criticism is not well supported. And a limited Eurobond up to 60 percent of GDP (ie the ‘Blue Bond’ as suggested by Jacques Delpla and Jakob von Weizsäcker) would address the first two issues.

The Blue Bond, guaranteed by all participating countries including Germany, would enjoy an AAA credit rating, because the aggregate fiscal position of the euro area is much better than that of the US or Japan. And since the depth of the resulting Blue Bond market would be comparable to that of the US and Japanese bond markets, it would be attractive even to external investors wishing to diversify away from the dollar, leading to a low yield.

The capacity to service Blue Bonds is there – its amount would be limited to 60 percent of GDP and its yield would be low. Could there be a case where a delinquent country refused to service the Blue Bond? In any case the seniority of Blue Bonds over any other government expenditure should be established in national constitutions. In the event of non-compliance, the EU Treaty should threaten  expulsion from the EU, and other enforceable sanctions could be also envisioned.

Debt above the Blue Bonds, ie ‘Red Bonds’, would be guaranteed by the issuing country only. Markets would carefully price these bonds and fiscal discipline would even be likely to improve. This would be a major advantage.

Another major advantage would be the separation of sovereigns and banks in their fate. Nowadays, a sovereign default would lead to the default of many banks in the country due to their government bond holdings, and the crisis can easily spread to other countries. But in the case of Blue and Red Bonds the default would apply to Red Bonds only. Holding Red Bonds could be prohibited for banks, or at least higher capital requirements could apply. This would lessen the impact of a sovereign default on the country itself and reduce contagion fears.

But how to introduce Eurobonds? An immediate debt exchange would threaten Italy due to its 120 percent-of-GDP debt. The ‘red debt’ would amount to 60 percent of GDP and Italy would face severe difficulties in issuing Red Bonds.

The solution is phasing in Blue Bonds through complete pooling of new issuances, in which a member state can participate till its share in the stock of Blue Bonds reaches 60 percent of its GDP. This would give Italy about four years of safety, till no Red Bond needs to be issued, and therefore safety for the euro area as well.

But what would come after four years? Would Italy be able to put its house in order by then? Or would Italy default on its Red Bonds, and if so, how damaging would that be? Or would Germans help out with a transfer? Hard questions. But the alternatives are not benign.

We need to say that Italy is not yet in a deep trouble: borrowing at a rate about 5/6 percent at 10 year maturity and around 3 percent at shorter maturities (averaging between 4 and 5 percent) is not something which is unsustainable. But what if Italy ends up in real trouble, ie it is not able to issue new debt?

Italy is clearly too big to be helped out with a further expanded EFSF, so there would be five main choices:

1. Immediate default – due to the size and interconnectedness of the country this would devastate the financial system outside the euro area as well. The very existence of the euro would be at stake.

2. External help – from the IMF as suggested by former MD Hendrikus Johannes Witteveen, or from an ad-hoc consortium lead by China and the US. It would be difficult to engineer such help and it would lead to an unpleasant creditor-debtor arrangement with all the associated problems.

3. Massive ECB financing – possibly through the EFSF as suggested by Daniel Gros and Thomas Mayer. This would be the best way to moral hazard. It may also risk causing inflation and weakening the anchoring potential of the ECB.

4. Complete Eurobond – this would require far-reaching changes in the governance of the euro area, including giving up national fiscal sovereignty. It would most likely require fiscal and political union with sizeable interstate transfers. This is too big a step, with serious equity concerns.

5. Limited Eurobond, ie the Blue Bond – the most palatable solution.

The coming months will tell us whether the euro area will be able to muddle through with its current settings, or whether Italy will face sufficient market pressure that enforces one of the above five choices.

 


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

Read about event More on this topic
 

Upcoming Event

May - Jun
31-1
10:30

MICROPROD Final Event

Improving understanding of productivity, its drivers and the way we measure it.

Speakers: Carlo Altomonte, Eric Bartelsman, Marta Bisztray, Peter Bøegh Nielsen, Italo Colantone, Maria Demertzis, Wolfhard Kaus, Javier Miranda, Steffen Müller, Hannu Piekkola, Verena Plümpe, Niclas Poitiers, Andrea Roventini, Gianluca Santoni, Valerie Smeets, Nicola Viegi and Markus Zimmermann Topic: Macroeconomic policy Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read article More on this topic More by this author
 

Podcast

Podcast

Taming inflation?

What are the implications of prolonged inflation?

By: The Sound of Economics Topic: Macroeconomic policy Date: May 25, 2022
Read about event More on this topic
 

Past Event

Past Event

How can we support and restructure firms hit by the COVID-19 crisis?

What are the vulnerabilities and risks in the enterprise sector and how prepared are countries to handle a large-scale restructuring of businesses?

Speakers: Ceyla Pazarbasioglu and Guntram B. Wolff Topic: Macroeconomic policy Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: May 25, 2022
Read about event
 

Past Event

Past Event

[Cancelled] Shifting taxes in order to achieve green goals

[This event is cancelled until further notice] How could shifting the tax burden from labour to pollution and resources help the EU reach its climate goals?

Speakers: Niclas Poitiers and Femke Groothuis Topic: Green economy, Macroeconomic policy Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: May 12, 2022
Read about event More on this topic
 

Past Event

Past Event

How are crises changing central bank doctrines?

How is monetary policy evolving in the face of recent crises? With central banks taking on new roles, how accountable are they to democratic institutions?

Speakers: Maria Demertzis, Benoît Coeuré, Pervenche Berès, Hans-Helmut Kotz and Athanasios Orphanides Topic: Macroeconomic policy Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: May 11, 2022
Read article Download PDF More by this author
 

Book/Special report

European governanceInclusive growth

Bruegel annual report 2021

The Bruegel annual report provides a broad overview of the organisation's work in the previous year.

By: Bruegel Topic: Banking and capital markets, Digital economy and innovation, European governance, Global economy and trade, Green economy, Inclusive growth, Macroeconomic policy Date: May 6, 2022
Read article Download PDF
 

Policy Contribution

European governance

Fiscal support and monetary vigilance: economic policy implications of the Russia-Ukraine war for the European Union

Policymakers must think coherently about the joint implications of their actions, from sanctions on Russia to subsidies and transfers to their own citizens, and avoid taking measures that contradict each other. This is what we try to do in this Policy Contribution, focusing on the macroeconomic aspects of relevance for Europe.

By: Olivier Blanchard and Jean Pisani-Ferry Topic: European governance, Macroeconomic policy Date: April 29, 2022
Read article Download PDF More on this topic
 

Working Paper

The low productivity of European firms: how can policies enhance the allocation of resources?

A summary of the most important policy lessons from research undertaken in the MICROPROD project work package 4, related to the allocation of the factors of production, with a special focus on the weak dynamism of European small and medium-sized enterprises (SMEs).

By: Grégory Claeys, Marie Le Mouel and Giovanni Sgaravatti Topic: Macroeconomic policy Date: April 25, 2022
Read article More on this topic
 

External Publication

What drives implementation of the European Union’s policy recommendations to its member countries?

Article published in the Journal of Economic Policy Reform.

By: Konstantinos Efstathiou and Guntram B. Wolff Topic: Macroeconomic policy Date: April 13, 2022
Read article Download PDF More on this topic More by this author
 

Working Paper

Measuring the intangible economy to address policy challenges

The purpose of the first work package of the MICROPROD project was to improve the firm-level data infrastructure, expand the measurement of intangible assets and enable cross-country analyses of these productivity trends.

By: Marie Le Mouel Topic: Macroeconomic policy Date: April 11, 2022
Read about event More on this topic
 

Past Event

Past Event

Macroeconomic and financial stability in changing times: conversation with Andrew Bailey

Guntram Wolff will be joined in conversation by Andrew Bailey, Governor of the Bank of England.

Speakers: Andrew Bailey and Guntram B. Wolff Topic: Macroeconomic policy Date: March 28, 2022
Read article
 

Opinion

European governance

How to reconcile increased green public investment needs with fiscal consolidation

The EU’s ambitious emissions reduction targets will require a major increase in green investments. This column considers options for increasing public green investment when major consolidations are needed after the fiscal support provided during the pandemic. The authors make the case for a green golden rule allowing green investment to be funded by deficits that would not count in the fiscal rules. Concerns about ‘greenwashing’ could be addressed through a narrow definition of green investments and strong institutional scrutiny, while countries with debt sustainability concerns could initially rely only on NGEU for their green investment.

By: Zsolt Darvas and Guntram B. Wolff Topic: European governance, Green economy, Macroeconomic policy Date: March 8, 2022
Load more posts