The euro’s last-chance saloon

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.