Paths to eurobonds

Guntram Wolff: You are the author of a study on Eurobonds. Eurobonds are certainly discussed at the moment, but there are a lot of different models of how to introduce Eurobonds and how Eurobonds should be designed. Would you like to give us a comparison of the different models out there?

Shahin Vallée: The paper is built on work that we’ve had at Bruegel in a couple of seminars. One organized by the EBRD and Bruegel in London and another one organized with the IMF in Brussels. The idea was to compare the different proposals, because there has been a number of proposals about Eurobonds in the last two years now. All of these address a different dimension. Our conclusion is that Eurobonds should be and are designed to address three categories of problems. The first one is a problem with the fiscal dimension. Eurobonds should help bring fiscal discipline and provide good incentives for fiscal discipline. The second one is to provide fiscal risk sharing, and this is a difficult question because in fact the monetary union was built originally without real mechanisms for fiscal risk sharing. This is the fiscal part. The second part is the financial stability part. The Eurobonds can contribute greatly to financial stability and can be a potential patent resolution mechanism to the current financial distress. And in that sense Eurobonds achieve two things. One, they help to cut the link between the banking system and the sovereign, which we’ve seen that in a number of cases has been an important source of stress. And second, the increase to supply of risk free (or perceived to be risk free) assets, which as we’ve seen in every financial crisis, there is a massive shrinkage of the supply of these free assets because perception over risk free assets changes profoundly.

And finally Eurobonds can help to improve monetary policy transmission mechanism, and I think this is an essential point. They can do that in two ways. Both by reducing the aggregate borrowing cost of the euro area and second by improving the transmission mechanism on a country per country basis. Our work is to try to understand how the different proposals address these dimensions. What we observe is that each Eurobond proposal is better than the next one at addressing one of these questions. So we need to rank and prioritize these questions and then see how the different proposals fit. Ultimately the goal is to lay out a potential path towards an ultimate solution, but there is no real ultimate solution. What we find is that there are different paths that in fact are very linked to the political path that needs to be chosen in the move towards a fiscal union. As long as we don’t have a clear answer of the type of fiscal union we want, it is hard to answer what type of Eurobonds we need.

GW: But in practical terms, how would you introduce Eurobonds now? Because we currently have faced very high interest rates in a number of countries and this is a source of major concern. You want to address this, but if you introduced Eurobonds now who would actually back them?

SV: As far as the introduction is concerned there are two questions. One is: is the important thing the stock of debt we have or the future flow of debt that we will need to manage? In that sense your question about the interest addresses the latter, which is the flow of debt which creates stability dynamics for a number of countries. I think ideally you would want to deal with both. You want to deal with the stock and you want to deal with the flow. Not all the proposals are good at dealing with both. Actually some proposals are better at dealing with the future flow. I think these proposals, in the short term at least, should be the ones that are favored, because what is key in reference to the crisis resolution aspect of any introduction of Eurobonds is to allow member states to access financial markets again at interest rates that do not challenge future debt sustainability dynamics. And if the political agreement over a mid-term long-term solution is not there, we can agree to a short term solution. This is why I think a solution such as the eurobills is quite interesting, in the sense that it allows member states to issue that jointly guaranteed but only on a short maturity basis. This way, if we observe that this doesn’t work or that the political agreement changes or is weak, then we can go back and change our commitment. I think this is an interesting proposition in the sense that it’s flexible but also addresses some of our short term dynamics.

Now there is a more fundamental question about the stock of debt and what we do with this, and this is not easily solved. We’ve built over the last year a number of rules and governance changes like the six pack, the two pack or the fiscal compact, and maybe some argue that we should build a Eurobond proposal that actually helps to bring down the debt burden. And in that sense the European Redemption Fund, that has been proposed by the German Chancellor of Economic Experts does a long way in that direction. But I think ideally, and the European Parliament seems to be heading in this direction, what we need to find is the good combination and the good sequencing of those different options. It’s quite possible that the right mix is something that mixes eurobills to deal with the future flow of debt and maybe the redemption fund as well to deal with the previous stock. The question is how we combine and sequence them.

GW: But what institutions would you need to underpin the credibility of these Eurobonds? Because you have international investors that want to buy Eurobonds but want to know who is going to pay for these bonds. They want to have reassurance that there are strong institutions behind this. You mentioned the six pack but going beyond, what do you think is needed as a solid foundation for Eurobonds?

SV: I think the most solid foundation would be to agree on the contours of a fiscal union. I think institutional questions can be solved if the underpinning political question has been solved. And this is why both the debate about budgetary and political union are essential. What’s regrettable so far is that both are not clarified. On the one hand, to caricature a bit, Germany argues that budgetary integration is necessary, but seems to consider budgetary integration only through the prism of fiscal discipline. On the other hand, the French also seem to agree that budgetary integration is necessary, but are not really ready to specify what this means, and whether if this means an abandonment of national fiscal sovereignty. I think as long as we have those unresolved debates is going to be very hard to produce a clear and solid institutional framework. What I hope is that the upcoming European meetings in the next few months will bring a discussion about what should be a budgetary union, whether if this should include transfers of some sorts, whether if this should include fiscal discipline and whether if this should include a framework for macroeconomic stabilization, discretionary or automatic. These questions are still unresolved and in fact they haven’t even been asked. And I think once they are asked we can think about the institutions in more depth.