The political pressure on Germany and other surplus countries within the Eurozone to introduce Eurobonds is constantly increasing. I’m not a big fan of Eurobonds without further political integration, but given the problems of the deficit countries, I fear we may not have the time to introduce a common democratic European government to orderly introduce Eurobonds. As I write this, Angela Merkel and Sarkozy just pleaded for a common European Economic Government. As Merkel’s CDU always cited this too as a prerequisite to the introduction of Eurobonds, I guess that the chances that we actually will get Eurobonds are increased, despite Merkel saying otherwise.
So the question addressed in this post is: Can Eurobonds work without further political integration and thus without creating a „transfer union“. Yes, that is possible.
The plan by Jacques Delpla, member of the Conseil d’Analyse Économique, and Jakob von Weizsäcker, external fellow at the think tank Bruegel makes sense. The idea is to allow all Eurozone countries to issue two types of bonds: „Blue Bonds“ and „Red Bonds“. Blue Bonds will be mutually guaranteed by all member states and thus classical Eurobonds. However, each country may only issue blue bonds up to 60% of it’s GDP, i.e. the Maastrich criteria for financial stability. If a country takes on more debt, it has to issue Red Bonds. They are not guaranteed by other Eurozone countries and is an obligation by the issuing member state only. Germany currently has 65% debt over GDP ratio and thus would finance 60% via Blue Bonds and 5% via Red Bonds.
Additionally, the following two points must be met to make the plan fly. These are not nice-to-haves. Both points are absolutely necessary or the whole plan is flawed.
- Blue Bonds are of higher rank than Red Bonds. That is, in case of default Blue Bonds will be repaid with higher priority than Red Bonds. If Blue Bonds can’t be fully repaid, than Red Bonds will receive no money at all.
- Red Bonds are not eligible collateral for the ECB and may not be hold by banks. This is to ensure that the banking system actually survives a state bankruptcy and a default of a Red Bond. If this clause is missing, member states might be blackmailed into bailing Red Bonds to rescue their banking system.
Such Eurobonds will not lead to (significant) wealth transfers between the Eurostates and the high liquidity and security of the Blue Bonds will be beneficial to all member states. The Red Bonds will be, in most cases, punitively expensive and all member states will be very reluctant to issue them. This will be a strong market driven mechanism to contain the debt of all member state within the Masstricht limits.
But not all problems will vanish.
- It contains only a Greek/Italian type of state debt increase as countries will be reluctant to take on debt voluntarily. But it will not help in the Ireland case, where the state debt accelerated from 0 to 100 in less than 10 seconds due to a defunct banking system. For this we would require also an mechanism to actually let banks to default without creating a financial crisis. My favorite approach here is the debt-equity-swap.
- It is not clear how a migration to this solution would look like for countries that have already high deficits. They will need Red Bonds and pay punitive interest rates right from the beginning. Their debt will be tranched creating some kind of Collateral Debt Obligation (CDO), but the overall debt burden is unlikely to decrease significantly, if at all.
- Deficits in the economic structure of a country stay, e.g. Greece will not experience an economic miracle and the Greek people will not face a bright future in the coming years. But this is not specific to this plan. Financing decisions are never the answer to structural problems.
- While the plan has provision to avoid banking crisis in the case of a country default, we are not there yet. A default of Italy will be as devastating to the banking system after implementing this regulation as it is now, as long the old normal bonds are still outstanding.
To summarize: Yes, Eurobonds can work and actually be an effective tool to ensure the Eurozone member state meet the Maastricht criteria. But don’t expect miracles from it.
A full paper can be found on the Bruegel website.