The fire started in the basement, almost completely burning down the house. Fortunately, your neighbor was out of town. You had told him to replace his old furnace to save money, but he procrastinated. Many neighbors offered to help, some more than others. The neighborhood's solidarity was touching but ultimately proved insufficient. Your neighbor was financially ruined.
This scenario seems less realistic in an advanced economy today than it would have been centuries ago. What was a financial innovation in the 1600s—fire insurance—is now commonplace. Financial innovation has proven more effective than solidarity. Fire insurance pools risks well beyond one's neighborhood, and both the compensation after a fire and conduct prior to the fire (such as incentives to replace old equipment) are spelled out in a contract. Changes in neighbors' feelings do not affect financial outcomes. And fire insurance does not rule out solidarity; if anything, it makes neighbors less likely to squabble in the aftermath of devastation.
The European neighborhood has nearly extinguished the flames of the economic and financial crisis ignited in the United States but smoldering in the euro area. No country was spared, and some were engulfed. Policymakers are appropriately designing mechanisms to enhance European solidarity. It is sensible for member countries to share economic risks, so that when one suffers a recession it receives help from the others and reciprocates when the cycle turns back in its favor. But establishing solidarity mechanisms, such as a fiscal transfer union, requires building consensus and takes time, particularly in the current environment, in which a portion of the European population is skeptical of the benefits of greater integration. Thus, now is also the time to find other, faster ways of pooling economic risks across countries, which could provide valuable insurance benefits well ahead of a formal fiscal union.
One financial innovation, growth-indexed bonds, is an old and simple idea, whose economic merits are widely understood. Like inflation-indexed bonds, routinely issued by many governments in Europe and elsewhere, growth-indexed bonds would provide a payment that depends on a well-publicized economic variable—in this case, nominal GDP growth. By accepting lower payments from an issuing country when its economic growth is low in exchange for larger payments when growth is high, international investors provide insurance against output slowdowns. Thus, a straightforward financial innovation would help meet the same objectives currently being pursued through initiatives for greater European solidarity. Coordinated issuance of growth-indexed bonds by several European governments would have three advantages: First, it would kick-start a sizable market quickly; second, as there are no restrictions on who can hold government bonds issued by European countries, risks would be shared with a potentially worldwide investor base, rather than within Europe alone; third, the extent of risk sharing would be predetermined in contracts. Ultimately, such issuance would be a useful complement to other initiatives aimed at greater risk sharing among member countries.
As argued in Policy Brief 16-2 [PDF], the value of growth-indexed bonds in protecting countries from debt crises is especially high in the current, high-debt environment. The global economic and financial crisis brought about the largest and most pervasive increase in government debt-to-GDP ratios after World War II. Several countries, including some of the largest advanced economies, have ratios approaching or in excess of 100 percent. Although deficits have been reduced, debt ratios have, at best, been stabilized at a higher level than prior to the crisis. While nominal interest rates are exceptionally low, neither real interest rates nor the growth–interest rate differential, a key determinant of the debt dynamics, are particularly low by historical standards. Against this background, a decline in growth rates in a highly indebted country could well lead investors to question the sustainability of the debt, cause an increase in the default risk premium, and thereby trigger a renewed interest–debt ratio spiral not unlike the near misses experienced in 2011-12 by sizable advanced economies such as Italy and Spain. By reducing the cost of debt in the event of a growth decline, growth-indexed bonds would lessen the risk of a debt explosion.