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European crisis management usually consists of avoiding the worst outcome. Yet in five decades the continent has established the most successful example of a politically and economically integrated region in the world. Now, as it becomes clear to European policymakers that avoiding the worst outcome for the euro (e.g., a break up of the euro area) might require previously unthinkable things like a eurobond, the implications for the long-term direction of the EU and the euro area are tremendous.
An introduction of eurobonds is not likely to be adopted lightly. Such a step would fundamentally alter the economies of the euro area in a manner not seen since the introduction of the euro itself a dozen years ago. Responsible political leaders cannot simply announce it at 2 a.m. on Sunday to please bond traders before the Asian markets open.
If hastily introduced, eurobonds would be democratically illegitimate and not likely to be seen as the anchor of fiscal stability sought by financial markets. Only a lengthy period of institutional, political, and economic preparation in the euro area would enable a eurobond to add to the region's fiscal stability and economic growth prospects. Financial markets are consequently mistaken in demanding "eurobonds now!"
In disappointing the markets craving such a move, the meeting between Chancellor Angela Merkel of Germany and President Nicolas Sarkozy of France suffered from a poor management of expectations. The two should never have allowed speculation about far reaching announcements on eurobonds to materialize in the markets. Fundamentally, France and Germany are correct in not rushing this issue.
To understand why requires an examination of the factors at work beyond the short-term prospects for the next peripheral government bond auction.
The core principle of "eurobonds" is the effective joint guarantee of all euro area member states of the debts of each individual member. In other words, taxpayers in one country—Germany or the Netherlands, for example—guarantee the repayment of the liabilities of taxpayers elsewhere in the euro area. Centralized EU bond issuers exist already. But these issuers—the European Financial Stability Facility (EFSF), the European Stabilization Mechanism (ESM), and arguably even the European Central Bank (ECB) balance sheet—are conceptually different. The EFSF/ESM is also jointly guaranteed by all member states, but their debt instruments, unlike a eurobond, can only be accessed under strict International Monetary Fund (IMF) conditionality. For the purpose of guaranteeing market access at a sustainable price of fiscally challenged countries like Italy, Spain, or the small peripheral countries, the joint guarantee of a eurobond is a very effective innovation.
In addition, creating a large euro area bond market might enjoy the benefits as a "safe haven" for investors similar to the $14 trillion US Treasury market, with its attractions as a source of liquidity in a crisis. As a result, eurobond interest rates would be lower, making it probable that even today's euro-denominated benchmark issuer, Germany, would not face substantially higher costs of funding. This would be especially true for Germany compared to the costly alternative of Germany trying to bail out the euro area periphery without eurobonds. In short, the efficiency gains and financial benefits of eurobonds are large and irrefutable.
The downside of these benefits is, of course, in the cost to taxpayers. Just as sovereign guarantees are backed by the ability of governments to tax their own citizens,1 jointly guaranteed eurobonds imply the willingness of euro area taxpayers to honor such guarantees in the future. In today's euro area, the reality is that the vast majority of government spending remains controlled by the national governments and not the supranational EU. Taxpayers in one euro area member are probably not yet ready to guarantee the debt resulting from the fiscal policy decisions of governments in other countries. Unable to vote in Greek or Italian elections, why should German taxpayers want to be liable for Greek or Italian government debts?
As a consequence, eurobonds in today's political climate would be seen as a blatant example of "taxation without representation." Such an arrangement is not likely to produce stable polities and contented citizens. Rather this formula is likely to produce tax revolts and revolutions. Whatever their financial benefits and however much financial markets call for them, rapidly introduced eurobonds cannot quickly overcome this fundamental democratic illegitimacy problem. EU politicians cannot and should not adopt such a setup in the short term.
But while the politics favoring eurobonds seem prohibitive right now, a subtle and pragmatic shift is under way in core Europe, particularly Germany. As late as December 2010, Chancellor Merkel dismissed eurobonds as illegal under the EU Treaty. This week at the summit with President Sarkozy, her position changed. She said that eurobonds "are not part of the solution of the current crisis," by implication opening the door to them down the road.
Her new more pragmatic approach suggests that under the right conditions, eurobonds would be politically acceptable. Indeed, the two main German opposition parties—the Social Democrats (SPD) and the Greens—have already declared their support for eurobonds. The correct framing of the issue is thus no longer whether but under what conditions they could become reality.
The attitude toward eurobonds in many ways recalls the debates of the early stages of the European monetary union and the euro itself in the late 1980s and early 1990s. At that time, discussions centered on the correct design of and implementation strategy for the euro. These talks led to the Treaty of Maastricht in 1992 and the launch of the euro coins and notes a decade later in 2001. The decade-long gestation period might be roughly the same for eurobonds. In any case, it is time for European political leaders to accelerate the practical, public, and official discussion about such a step.
At his press conference in mid-August, President Sarkozy stated explicitly that eurobonds must follow a process of additional European economic integration. This is a view that will be well known to the designers of the euro itself. In the 1980s and early 1990s, they generally split between those espousing the so-called "coronation theory" and those favoring the "locomotive theory." Sarkozy's statement implies the former, in which a new pan-European economic instrument must occur as a "crowning moment" at the end of substantial further economic integration.
Ironically, the slow and deliberative pace he called for represents the opposite strategy from what was taken for the euro itself. Recall that euro area exchange rates were irrevocably pegged to each other in 1999, without much real economic integration of the euro area having taken place beforehand. The resulting euro was expected to act as a locomotive to pull Europe towards greater and greater union.
The European financial crisis has arguably proved the fallacy of the "locomotive theory." Not surprisingly, as a result, the French president has concluded that Europe will not again rush to launch a far-reaching innovation like euro bonds without a prolonged preparatory period of economic and institutional reforms to make it work. Just maybe this central lesson from the first decade of the euro has been learned.
There are multiple ways to technically introduce eurobonds. They can be issued centrally and then distributed to individual member states or issued by each member itself. They can initially cover only new debt (gradually replacing maturing old national debt by new eurobonds). They could require the swapping of existing national debt into new jointly guaranteed eurobonds. Or they might be intended to replace parts of outstanding national debts (say 60 percent of GDP) or all of it.
However, since eurobonds imply taxpayers' commitment, euro area leaders must make preparations that are inherently political in nature. At least three issues must be addressed.
First, the euro area must establish the institutional capacity to preemptively reduce or overrule irresponsible fiscal decisions by individual member states. Such a step would require a dramatic pooling of fiscal sovereignty among euro area members. The latest Franco-German proposals for obligatory national balanced budget amendments like those in the states in the United States, as well as a new euro area governance council, are just the first steps. The ex post facto ability to sanction fiscally wayward member states over deficits that have run out of control will no longer suffice. The euro area's "European Semester" of scrutiny by all members of individual countries' budget proposals ahead of national parliamentary approval must be made binding and enforceable.
Second, euro area governments must likely ensure that their countries are fiscally more comparable than is the case today. It is hard to see how Italy (without which eurobonds would lose a large part of their relevance) with its record of more than 120 percent of GDP in government debt could enter into a fiscal union with France, Germany, or others that have far lower general government debt levels. Unless Italy and other high debt countries reduced their government debt levels to the euro area average (e.g., French and German levels) ahead of time, the political obstacles to joint guarantees of all debt will likely be prohibitive. It is thus hard to imagine eurobonds as an option for any euro area member with government debts exceeding 80 to 90 percent of GDP.
The ghosts of the shallow euro accession qualification requirements from 1997—which required budget deficits of below 3 percent in 1997 only—loom large. With eurobonds, euro area leaders will want to ensure that all countries actually reduce their stock of debt materially before qualifying for jointly guaranteed debt.
And third, euro area leaders must do what their predecessors did not do during the run-up to the euro introduction. Namely, they must ensure that participating countries at the start are on a sustainable fiscal and growth path, even when accounting for aging populations and other long-term threats. When debt is jointly guaranteed, out-of-control age-related expenditures in one country or hopelessly dysfunctional and inflexible labor markets in another cannot be tolerated. In other words, substantial structural economic reform programs must be implemented to ensure and align the economic growth prospects of euro area members converting to eurobonds.
Because of all these reasons, the road to eurobonds will be long and arduous. The EU Treaty will likely add another layer of complexity. But given that the adoption of eurobonds—like the euro itself—would de facto be irreversible for participating countries, it must be this way. Europe cannot afford to speed unprepared down a one-way road again.
By announcing eurobonds as a new strategic goal and initiating a practical discussion of the many institutional and economic reform preparations required, EU leaders and Angela Merkel in particular have the opportunity to take the euro area out of the current crisis. Future access to eurobonds would be a political and economic incentive for crisis-stricken countries to climb out of the crisis with them—at the end of a lengthy transition period.
Notes
1. In countries with large natural resources and consequently large amounts of exploitable government assets available, tax revenues will play a lesser role. However, in Europe only Norway is arguably in this situation.
