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Sometimes old promises come in handy. European Union Commissioner Olli Rehn must be pleased that back in June he promised to prepare a "feasibility study" before the end of the year on the topic du jour in Europe, namely eurobonds.1 As the European Commission will soon forcefully wade into Europe's imminent and far-reaching debate about eurobonds, Commissioner Rehn can deny charges that the study was foisted on Europe by "elitist Brussels-based bureaucratic policy opportunism." Instead he can just refer to his old commitments to elected EU parliamentarians.
For financial markets and pundits clamoring for an "expeditious and comprehensive solution" to the European debt crisis, eurobonds—i.e., national sovereign bonds guaranteed in a joint manner by all euro area member states—have increasingly loomed as a panacea for Europe's multifaceted economic crisis. If only, as the buzz goes, euro area leaders would exert bold leadership….
True leadership cannot always entail a yes right away, however. A large part of today's euro area crisis, after all, is rooted in unfinished preparations for the euro before its introduction from 1999 to 2001, when it was politically impossible to say "NO!" to would-be founding euro members Italy, Belgium, Spain, and Portugal (and later Greece), and instead was necessary to overlook their high debt levels2 and structural rigidities.
The leadership Europe needs today is not the boldness to say "yes" to a new far-reaching integrationist initiative, but to say "NO!" to market demands for "eurobonds now." European leaders should instead lay out the political and institutional homework to prepare for eurobond introduction. Two requirements seem evident.
First, fiscal moral hazard and the democratic deficit must be contained. Jointly guaranteed eurobonds imply a single euro area long-term interest rate and cost of financing for all member states. The scale of the implicit subsidy from the most fiscally sound to the less sound member states would depend on where a new joint eurobond would trade relative to today's national bonds (see below). But the potential for moral hazard is obvious as long as spendthrift countries can finance heavy domestic spending with eurobonds at others' expense.
Under existing institutional arrangements, taxpayers in one euro member state would have no say over spending in other states whose eurobond debt they would be jointly guaranteeing. The euro area is not yet like the United States, where the majority of taxation and disbursements (in the form of direct federal payments to individuals and grants to state and local governments) occurs at the federal level. Euro area taxes and spending, by contrast, will remain "decentralized" at the member state level for the foreseeable future. This democratic "taxation without representation" deficit must be addressed.
An eventual establishment of a large independent euro area budget (distinct from today's relatively minor EU budget capped at around 1.24 percent of GNP) with control exercised by an elected euro area parliament is so unlikely as to be a political fiction for the foreseeable future.
Europe has discussed a beefed-up version of its traditional, but until now virtually unenforceable, Stability and Growth Pact, in which countries could be sanctioned over loose fiscal policy. But such a step would not be adequate if all debt issued is jointly guaranteed. Threatening large fines for countries with excessive deficits—making these deficits even larger—would be a non sequitur once deficits are financed through jointly guaranteed debt. Like coercing an alcoholic to stop drinking wine by buying him a glass of whiskey, fiscal sanctions are even more counterproductive than today once eurobonds are introduced.
Eurobonds, in short, must be anchored in the political possibility of transferring fiscal competences from the national to the euro area level (thereby aligning the economic benefits and democratic responsibilities related to eurobonds) since they would lack the ability to credibly sanction fiscally wayward members.
At least two other options seem plausible, however. Fiscal policy, taxation, and government spending could remain predominantly at the member state level, but the euro area would have the power to rein in deficits and borrowing before it occurs, i.e., before more jointly guaranteed debt is issued.
Such a step would require national euro area government budgets to be vetted and approved by the euro area as a whole, granting the euro area a preemptive veto over national budgets. Such a veto could take the form of nullifying an entire national budget or simply parts of it. 3 Either way would obviously entail an unprecedented surrender of fiscal sovereignty by member states—far beyond anything contemplated in the past. To say the least, political support for such an institutional strait jacket would take time to win acceptance.
Another approach might sidestep this arrangement and instead impose spending checks at the member state level. An irrevocable set of national "Constitutional Balanced Budget Amendments," for example, has been suggested again by Chancellor Angela Merkel of Germany and President Nicolas Sarkozy of France. In this formulation, only euro area members embracing such binding amendments would gain access to jointly guaranteed debt.
Conditioning eurobonds to national balanced budget amendments might well be attractive to skeptical countries. But given the different constitutional traditions across the euro area, with some member states able to change their constitutions easily, a requirement for a constitutional balanced budget amendment might not suffice. More likely, additional institutional restrictions will be required.
The second issue that euro area leaders must address prior to introducing eurobonds is their economic soundness. It is evident that eurobonds would only be politically feasible if they had a sufficiently solid economic foundation to earn a rating of AAA. Germany and other still AAA-rated euro members would never give up their national ability to issue AAA-rated bonds in return for jointly guaranteed instruments of a lower credit rating.
Achieving the economic soundness of an AAA rating for eurobonds—given current national debt levels across the euro area, the region's growth prospects and current institutional travails—will obviously be a major challenge. It would at least require a higher growth rate and the institutionalization of "irrevocable Northern European fiscal discipline" across the region—goals unimaginable without renewed structural economic reform efforts. Such reforms would have to entail labor and product market liberalization, as well as pension and health care sustainability.
Could eurobonds serve as a financial incentive forcing the sweeping structural adjustments that are necessary? If they did, the upheaval of the member nations would be worthwhile. It is hard to fathom a bigger future economic inducement for acceptance of today's austerity drives than eurobonds.
The introduction of high quality eurobonds would benefit the euro area by providing a positive new source of liquidity for investors. A market of €6 trillion to €7 trillion in eurobonds would rival the size of the market for traded US Treasury Bonds. It could in time possess many of the same "global safe haven characteristics." Accordingly, eurobonds could trade substantially below the yield average of currently issued national euro area government debt.4
How low would the eurobond yield be? That is hard to say. But the recently introduced "conditional eurobonds" in the form of European Financial Stabilization Facility (EFSF) bonds suggests ample investor demand. EFSF bonds have generally been placed in the markets at around 50 basis points above benchmark German government bonds.5 Yet, it is clear from the US Treasury market that "size matters" in bond markets, too. Once eurobonds are launched, the euro area would most likely proceed to full convergence of existing national debt into the new instrument. Consequently, eurobond proposals that entail only partial convergence to eurobonds (say up to 60 percent of GDP), or that foresee a gradual transition process, would mean suboptimal yield levels and higher cost of financing for the euro area.
Full conversion to eurobonds of all national euro area government debt is further likely to have considerable positive "confidence effects." Closing down national euro area bond markets would signal that the entire euro project is irreversible. A prolonged twilight zone of dual national and eurobond government debt markets in the euro area would likely sow doubts about the euro and the euro area in financial markets. Full conversion into eurobonds would reduce the risk of a future breakup of the euro to zero, speeding the "international reserve status" of both the euro currency and bonds.
All this may seem like a pipe dream. But long journeys begin with the first step and a vision of the goal. It is time that European leaders articulate both for eurobonds.
Notes
1. See Olli Rehn's speech to EU Parliament, June 22nd 2011 at
2. Actually, Portugal with 54.4 percent debt/GDP in 1997 passed the Maastricht Treaty's 60 percent debt criteria and Spain at 66.1 percent that year was quite close. Italy and Belgium though as at around 120 percent in 1997
3. The US "line-item veto" allows the president to take out individual parts only of Congressionally-approved federal budgets, rather than reject the entire package. In the United States of course, a two-thirds majority in Congress can overrule a presidential veto.
4. The IFO institute on August 17th published an estimate that fails to account for such liquidity effects, and consequently arrives at what is likely a significantly upward biased estimate for the likely yield of eurobonds relative to German national government debt today.
5.http://www.efsf.europa.eu/investor_relations/issues/index.htm.
