Autor: Carlos Contreras
The recent European sovereign debt crisis has shown how vulnerable the euro zone is under a functioning system in which the monetary policy is set up at the European Union level, while fiscal policy is carried out at the national levels. However, the EU, a project still under construction, should have the capacity to create solutions.
1. Introduction
In this vein, the President of the European Central Bank (ECB) pledged to do “whatever it takes” to preserve the survival of European Monetary Union (EMU), and he did. Several non-conventional monetary policy measures were implemented to address not only the risks of a too prolonged period of low inflation, but also to tackle the euro sovereign debt crisis. Purchases of government bonds by the ECB was also justified to ensure price stability in the euro area, since a currency can only be stable if its continued existence is not in doubt (Asmussen, 2013).
In May 2010, the ECB announced the Securities Markets Programme (SMP), whose main target consisted of lowering the interest rates of euro members in financial distress. It resulted in ECB purchases of government bonds in the secondary markets, and thus in an increase of those countries bonds’ prices. According to some commentators, by doing so the ECB would have intervened in the market forces (Helm, 2012). Later, in July 2012, the Governing Council of the ECB announced the Outright Monetary Transactions Programme (OMT). In spite of its technical features, 1their critics claimed that the ECB had breached its mandate by announcing potentially unlimited sovereign bond purchases. For some authors, by implementing the OMT Programme the ECB had exceeded monetary measures marks and interfered into the terrain of fiscal policy. This would have resulted in a violation of Art. 123 of the Treaty on the Functioning of the European Union (TFEU), according to which monetary financing of sovereign entities is strictly prohibited. Additionally, they claim that political independence of the ECB could have been put in danger. In the same way, the German Federal Court (Bundesverfassungsgericht or BVerfG), putting into doubt the legality of the OMT, decided to refer for the first time a case to the Court of Justice of the European Union (CJEU). The BVerfG’s judgment strongly implied that the OMT program was an act of economic policy, therefore outside the monetary mandate of the ECB, because of its objective, the selectivity of the potential purchases and the risk to compromise the functioning of European Stability Mechanism (ESM). (Pennesi, 2016). In the aftermath of these disputes, in March 2015 the Eurosystem started buying government bonds under a new mechanism, the Public Sector Purchase Programme (PSPP), 2which to the current date is still in place.
However, unconventional monetary policy has not been the only solution tabled to solve the European sovereign crisis:
On the one hand, since the euro zone was conceived as a monetary union without a fiscal union, it has been proposed to achieve a much deeper fiscal integration among euro members. This would imply an extended government budget at the EU level, combined with an EU tax system (Fuest and Peichl, 2012), and the creation of a European finance minister (EU-FM), (Enderlein and Haas, 2015). Others consider that an extension of the fiscal powers of «Brussels» would be politically unacceptable, since it would put at risk the democratic principle of no taxation without representation.
On the other hand, some economists claimed that an orderly procedure to restructure the debt of an insolvent member estate, as well as a fiscal insurance mechanism were indispensable to protect taxpayers in other euro zone, in the event of debt restructuring (Dolls et al., 2016).
Finally, the German Council of Economic Experts proposed the European Redemption Pact (ERP) as an alternative strategy for exiting from the EU debt crisis. This pact would include a binding commitment by all participating countries to bring public debt ratios below the reference value of 60% within the next 20 to 25 years. To ensure that this objective might be reached with realistic primary balances, participating countries could transfer their debt exceeding this threshold into a redemption fund for which participating member countries were jointly and severally liable (German Council of Economic Expert, 2011; Parello and Visco, 2012; and Doluca et al., 2012).
2. The Eurobonds as an alternative tool
An alternative solution (compatible with the existence of a fiscal union) would consist of pooling some fiscal risks. Unifying national debts and creating Eurobonds have been viewed as a tool for not only boosting integration and the efficiency of financial markets in the euro area, but also as a potentially powerful instrument to solve the European sovereign debt crisis.
According to its standard design, this debt instrument could be issued by a newly created common European Fiscal Authority or European Debt Management Agency, and would be jointly and severally backed by all countries members of the euro zone. However, this design has not been unique. Multiple Eurobond designs have been proposed: EMU Fund Bonds (Boonstra, 2005 and 2011); Financial Stability Fund Bonds (Gros and Micossi, 2008); European Investment Bank Bonds (De Grauwe and Moesen, 2009); European Monetary Fund Bonds (Mayer, 2009); Blue-Red Bonds(Delpha and Von Weizsäcker, 2010); European Debt Agency Bonds (Tremonti and Juncker, 2010); European Safe Bonds or ESBies (Brunnermeier et al., 2012); Synthetic Eurobonds (Beck et al., 2011); Trichet Bonds (Economides and Smith, 2011); Eurobills (Hellwig and Philippon, 2011 and Bishop, 2013); Partial Insured Sovereign Bond (Dübel, 2011); Revised Blue Bonds (Gopal and Pasche, 2012); and Structured Eurobonds (Hild et al., 2012). Note that these designs greatly differ in their scope, goals, tenor of the debt, level of intergovernmental commitment, extent of solidarity, degree of legal and institutional obstacles, as well as the feasibility of implementation roadmaps.
Important institutional and legal obstacles have become apparent to make progress in the direction of creating a European common bond but in this brief note, we focus in particular on the economic advantages and drawbacks of introducing such instrument.
2.1. Advantages of introducing Eurobonds
Many reports have been published on the possible pooling of sovereign issuance in the euro area and there is a widespread consensus that the introduction of a common supranational Eurobond would imply several merits. The following have been particularly highlighted:
- A tool to resolve the eurozone debt crisis. Eurobond is a mechanism to buy time by reducing the degree to which heavily indebted countries need to apply short-term austerity measures. Implementing such a common public debt in the EU area could reduce risks of recession and facilitate faster economic growth for the whole region.
- A way of stopping speculative attacks. Sometimes, psychological fears that certain member states are or may become insolvent, initiate inefficient speculative attacks: the markets demand a risk premium that raises the cost of refinancing these bonds and depresses their prices, generating a sovereign debt crisis. The introduction of Eurobonds might contribute to break this loop.
- A method to reduce public debt yields of those member estates in financial stress. Due to the higher liquidity and ease of trading of Eurobonds, investors and traders would be willing to accept lower yields. By reducing interest payments governments could reduce their future budget deficits. As a result, public debt sustainability would improve in the euro-zone.
In addition, a number of merits arising from introducing European common bonds have been stood out in connection with financial issues:
- Mitigating bank-sovereign crisis loop. Historically, banks and sovereigns have been indissolubly tied together. The vicious cycle between banking and sovereign crisis has been a salient feature of the recent eurozone crisis. The conversion of euro area national debts into a common eurozone debt would benefit the banks in Europe, break this strong interdependence and help put a stop to the banking crisis.
- Creating a new safe asset. Due to its increased depth, breadth and liquidity, investors would increase their demand of Eurobonds for investment and precautionary purposes, just as they presently do with US Treasuries. Thus, the introduction of Eurobonds would generate a seigniorage effect in the euro zone.
- A deeper public debt market in Europe. The creation of Eurobonds would transform the currently fragmented European capital market for sovereign bonds into one single and vast European Government bond market.
- Solidifying the euro as a global reserve asset. The creation of a single debt instrument traded in a vast market could reinforce the euro as a means of payment instrument, and as currency for official store of value purposes (a reserve currency that central banks choose to hold their savings in).
2.2. Drawbacks arising from the introduction of Eurobonds
So far, governments in the euro area are individually responsible for the debt they have issued. According to the no bail-out clause (Art. 125 of the TFEU) it is prohibited for the EU or any of the national governments to assume responsibility for the debt issued by another member state (Pisani-Ferry, 2012). Thus, the creation of some type of Eurobonds could require a reform in the TFEU, but beyond this legal obstacle, there also some economic problems that introducing Eurobonds might mean for the Eurozone. A wide academic literature exist on disadvantages of pooling fiscal risks in a scenario in which public sector debt ratios are very different by country:
- Adverse selection. The introduction of Eurobonds might raise the interest rates at which the most creditworthy euro members currently pay on their debt. This could lead to a rejection of Eurobonds by highly solvent countries, but this refusal to participate would imply the uselessness of the Eurobond mechanism itself.
- Free riding. A model of fiscal risk pooling could force the more frugal countries to start paying for prodigal countries’ deficits. Fiscally prudent members might be penalized for other members’ dissipation. If in this scenario, currently very solvent countries change its fiscal policy profile, gradually over time, eurozone countries could face the raise the debt-GDP ratio for the entire region, resulting in undesired credit rating cuts and increases in debt yields.
- Moral hazard. It relates to the fear that countries’ “bad” behavior in overspending and accumulating debt would be rewarded through a government bailout. The introduction of Eurobonds might reduce incentives to perform fiscal austerity policies in the future. If highly indebted countries were rescued, their fiscal policy behavior would tend to be more lax. Moreover, if governments with high public debt ratios may finance themselves at low yields the incentives to carry out budget discipline measures vanish. It would foster the illusion that is possible for a country to get out of financial difficulties without undertaken fundamental reforms.
- Losing signaling role of financial markets. Issuing Eurobonds would remove the disciplining effect of capital markets on the ability of member states to issue more debt.
- Fiscal sovereignty loss. Previous fiscal constraints, that are required for a proper functioning of a joint issuance mechanism, would eliminate each country’s ability to control its interest cost burden and would reduce its sovereignty in fiscal matters.
- Loss of liquidity at the national public debt markets. If the Eurobond market is to be added to the existing national public debt markets, instead of substituting them, the opposite effect to the wished might occur. We could witness an increase in the level of market fragmentation, as well as a loss of liquidity at the national public debt markets with respect to the current situation.
3. Conclusions
Designers of European common debt systems have proposed alternative mechanisms aimed at restoring the disciplinary role of the market within the euro zone following the introduction of the Eurobonds. Avoiding the effect of free riding problems arising from the introduction of Eurobonds implies finding a way to ensure that one country’s profligacy will not spill over to another country’s debt burden; and therefore, ensuring that member states assume the responsibilities of their own fiscal policies. Moreover, introducing European common debt issuances will require finding a way to neutralize the moral hazard problem within the euro zone, and to internalize the signalling and disciplining force of the market. In short, to succeed the introduction of Eurobonds would require to enshrine fiscal discipline in a fair and credible way, as well as creating the right incentives for countries to maintain debt ratios at manageable levels.
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Autores:
Carlos Contreras
Licenciado y Doctor en Economía (Universidad Complutense de Madrid) y Master of Science in Economics (University of York). Profesor Titular de Economía Aplicada VI (UCM). Autor de varios libros y artículos sobre finanzas, fiscalidad, deuda pública y política fiscal en Revista de Economía Aplicada , Journal of Public Administration, Finance and Law, Hacienda Pública, Revista de Economía Pública, y otras.
Mónica Contreras