A historic case for eurobonds

VoxEU.org

The ongoing eurozone crisis has at least four dimensions: Divergent labour costs between countries, a reluctance to embrace fiscal sharing, seemingly high levels of some sovereign debts, and self-fulfilling high interest rates on some sovereign bonds that may lead to default.

Eurobonds have been proposed as a tool to address the last issue. Although these have been discussed for more than two years, during which time the crisis has worsened, no progress has been made, perhaps because the idea seems too new, and because of the ambiguity of political positions. Yet the creation of a new instrument of public debt is not a new problem in history, and past experiences provide clear lessons.

There is no example in history of the rise of a political power without the simultaneous creation of its proper financial instrument of sovereign debt. The creation of a new financial instrument rests only on one basis, its credibility. For each of the past creations, that credibility was based on a central principle: the alignment between bondholders and both the tax revenues used to service the debt and the funding of the new debt. In other words, specified taxes were levied on which the service of the debt had first claim.

This principle was at work in the Italian cities of the Middle Age, in the 16th century Castile of Philip II, in the Dutch republic of the late 16th and 17th centuries, in England after the Glorious Revolution, and in the foundation of the US. In 18th century France, the limited use of that enforcement mechanism may have contributed to the fiscal problem of the Ancien Rgime that led to the French Revolution. All these countries had to start anew to establish mechanisms for a new financial instrument of the public debt. The same challenge faces European countries today.

And while financial markets are now far more sophisticated and much of today's complexity is incomparable with the past, one thing that hasn't changed is the importance of the credibility of the debt. And on that measure, Europe's leaders have something to learn from their predecessors in centuries passed.

Eurobonds could be created with an ad hoc institution, the Euro-Fund. Because of the multiple governments, that fund would have some features of financial intermediation, but would not be a bank. It would be an independent institution, with minimal staffing and policy role. In the current situation of the states' debts, its first initiative could be the purchase of 50 per cent of the public debt of participating countries. It would finance these purchases by issuing eurobonds. The participating countries would be committed, by treaty, to devote a specific tax for payments to the Euro-Fund. That tax would have first claim to the revenues of a country, prior to any expense of any sort.

Each country would keep a separate balance at the Euro-Fund and be charged the same rate on that balance. A surplus or deficit of the tax revenues would entail a variation of the debt of the country at the Euro-Fund. The liability of a country at the Euro-Fund would have a maximum of 60 per cent of its GDP. A country's public debt above that level would be financed like any sovereign bond. A country could keep a margin of safety below the ceiling for any emergency refinancing of its remaining sovereign debt and to prevent speculative attacks on its interest rate.

The funding would ensure the credibility of the eurobonds. It would satisfy the political or constitutional concerns about transfers between the current states. At the same time, it would represent a true European project. The ad hoc tax would make each citizen more conscious about the implications of the public debt and the participation in the European project. Financial institutions could hold in their portfolio a safe asset that would have a large market.

Right now, speculative attacks on interest rates can be successful because they select targets in fragmented markets. Interest rates in Italy are high because Italy would default if interest rates are high. They rise in Spain, France, and even Germany because a default of Italy would have a major impact on their financial institutions. Eurobonds may not entirely eliminate contagion, but they would greatly reduce its possibility. In the current situation, banks hold in their portfolios bonds of their national state, or use these national bonds as unstable collaterals to get euros. Hence, they are more vulnerable to the public finances of their country and the state is more vulnerable because of the need to bailout the banks if they fail. With eurobonds, banks would be less affected by the instability of the public finance of their country.

Most countries in Europe now have a sovereign debt above 60 per cent of their GDP and would keep a sovereign debt that would be priced by itself in the market. The interest rate on these sovereign bonds would obviously be higher than on eurobonds and would depend on a country's commitment to fiscal stability. But because these rates would apply to a smaller fraction of a country's debt, any increase of the fiscal surplus would have a larger proportional effect on the service of that debt and therefore on its interest rate, thus enhancing the marginal incentive of governments towards fiscal stability. Furthermore, should a default occur, its side effects would be reduced because it would be expected to affect only a smaller fraction of a national debt.

This is an edited version of an article originally published on www.VoxEU.org. Reproduced with permission.