Erik Jones’ Remarks - Why Europe Needs Eurobonds?

Why Europe Needs Eurobonds(?)

Erik Jones
SAIS Bologna Center

Good morning. It is both an honor and a privilege to join a panel with such distinguished participants. I would like to thank the organizers for including me in such an impressive event. I would also like to thank them for giving me a topic that has so much in-built support from my copanelists. Our first speaker, Paul De Grauwe, is rightly credited with restarting the debate on eurobonds in an influential paper that he wrote with Wim Moesen in April 2009.¹ For those of you who are interested in a recent synthesis, I would recommend De Grauwe’s latest essay on economic governance in a fragile eurozone.² As part of that debate, Mario Monti has been a consistent advocate of Eurobonds as a source of solidarity and market discipline;³ Lorenzo Bini-Smaghi threw his weight behind the idea in a speech he made at the IMT in Luca last March;⁴ and Zolt Darvas has reinforced calls made by his Bruegel colleagues, Jacques Delpla and Jakob von Wiezsäcker to introduce eurobonds as well.⁵ Hence my goal from their perspective is primarily to give due weight to their insights and contributions.

Of course the organizers have been careful to include some more skeptical voices on the panel. I think that is why they put the question mark in the title. Yves Mersch has described the eurobond proposal as both ‘unhelpful’ and ‘premature’, explaining that ‘if you want to Europeanize debt then you have to Europeanize tax collection’ and pointing out that it would be more useful to focus attention on necessary structural reforms.⁶ As if that were not explicit enough, our moderator, Giancarlo Corsetti, has joined with an impressive array of authors in a recent CESifo report to argue that the emphasis in the debate should be on crisis response and – and I quote – ‘under no circumstances should the eurozone move to Eurobonds as advocated by some European
politicians and commentators’ because such ‘Eurobonds [would] do nothing but strengthen incentives for opportunistic behavior on the part of debtors and creditors.⁷ My goal in this context is simply to suggest that there are ways to design the Eurobonds that mitigate such objections.

The starting point is not the eurobond proposal itself but the challenges that the proposal is meant to address:

First, European fiscal policy coordination has not resulted in sufficient discipline or even an adequate level of transparency in fiscal accounting practices. This was true long before the current crisis and implicates France and Germany as well as Portugal and Greece. Moreover, there is little evidence to suggest that the recent reforms to the procedures for European macroeconomic governance – the ‘European semester’ and the ‘Euro-plus Pact’ are going to be enough to make a difference.

Second, the rapid pace of nominal interest rate convergence prior to monetary union and the low nominal interest rate differentials charged during the first years of the euro suggest that sovereign debt markets in Europe have significant potential to mis-price underlying default risk. Moreover, this is not simply a function of poor information; it derives from the interaction between financial market integration and monetary union – hence it is likely to recur should politicians succeed in restoring market confidence.

Third, the cost of imposing discipline in European sovereign debt markets greatly exceeds the danger of moral hazard at any given point in time. Although there are clear incentives to ‘teach’ market actors not to underestimate sovereign default risk in the future (and sovereign borrowers not to overestimate their access to the markets), the impact of restructuring sovereign debt in the eurozone would be considerable. Moreover, the difference between benefit and cost increases dramatically as member countries get deeper into trouble – which means that some form of bailout under the current arrangements is almost inevitable no matter how much it may be unpopular with one or another member state electorates. The difficult decisions taken with respect to Greece just this weekend reflect that fact.

So the challenge is to discipline the member states while stabilizing financial markets and avoiding moral hazard: Governments should borrow responsibly, financial actors should pay attention to risk, and both borrowers and lenders should be accountable for their decisions. I am sure that there is no-one on this panel who would refuse to sign up to this agenda. The question is whether a common eurobond provides the best instrument for achieving those shared objectives.

Certainly a bond that allows a country like Greece to borrow as much as or more relative to annual output than a country like Germany without paying higher interest rates until it is too late would not provide an acceptable solution. That is what got us into this mess in the first place – as Giancarlo Corsetti and his colleagues are correct to insist. Therefore it is important that any eurobond proposal come with ‘strict conditionality’: governments who want to raise resources with such an instrument should accept tight restrictions on their borrowing. The eurobond proposal put forward by Jean-Claude Juncker and Giulio Tremonti last December sets the limit at 40 percent of GDP. But that is likely to be too restrictive because too many countries would find significant needs unmet. The Maastricht Treaty provides a higher threshold for responsible borrowing – at 60 percent of GDP. This seems more realistic. For those worried about such a high threshold, it would be possible to charge increasing premia on debt issued ever closer to that limit. This is consistent with the spirit of the original De Grauwe- Moesen plan and with the synthetic proposal that De Grauwe has made in the more recent publication I mentioned.

But the real incentive to avoid excessive indebtedness comes when a government needs to borrow beyond the maximum limit. Such borrowing would not be available through common eurobonds, it would have to be made using strictly national debt instruments, and it would come at a significant market premium because it would provide a clear signal to the markets of a government’s excessive indebtedness; to reinforce that signal, we could also require that borrowing in national debt instruments above the threshold for financing through eurobonds would be ‘junior’ in terms of repayment to the ‘senior’ common debt instruments. This is in line with the Delpla-von Weizsäcker plan.

Additional advantages come from the ‘strict conditionality’ for participation. Governments that choose to issue the eurobonds could face much more intrusive auditing of their accounts, just like firms that list on a public stock exchange. They could have much stricter reporting and financial planning requirements, going beyond even the ‘European semester’. And they could face a real administrative sanction in the form of restricted access to common eurobond financing should they refuse to comply with policy recommendations related to fiscal consolidation. Moreover, the strength of the proposal lies in the fact that governments would have to accept such conditionality voluntarily in order to get access to common financing instruments. Mr Mersch believes we should focus on structural reforms – and he is right. But to do so we need larger carrots in addition to larger sticks. A common eurobond offers both measures.

This brings us to the market pricing of risk. Part of this story has already been addressed through the limits on borrowing, the improved market signaling, and the higher requirements for transparency. At this point we should also introduce a structural dimension. Sovereign debt is used in liquidity operations between private sector financial institutions and the correspondent institutions of the European System of Central Banks. More simply, banks use sovereign debt as collateral when they need to get access to cash. In turn, this means that there is always some demand for sovereign debt instruments. Bank treasurers responsible for negotiating interest rate swap contracts were very aware of that fact and they took advantage of the solid demand for sovereign debt instruments across the eurozone in designing and implementing their convergence trading strategies in the 1990s. The notional value of these swaps greatly exceeded the volume of sovereign debt instruments in circulation. And bank treasurers I have spoken with are convinced that it was the trade in derivatives rather than the trade in sovereign bonds that brought about the convergence of nominal interest rates. By implication, the derivatives markets and sovereign debt markets are tightly inter-connected.

There is considerable direct exposure in the financial system to sovereign debt instruments as well – particularly on the banking books of private sector financial institutions, where assets are supposed to be held to term and so, absent a credit event, are not marked to market. Paradoxically, when these banks come under stress and so require emergency liquidity from the European System of Central Banks, they tend to increase the size of their banking books and so increase their exposure to sovereign debt instruments as well. By the same token, the European Central Bank has little choice but to accept distressed sovereign debt instruments as collateral for bank liquidity operations. The decision of the ECB’s governing council last May to lift any rating requirement for the use of Greek sovereign debt as collateral is one illustration; the decision to lift ratings requirements for Ireland this March is another.

The solution to all these concerns is to make common Eurobonds eligible for banks to hold on their banking books to use as collateral for liquidity but to apply strict limits on the eligibility for any other type of sovereign bond. Here again, the eurobond would provide a clear signal to the markets – meaning not only bond traders but bank treasurers and central bankers as well. In turn, that signal will help them better to price in associated risk.

This brings me to the final point about moral hazard and bailouts. Right now it is hard to imagine how the eurozone can easily afford a sovereign default. This is the point that many commentators have made repeatedly over the past few weeks. Any credit event would force bank treasurers holding distressed sovereign debt instruments to mark those assets to market and so absorb a significant capital loss. The correspondent institutions of the European System of Central Banks would have to absorb capital losses due to their exposure to distressed sovereign debt instruments as well – and the ECB may have to call for new capital from its members as a result. That is why the pressure to avoid a restructuring is so intense and it is an open question whether so-called ‘soft’ forms of restructuring like a maturity extension would be enough to dodge the bullet. Standard & Poor’s made it clear this past weekend that any soft restructuring would constitute default. A common eurobond could resolve this dilemma and so make it easier for countries to engage in an orderly restructuring. The ‘senior’ eurobonds would continue to rollover even if the national bonds used for excessive borrowing were brought into technical default. In turn this would make it more likely that private sector actors could participate in the losses without any adverse systemic implications; they could take the hit without threatening to bring the whole financial system grinding to a halt. Most important of all, private sector investors would be well-aware of their exposure to this possibility before they made the investments in the first place.

As things stand now, there is simply too much systemic risk for politicians to insist on an orderly restructuring of sovereign borrowing in countries like Greece and Ireland. The only recourse is to bail those countries out – and to keep renegotiating the bailout packages until the markets can be convinced that a crisis has been averted. Unfortunately, that is at best a short-term solution and it has significant medium-tolong- term implications. If it fails, the resulting crisis will be harder to manage; if it succeeds, the next crisis will be harder to avoid.

Of course there are significant problems with the eurobond proposal – not least those associated with its implementation. Daniel Gros has written persuasively about the difficulty associated with introducing new instruments that have seniority into a pool of debt that is nearing default.⁸ I think these implementation issues are worthy of discussion and have a few ideas about where that discussion should start. Nevertheless, Mr Mersch is right to insist that we consider ‘first things first’ and so it is worth reasserting the basic objectives.

If we agree that countries should be more disciplined and transparent in their fiscal policies; that markets should be more efficient and effective in pricing in risk; and that moral hazard should be avoided so that stability can be maintained without unpopular bailouts; then we must first decide what is the best route to achieve those objectives. Even reformed and reinforced, the current architecture for European macroeconomic governance offers no guarantee of discipline. Given the market opportunities associated with financial integration and monetary union, a crisis resolution mechanism will not improve market pricing of sovereign default risk. And nothing proposed so far promises to deal with the moral hazard emerging alongside the fragility of Europe’s integration financial system.

No matter how difficult it may be to implement, a common eurobond offers the prospect of resolving these dilemmas. Hence the first step is to choose whether to embrace that solution or to engineer an equally promising alternative. Thank you for your attention.

Notes

1. http://www.ceps.eu/book/gains-all-proposal-common-eurobond
2. http://www.econ.kuleuven.be/ew/academic/intecon/Degrauwe/PDG-papers/Disc...
3. http://www.ilsole24ore.com/art/commenti-e-idee/2010-12-22/eurobond-inter...
4. http://www.ecb.int/press/key/date/2011/html/sp110311.en.html
5. http://ideas.repec.org/p/mkg/wpaper/1002.html
6. http://imarketnews.com/node/23761
7. http://www.voxeu.com/index.php?q=node/6199
8. http://www.voxeu.org/index.php?q=node/5891