Eurobonds: The design is crucial

Roel Beetsma, Konstantinos Mavromatis, 21 December 2012

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The debt crisis in Eurozone southern states has given rise to a number of measures to strengthen fiscal governance in Europe. It has also sped up plans for further integration of policymaking in the Eurozone. The European Council (2012) envisages the transition to a genuine economic and monetary union being based on four building blocks: an integrated financial framework (a ‘banking union’); an integrated budgetary framework; an integrated economic policy framework and measures to ensure the democratic legitimacy; and accountability of decision-making in the EMU. An integrated budgetary framework might also envisage common debt issuance.

A number of political leaders are now coming out in favour of some form of common debt issuance, while both the European Commission (2011) and experts have made concrete proposals in this direction, claiming that Eurobonds can be part of the solution to the crisis provided they are designed properly (see, for example, Favero and Missale 2012). The introduction of Eurobonds can be either beneficial or harmful, depending on the specifics of how they are designed.

Some proposals

It would be difficult in a short column to do justice to all that has been written so far about Eurobonds. We therefore only discuss a few of the proposals that have been circulated. Delpla and Von Weizsäcker (2010) have made the “blue and red bond” proposal, under which the EU countries pool their sovereign debt to, at most, 60% of GDP under joint and several liability as senior “blue” debt, while any debt above 60% would be issued as junior “red” debt. Hellwig and Philippon (2011) foresee a maximum of 10% of GDP of mutually guaranteed short-term debt, while De Grauwe and Moesen (2009) propose a collectively guaranteed Eurobond, on which the interest rate will be differentiated across participating countries on the basis of their market interest rates.

Why Eurobonds?

Issuance of debt under joint and several liability would reduce governments’ vulnerability to the whims of the financial markets. That is, it would prevent speculative attacks on countries that are not justified by fundamentals and that could potentially force governments into following policies that are undesirable from a macroeconomic stabilisation perspective, such as procyclical tightening when consumer and producer confidence is already at a low. Eurobonds can be issued by a highly indebted member state (or a group of member states) in an attempt to strengthen its financing and borrow at a lower cost, paying a “pooling” interest rate.

In other words, Eurobonds can work as government bonds and collective Eurozone liability at the same time (Frankel 2012). Moreover, the issuance of a single type of Eurobonds on behalf of all Eurozone members would ensure high levels of liquidity, creating a market for individual debt instruments that is comparable in size to the market for US federal government debt. Not surprisingly, the leaders of major Eurozone countries like Italy and Spain have spoken out in favour of Eurobonds.

Against Eurobonds?

Eurobonds have their opponents. In particular, countries with relatively solid public finances and that are paying low interest rates fear that the “pooling” interest rate would drive up their own debt-servicing cost. In addition, some economists such as Issing (2009) point to the danger of moral hazard for countries that already have a weak record in terms of budgetary discipline. Those countries, when they know that at least part of their debt is guaranteed by other countries, will be tempted to increase their spending and start issuing more debt. After all, the interest rate on the guaranteed component of the debt is insensitive, or largely insensitive, to an individual debt increase.

These worries are not unfounded, as experiences over the past decade have shown. Rather than using the windfall in terms of lower interest rates to strengthen their public finances, both the public and private sectors of southern European countries have gone on a spending spree. This moral hazard problem has been recognised by the European Commission (2011). However, it believes that there are ways to work around this problem.

It’s all about the design

In Beetsma and Mavromatis (2012), we provide a formal analysis showing that the design of the system of common debt issuance is crucial to its desirability. We present a two-period model featuring a political distortion that induces a government to issue too much public debt in the first period – from a social welfare perspective. In the second period, the government goes into (partial) default when resources threaten to fall below some threshold level. Obviously, issuing more debt implies higher debt-servicing costs and raises the likelihood that this threshold will be crossed. While the possibility of default in itself induces the government to issue more debt, this effect is kept in check by the response of the interest rate required for investors to be willing to hold the debt. Hence, debt is excessive, though to a limited extent.

We consider different forms of debt mutualisation within a union of countries. One is a guarantee by the other countries for the repayment of public debt up to a certain maximum amount. Hence, the government issues a single type of debt and all the debt it issues carries the same interest rate. The guarantee can be made "unlimited" such that the other countries provide financial support up to the guarantee level if necessary, even if debt exceeds the guarantee level. However, the guarantee can also be made “limited”, in the sense that any financial support from other countries is lost when debt is issued beyond the guarantee level.

We also consider a “blue and red bond” proposal under which the government may issue two types of debt alongside each other. Blue bonds are senior and collectively guaranteed, while red bonds are junior and not collectively guaranteed. Red debt can only be repaid if financial support from the other countries does not need to be invoked. Its repayment depends on the fortunes of the public finances of the issuing country. Since both types of debt carry different risks, they also feature different interest rates.

A debt guarantee eliminates the response of the interest rate to an increase in debt as long as the maximum guarantee level is not exceeded. In itself, this provides the government with an incentive to issue even more debt than in the absence of the guarantee. The same result is found for the case of the blue/red bonds proposal. However, depending on the maximum level for the guarantee or the maximum threshold for blue debt, the equilibrium debt level may or may not exceed debt in the absence of any form of debt mutualisation. In fact, in the presence of a limited guarantee, setting the maximum guarantee sufficiently low, but not too low, induces the government to issue less debt than in the absence of the guarantee, thereby raising social welfare. The reason is that the loss of potential financial support when the maximum guarantee is exceeded induces the government not to issue more debt than is guaranteed. Neither an unlimited guarantee, nor the blue/red debt arrangement can generate this beneficial outcome within our framework.

To further substantiate the potential role of moral hazard, we also extend the basic model to allow the government to select an optimal amount of structural reform in the first period. This enhances the efficiency of the economy and generates additional resources in the second period. Conditioning eligibility for financial support under the limited guarantee scheme on sufficient reform may induce governments to reform further. However, there is a trade-off between encouraging more reform in this way and inducing the government to issue less debt by setting a lower maximum guarantee level. Concretely, setting a higher reform threshold requires an increase in the guarantee level in order to persuade the government to participate in the scheme.

Conclusions

A priori, one cannot say whether Eurobonds are desirable or not. This very much depends on the way the system is designed. A clever design of a Eurobonds system may provide governments with incentives to both issue less debt and pursue more structural reform.

References

Beetsma, R and K Mavromatis (2012), “An Analysis of Eurobonds”, CEPR Discussion Paper, 9244.

Bofinger, P, L P Feld, W Franz, C M Schmidt, B Weder di Mauro (2011), “A European Redemption Pact”, VoxEU.org, 9 November.

Claessens, S, Mody, A and S Vallée (2012), “Paths to Eurobonds”, IMF Working Paper, 12/172.

De Grauwe, P and W Moesen (2009), “Gains for All: A Proposal for a Common Euro Bond”, Mimeo, University of Leuven.

Delpla, J and J von Weiszäcker (2010), “The Blue Bond Proposal”, Bruegel Policy Brief, Issue 2010/3.

European Commission (2011), “Green Paper on the Feasibility of Introducing Stability Bonds”.

European Council (2012), “Towards a Genuine Economic and Monetary Union”, Report by the President of the European Council.

Favero, C and A Missale (2012), “Sovereign spreads in the Eurozone: which prospects for a Eurobond?”, Economic Policy 27(70), 231-273.

Frankel, J (2012), “Could Eurobonds be the answer to the Eurozone Crisis?”, VoxEU.org, 27 June.

Hellwig, C and T Philippon (2011), “Eurobills, Not Eurobonds”, Mimeo.

Issing, O (2009), “Why a Common Eurobond Isn't such a Good Idea”, White Paper 3, Center for Financial Studies, University of Frankfurt.
 

Topics: EU institutions
Tags: debt, debt restructuring, eurobonds, Eurozone crisis

Professor of Pension Economics and Vice-Dean of the Faculty of Economics and Business, University of Amsterdam

Assistant Professor at the Faculty of Economics and Business, University of Amsterdam