Sunday, February 6, 2011

A single European sovereign bond? Pie in the sky, unless…

Delors’ Union Bonds

Nearly 20 years ago, in 1993, Jacques Delors proposed the issue of “Union bonds", whose repayment would be guaranteed by the Community budget, in addition to EIB (European Investment Bank) loans to finance infrastructure investments in transport, energy and telecommunications (EC White Paper on Growth, competitiveness, and employment. The challenges and ways forward into the 21st century, (COM (93) 700 final). This was a pale reflection of a much more ambitious and radical plan suggested to Delors by one of his economic advisers, Stuart Holland, who envisaged the issue of Union bonds by a European Investment Fund as a vehicle for the transfer of a substantial share of Member States’ national debt to the Union. After such “tranche transfer” member states would continue to service their share of their debt, but at a lower interest rate (Stuart Holland, The European Imperative: Economic and Social Cohesion in the 1990s. Foreword by Jacques Delors, Nottingham: Spokesman Press, 1993). Stuart expected the bonds not to count as debt of the member states, by analogy with US Treasury bonds, but because member states would continue to service them that analogy does not hold. Neither did he contemplate any need for a Union guarantee: the EU having virtually no debt, Union bonds would be credible regardless. Union bonds remained a dead letter.

Eurobond redux

The recent euro crisis, correctly seen as a crisis of sovereign debt, resurrected the idea of a single Eurobond whose issue would gradually replace at least part of the member states’ sovereign debt. In 2009-2010 several proposals in this sense were voiced again, among others by Paul de Grauwe and Wim Moesen (Gains for All: A Proposal for a Common Euro Bond, in: Intereconomics, Vol. 44, No. 3, 2009, pp.132-135), Daniel Gros and Stefano Micossi (A bond-issuing EU stability fund could rescue Europe, 2009, Europe’s World, spring); Jacques Delpla and Jakob von Weizsäcker, The Blue Bond Proposal, Bruegel Policy Brief 2010/3, May); Erik Jones, (A Eurobond proposal to promote stability and liquidity while preventing moral hazard, ISPI Policy Brief, n.180, March 2010); and, of course, Stuard Holland again (Europe needs a Gestalt shift, 2010 and elsewhere).

One such scheme was authoritatively backed by Luxembourg Premier and Treasury Minister Jean-Claude Junker and the Italian Finance Minister Giulio Tremonti in the Financial Times of 5 December 2010 (E-bonds would end the crisis). Giuliano Amato also forcefully endorsed it (in IlSole-24Ore of 11 December 2010). But German Chancellor Merkel and French President Sarkozy rejected the idea, together with the alternative proposal of raising the size of the EFSF (European Financial Stabilisation Facility) set up in May 2010 to deal with Euro-zone sovereign default .

Lower interest rate

The scheme for a single Eurobond comes in different sizes and forms, but all proposals have an underlying consideration in common: a European bond would attract a lower interest rate than the average (weighted) interest rate at which nation states could borrow in international markets, because of the lower liquidity premium and the lower credit risk premium. The funds raised through issues of a single Eurobond could be channeled to Eurozone member states in various ways: by buying their new national bond issues, or by buying back old national bonds, or by lending to member states against the security of domestic bonds. If a tranche of member states’ debt could be “transferred” to the EU in this way, say something of the order of 60% of European GDP, in line with EU own-policy stated in the Maastricht Treaty and the Growth and Stability Pact, a Eurobond should not worry global financial markets. A stock of all-European bonds would give the Euro a wider appeal and promote its diffusion as a reserve currency. Eurozone debt as a percentage of GDP was 84% in 2010 (79% in 2009), 60% of it would be €5.5 trillion, large enough to compete with the US Treasury bonds and reap any conceivable benefits in terms of liquidity.

Responsibility for servicing these bonds could be envisaged as: several; several and collective; European.

Several responsibility

Every participating member state would be responsible for servicing these bonds in a pre-fixed proportion, say proportionally to the shares it holds in the European Central Bank (the kind of approach followed by De Grauwe and Moesen, 2009).

But an investor potentially interested in this type of bond could invest in it today, simply by purchasing a portfolio of bonds issued by all member states in the same proportions. Such composite instruments are not unusual: the Markit iTraxx SovX Western Europe Indez, for instance, is a basket of mostly Eurozone Credit Default Swaps. The yield on such composite bond would have to be exactly the same as that of a corresponding balanced portfolio. There would be no interest saving in issuing such a bond, for it would be a useless exercise. If the bond attracted a liquidity premium so should the composite portfolio, and financial intermediaries would profit from its introduction on an increasingly larger scale and, therefore, they would be bound to introduce it, without any official initiative or inducement.

Collective and several responsibility

Under this kind of scheme the bond could be covered by a "collective and several" guarantee, i.e. in case of default bond-holders could claim reimbursement from any participating member state of their choice (cf for instance, Jones 2010). A spokesman for President Sarkozy was reported as saying. "This proposal is not entirely new. It raises difficulties notably in terms of sharing costs and profits... " (, 10 December 2010). Obviously the interest cost of borrowing through a single Eurobond, though lower than the average cost of borrowing individually by member states, would be higher than that applicable to “virtuous” states. However the lower interest rate due to the lower risk and enhanced liquidity could benefit all: all countries could be charged a rate lower than but proportional to their own market rate, all being better off, even leaving something left over for accumulating a reserve.

In the case of several and collective responsibility for the bonds, however, there would remain two distributive problems. A minor problem is how to cope with member states with a debt/GDP ratio lower than the tranche of national debt whose transfer to the EU is envisaged. Slovakia at 42% debt/GDP ratio in 2010, Slovenia at 34%, Luxembourg at 20%, or Estonia with with a paultry 8%, would have to be granted a scaled down maximum liability in case of default. A second, major, problem is that more “virtuous” countries like Germany would be more exposed than weaker members to the risk of having to bail-out defaulters; who could indulge moreover in “moral hazard” behaviour and deliberately take advantage of the cover from such collective responsibility (though moral hazard would be limited to the share of their debt covered by Eurobonds, since the rest of their debt would attract a higher marginal interest rate). Thus it is perfectly understandable that Germans and other “virtuous” member states would be irreducibly opposed to such a scheme (unless accompanied by the realization of objectives close to the hearts of the virtuous, e.g. fiscal conformity across EU member states). True, even as things are now these countries are exposed to the risk of having to bailout defaulters, so much so that interest rates on German 10-year bonds have also increased from under 2% to almost 3%. But as things are now their liability is not automatic, it can be accepted or refused according to German perceived interests (such as German banks exposure to default), and subjected to conditionality imposed on defaulters. Therefore such a solution of collective and several responsibility for the single Eurobond is almost certainly politically impossible.

A European guarantee

Under this type of scheme the bond would be covered by a European guarantee extended by a hypothetical European Debt Agency that would have the task of “managing” a debt that has now become European. But “managing” debt involves manipulating the term structure of debt (funding and un-funding) and cover of exchange rate risk of bonds issued in foreign currency and the like, not the burden of debt service and repayment. It is crucial to consider that the European Union budget represents just over 1% of European GDP and, what is devastatingly worse, has a ZERO primary surplus, because the EU lacks the power of taxation and its scant revenues (primarily a share of VAT and the shrinking revenue from external common tariffs) can be supplemented by national contributions proportional to GDP only to balance the books and no more. Thus neither the EU Budget nor special Agencies obtaining resources from it can “manage” European debt, including its service, on the scale envisaged by the proposals (of the order of magnitude of over €5 trillion). Therefore such Eurobonds would get a rating lower than, say, that of Italy, who with tax revenues of 43% of GDP has at least the theoretical possibility of running a primary surplus and serving its debt.

Under a European guarantee the bonds in question would be among the junkiest of junk bonds, with a credit rating and an interest spread not lower but higher than the Eurozone average.

Junk bonds, unless…

Unless the Agency in charge of debt service were to be endowed from the start with an amount of resources adequate to credibly guarantee its Eurobond issues. But:

The EFSF could not act in that capacity because it can count only on participant states' national guarantees, not ready cash. Thus bond issues have to be over-collateralised in order to secure AAA rating since they are guaranteed by less-than-AAA rated countries, reducing the EFSF operational capacity from the trumpeted €440bn to about 230-240bn. And such funds would partly dissolve with any downgrading of guarantor member states, and would vanish proportionally to their share in the case of their default. So much is this so that a proposal has been discussed in Brussels "in finance ministry circles" whereby non-triple A nations such as Italy, Spain and Belgium should contribute cash payments to the EFSF rather than guarantees (, 21 January 2011). And recently Eurostat ruled that “Member states will have to account for EFSF’s debt issues as gross debt, proportionate to their share in the EFSF” ( 28 January 2011).

Nor could the ECB act in the capacity of guarantor, for several reasons. First, even modest ECB purchases of the sovereign debt of the weaker states during the recent crisis (on a scale of just over $82bn since last February) raised concerns about the quantitative growth and above all the quality of ECB assets, which required a more than doubling of ECB capital from €5bn to €10.8bn at the end of 2010. Secondly, the ECB has announced last week that even those purchases have come to an end. Thirdly, such operations are bound to infringe ECB independence and the pursuit of its inflation target of close to 2% but no more than 2%. Alberto Quadrio Curzio (Corriere della Sera, 12 December 2010) has suggested the issue of €1000bn bonds guaranteed by the surplus gold holdings of Eurozone Central Banks; Germany’s 3,406 tonnes, plus Italy’s 2,451 tonnes and France’s 2,435 tonnes, together hold reserves higher than those of the Fed at 8,133 tonnes. This may not be the best option, for it would impinge on Central Banks independence and meet general legal obstacles (as well as special obstacles in a country like Italy where the Central Bank has the curious feature of still having dominant private shareholders); but at least Alberto has faced the issue squarely and suggested a possible solution.

Certainly the EIB could issue Eurobonds on a large scale – although if and only if its capital were raised to an extent commensurate with the scale of its envisaged operations, in the form of monies actually disbursed up-front or guaranteed by AAA-rating states and not, as Stuart Holland so implausibly argues, because it can finance national investments with loans that are alleged not to count as national debt (they still need to be serviced by borrowing member states, why should they not count as part of their debt and where in the treaties does it say that they do not?). The same could be said of a correspondingly capitalized European Debt Agency or similar ad hoc institution. But any such capital increase would have to be raised by the weaker (low rating, high spread) individual states first.

Would global financial markets really be sufficiently benevolent, enlightened and optimistic as to see such an increase in national debt as a move towards the reduction of European sovereign risk? Suppose the indebted individual members of a family incurred new debt to provide a family-guarantee on some of their debt; would creditors really regard this as offering them additional protection, or as an increased risk of default deriving from moral hazard encouraging higher profligacy by those family members?

Without a considerable and effective tightening up of fiscal constraints, as demanded by Germany, it is unlikely that Euro-zone creative accounting via the creation of a Special Debt Agency – a kind of Special Investment Vehicle à la Enron – would restore global investors’ confidence in Euro sovereign debt. The single European bond seems to require fiscal Union as its pre-condition, rather than being a substitute for fiscal Union. Not in our lifetime (i.e., over our dead bodies) comes the Eurosceptic, nation-staters’ cry.

Think Small: the solution

Fiscal Union is not a yes or no option: it comes piecemeal too, responding to the minimum stake that different member states can afford or stomach. All that is required is that at least some of the national tax revenue of member states – corresponding to a uniform, at least initially small percentage of national GDP – is specifically earmarked to servicing the single Eurobonds issued by a European institution. This is how it could begin; its effects would be cumulative over time. Of course it would not generate additional resources to service sovereign debt but, starting from the other end of the salami, so to speak, it would be an effective way of enforcing the fiscal constraints that are a precondition of both a European response to European sovereign debt and an ever-deeper Union. If not now, when?

And if not, is there European life after member-state sovereign default?


Bob said...

Is it legal for a member state to be bailed out by other member states or by the European Union?

D. Mario Nuti said...

Thanks for the reminder, Bob. I did not raise this issue because the answer is controversial and I have already mentioned the dangerous ambiguity of the “Moscow rules” enshrined in EU Treaties in three previous posts, on "European Bail-Outs", on "A non-bail-out bail-out" and on "Sovereign Default". A bail-out is specifically forbidden, except in "exceptional circumstances", which may or may not include a financial crisis.

D. Mario Nuti said...

My excellent friend Marcello de Cecco tells me that the long-term sequestration of some government revenue to pay creditors in full for defaulted bonds has well-known precedents, such ad the Greek default of 1897.

Greece defaulted twice in the 1890s, first in 1893, due to the harvest failure of a sweet grape (uva passolina), the most important Greek export at the time; then in 1897, when Greece attacked Turkey and were resoundingly defeated.

Those defaults – like the current Greek crisis – were due to a regime undertaking that they could not afford; the Corinth Canal and the purchase of two French ships then, funded by foreign credit, and these days the Olympics, funded by French and German banks and built also by French and German companies, as well as the purchase of German submarines canceled as inadequate by Papandreu when he became Premier.

In 1893 the Greek Premier announced Parliament that the country was broke. An official of the International Financial Committee that represented creditors set up office at the Pireus and started collecting import and export taxes, directly and in gold. The head of the controlling committee was a distinguished Italian statistician, Vittorio Ellena. This practice ended when the entire defaulted debt was repaid – in 1978 (sic).

Benjamin said...

"long-term sequestration of some government revenue to pay creditors in full" can be done very easily these days, through securitisation of those items of government revenue that you want to "earmark" to that purpose, withouot having foreign officials counting and collecting the cash or the gold as it comes in. Is that all you are suggesting?

D. Mario Nuti said...

Not exactly, Benjamin. The idea is first to transfer to the appropriate EU agency the items of government revenue to be earmarked to European sovereign debt service, and only then securitise or otherwise sequester the revenue items in question in order to service that debt reliably and safely.

Thomas Palley said...

Dear Mario,

Many thanks for your article. Attached is a proposal that I recently circulated and which is being issued as a working paper by the Institute for Macroeconomics (IMK, Hans Boeckler Stiftung, Dusseldorf).

We are clearly thinking along very similar lines. Your own proposal has similarities with the “Blue Bond” proposal issued by the Bruegel Institute, but you also recognize the euro suffers from systemic problems whereas the Bruegel Institute is stuck in a crisis resolution mode.

I share your view about systemic problems, but I also introduce the ECB into the analysis and argue that the ECB must be allowed to conduct open market operations in European bonds. In other words, at the moment both the monetary and public finance architectures of the euro are flawed.

The solution is a "true" European bond that is used to refinance a significant portion of existing national debt; which is used to help governments finance their future budget deficits; and which the ECB can use to manage a Euro zone risk free interest rate via open market operations that supplement its overnight Lombard interest rate.


Tom Palley

D. Mario Nuti said...

Thanks, Tom. For some reason your attachment did not appear with your comment, I will insert the link as soon as your paper is published. But I did have sight of your draft, which I found theoretically very attractive – especially your formal model that illustrates very well the possibility of multiple equilibria stable and unstable, the irreversibility of change (hysteresis) and the possible ways in which funds raised could be used for the reduction of national debt.

But your European Public Finance Authority has the usual drawback or not being adequately funded, for it takes on the same functions of the US Treasury without any of its powers of tax imposition. The unlimited responsibility of European member states for European bonds is not a perfect substitute for fiscal Union, which would involve EU liability via the EU budget with European taxation power – i.e. national liability limited by taxation.

You distinguish between a Central Bank being “detached” (not allowed to buy government bonds) and “independent” (though possibly allowed to buy government bonds). But I cannot imagine any Central Bank independently pursuing an inflation target having any need to transact government bonds, i.e. an independent central bank need be detached. A detached central bank could use government bonds transactions in the pursuit of policy objectives other than inflation targeting, but could not at the same time claim to be independent.

Personally I would be perfectly happy with your EPFA, as I never believed in the economic policy schizophrenia involved in delegating inflation targeting to an independent Central Bank, and fiscal targets to an equally independent government. Its foundations are rooted in the theory of rational expectations, the vertical or near-vertical Phillips curve i.e. no significant trade-off between inflation and unemployment that allows splitting management of the two evils between separate independent agencies.

Apart from anything else, lack of co-ordination between fiscal and monetary policy is a recipe for higher interest and exchange rates, and higher fiscal deficits (and therefore higher unemployment and inflation), than could be obtained with fiscal-monetary co-ordination.

But you do not seem to criticize the principle of CB Independence, and in any case laws and statutes and regulations impose it, in particular for the ECB which is exceptionally independent, even more than the Bundesbank on which it was modelled. The ECB could not compete – in its range of instruments and objectives - with the Federal Reserve, or the Central Bank of Japan or even the Bank of England.