Duncan’s Economic Blog

Europe needs a Eurobond

Posted in Uncategorized by duncanseconomicblog on July 20, 2011

The outlook ahead of Thursday’s crucial Eurozone summit is bleak. The policy makers seem set to only talk about Greece and ignore the Spanish and Italian elephants in the room.

I first set out my three step Eurozone crisis resolution plan in November last year.

Broadly put – I suggested:

(i)                  Conduct genuine stress tests of all Eurozone banks (including their ability to withstand a partial default by periphery countries)

(ii)                Recapitalise those banks that fail

(iii)               Allow a partial default inGreece,Portugal,Ireland– both writing down the principle and modifying the interest rate on outstanding debt.

Throughout this process huge liquidity support would be needed from the ECB to keep periphery banks functioning.

Whilst I welcome today’s call from several leading European economists to use the EFSF to recapitalise banks, I think we may now beyond this point.

I recently set out why all the conventional resolutions (inflate, deflate, devalue or default) to the Eurozone problems where either unavailable or unattractive.

The Eurozone now has a simple choice – break up (and it will be messy) or move to a common European bond – i.e. work to ultimately pool all the different Eurozone sovereign debts into one asset class.

If taken as a bloc then Eurozone government debt to GDP is around 80% – high but very manageable.  

I see no reason why the spread over US treasuries would be especially high, to me it seems perfectly reasonable to envisage a common 10yr Eurobond trading around  3.5-4.0% – higher than current French & German yields but vastly preferable to the 6.0%+ the Spain & Italy are now facing and well below the 16%+ that the market is offering Greece.

Two and a half years ago I suggested that a Eurobond was one possible solution to the problem. It now seems the only workable solution – as George Irwin argues at CiF.

Some say that defaults will not be the end of the Eurozone. The analogy is sometimes made with the USA which has a common currency but state governments which are perfectly able to default without endangering that currency.

I think these analogies falls down when one looks in detail at the European banking system. Despite the existence of major international players, the banking markets are still mainly ‘national’.

If, say, Delaware defaults that doesn’t risk collapsing most of the banks in Delaware in the way a Greek default does in Greece.

And, as we learned in 2008, the banking system is incredibly inter-connected – if Greek banks fail, this hits French and German banks – which in turn hits UK banks.

Be under no illusions – a common bond means a huge step towards further political unification for the Eurozone. EU oversight over government spending and deficits would have to become much stricter.

The German public fear a ‘fiscal transfer union’ – perhaps forgetting that for much of the decade 1995-2005 the transfers would have flowed from the then booming South to a struggling Germany. That said, it should be noted that former Social Democrat Finance Minister Peer Steinbruck favours Eurobonds. But higher interest rates on a common Eurobond and some fiscal transfers might well be a good deal cheaper than a messy break-up with bank failures and rapidly depreciating Southern currencies threatening German export markets.

This is all a fiendishly difficult political sell for German (and Austrian, Dutch and Finnish) politicians. For this reason it will probably not happen, but it seems the best way out.


5 Responses

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  1. Frances Coppola said, on July 20, 2011 at 1:16 pm

    The problem with Euro bonds is of course that the implied fiscal transfers are explicitly ruled out in the EU Stability & Growth Pact and are unconstitutional in Germany. Not that Germany and France have not hesitated to break other Pact rules when it suited them – notably when both countries ran deficits far higher than the Pact’s 3% limit. But committing themselves to underwriting the debts of all other EU countries for evermore is a different matter, isn’t it? It can be argued (strongly) that Germany has built its prosperity on the debts of other EU countries and now should pay up, but German taxpayers don’t see it that way. Euro bonds have no prospect of happening, however sensible they may be as a solution, while German taxpayers still blame the people of Greece and other peripheral countries for the mess they are in. Euro bonds require the EU to pull together as a political entity. It shows no sign of doing so.

    • duncanseconomicblog said, on July 20, 2011 at 1:21 pm

      Agreed they are unlikely in the short run – although if (when) the crisis gets worse I wouldn’t rule it out.

  2. gastro george said, on July 20, 2011 at 8:35 pm

    “It can be argued (strongly) that Germany has built its prosperity on the debts of other EU countries and now should pay up, but German taxpayers don’t see it that way.”

    That is the political point that needs to be sold to the German people. If the Greek economy goes under, then they will stop buying German cars and washing machines, and where would that get the German economy?

  3. Barry Thompson said, on July 20, 2011 at 9:01 pm

    Eurobonds are in Germany’s (and all of Europe’s) long term interest.

    Without them, government debt crises across the periphery will continue, which will stagnate growth in the periphery and limit German export growth, and very likely lead to a Euro break up, which is bad news for Germany.

    With Eurobonds, there is no longer a European government debt crisis and austerity policies can be lifted to allow growth to return to the whole Eurozone economy, which is what Germany needs to thrive.

  4. Tanweer Ali said, on July 21, 2011 at 6:36 am

    The FT on 7 July carried a piece by Kemal Dervis, arguing for EU funding for a growth strategy for Greece. Since it is clear that without growth, all attempts to bring Greece’s debt under control will fail, and in this sense austerity drives are counterproductive, wouldn’t a Greek growth fund be something that could be funded by an issue of the sort of Eurobonds that you have advocated? Such a fund would concentrate on creating jobs and boosting growth, and could be managed in a way that ensures the involvement of outside players, e.g. the European Commission, in its implementation. This would help to maximise effectiveness and to deflect accusations of throwing good money after bad. Not all Eurozone member states need be involved in guaranteeing such a debt issue, perhaps at this early stage just a handful of countries could take part. This would be a start and if successful would build confidence in the idea of a Eurobond. If we know anything about EU integration, surely we must recognize that a piecemeal approach is most likely to work.

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