Europe needs a Eurobond
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.
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.