The idea of Eurobonds, or Union Bonds, is slowly making progress. It could be a way out of the debt crisis. Some hope that such bonds could soften the hard budget constraint on public finances. However, in the present crisis, an even more important aspect is that Union Bonds could create an integrated bond market, which is necessary to stimulate productive investment and economic growth.
The euro crisis has painfully demonstrated that, despite the single currency, the European Union does not have fully integrated financial markets. Today, Greek and Irish bonds pay 3 to 4 times higher interest rates than German ones. These yield spreads have now attained levels, which are truly exceptional and unsustainable. They increase the internal imbalances in Europe because they generate comparative advantages for Germany, while the high costs of borrowing restrains economic growth and makes fiscal adjustment more difficult in the South.
The German Bund is perceived as a safe liquid asset, but from a global point of view German government bonds represent a small asset market that has no European significance other than that it serves as a benchmark. Only the German government can borrow on these terms. Thus, governments, banks and non-financial corporations in peripheral states are confronted with deteriorating abilities to finance their operations, while they benefit from cheap capital in Germany. This situation bears some similarity with monetary policy in the 1980s and 1990s, when the dominant role of the Deutschmark was perceived as a heavy burden by many other Europeans.
The same is true for the political domination of Germany. In the past the dominator was the Bundesbank; now it is the Chancellor. The benchmark function of the German Bund seems to justify German policy makers in imposing their policies on the rest of Europe. Some argue that if other member states only followed Germany’s restrictive fiscal policies, they would enjoy similar borrowing conditions. However, this is not true. In fractured credit markets, peripheral borrowers will never be able to access capital at the same conditions as German borrowers. Even in Austria, the Netherlands or Finland, governments have to pay a premium over German bonds which reflect the small and illiquid nature of markets. Clearly, there is a price to pay for non-Europe in the bond market.
As a consequence of these competitive distortions, a political backlash against this system, including against European integration, is becoming increasingly more likely. An example of this is the rise of right-wing populist parties. Marine Le Pen is now leading opinion polls in France.
In this context, the idea of issuing Eurobonds gains a new political dimension. Today, Eurobonds are the financial equivalent of a single currency and a unified monetary policy. The solution is to create economic conditions, which generate an optimistic climate for job creation and growth and to improve justice and fairness in the European Union.
Eurobonds could contribute to the denouement of Europe’s sovereign debt crisis in a number of ways. Many proposals seek to increase liquidity in Europe’s markets, and at the same time they wish to lower the cost of borrowing for highly indebted member state governments. The problem is that they rarely explain, who is liable for the Euro-debt, because the EU or the Euro Area does not have its own tax base from which the debt could be serviced. If member states are liable for Eurobonds, there is the risk that some will have to pay for others without being able to decide the underlying policies.
For this reason, I have proposed Union Bonds, which would pool national sovereign debt into a portfolio that reflects the whole Euro Area without additional burden. It would generate significant improvements over the present situation:
- First, Union Bonds would generate a large and deep European bond market. An independent Trust or the future ESM would buy nationally issued debt and bundle it into a new security called Union Bond. Gradually Union Bonds would absorb all national debt securities and become the representative benchmark for the Euro Area. This substitution does not require Union Bonds to have the status of sovereign debt.
- Second, Union Bonds would reduce the risks of a banking crisis following a sovereign default, because they reduce the concentrated exposure on some risky assets. Banks could sell Southern European debt to the Trust and in exchange buy Union Bonds. Thus the liquidity in European bond markets is improved overall.
- Third, all member states still need to issue debt in primary markets on their own merits. Governments which can borrow at low-interest do not lose this advantage; nor do they have to bail out or pay for the high-interest debt of their partners. Because vigilant markets will asses default risks and ensure market transparency, Union Bonds will minimize moral hazard problems,.
- Forth, because the Trust can also intervene in primary markets, Union Bonds can reduce the cost of borrowing for highly indebted governments.
- Fifth, the Trust can thereby replace the market stabilization function of the ECB’s direct bond purchases in the secondary market. Moreover, the ECB could swap its portfolio of risky sovereign debt against less risky Union Bonds.
- Sixth, by Europeanizing public debt, Union Bonds would also stabilize private bond markets. Because banks would not have to fear liquidity bottlenecks, they would continue to fund profitable investment opportunities and thereby support economic growth and the sustainability of debt.
Problems with the liquidity and sustainability of public debt are not unique to Europe. They are inherently linked to the process of monetary integration. An early historical example is the United States. In 1790, Alexander Hamilton, the first Secretary of the Treasury of the United States, managed to make a famous deal whereby the federal government would assume state debts incurred during the Revolution. Hamilton encountered a lot of resistance, but he established a clear and discernable reimbursement policy that inspired investors’ trust and laid the foundations for the United States’ economic future. Europe has its Hamiltonian moment now.