The special EU summit held in Brussels on Wednesday revamped the discussion on Eurobonds (i.e. the issuance of common government bonds to pool the Eurozone debt liability) as a possible option to address the euro crisis and save the currency.
Two conflicting views emerged. France made it clear that it would like to see Eurobonds established, even though it was acknowledged that this cannot happen overnight. Germany opposed this position on grounds of both economic opportunity and legal feasibility.
Spain, Italy, the European Commission, and a growing number of other European countries seemed to discreetly support France, thus leaving Germany rather isolated. The IMF and the OECD also released comments that sounded very much like an endorsement of Eurobonds.
Yet, in the absence of a consensus, any decision was postponed to a future formal summit that should take place towards the end of June, after the Greek and French parliamentary elections.
In the meantime, the economic situation in the European Union continues to deteriorate. Doubts concerning the permanence of Greece in the Eurozone (fostered by rumours that EU Member States are preparing contingency plans for the exit of Greece) and the risk of a bank-run which might extend to Spain feed uncertainty and negatively affect stock markets in the continent.
What role would the Eurobonds play in this situation?
The options on the table
As outlined in a European Commission Green Paper released last November, there are three options for issuing common government bonds in the Eurozone.
Under Option 1, all national government bonds issued in the Eurozone are converted to common Eurobonds that carry joint and several guarantees. Option 2 involves the partial replacement of national bonds with Eurobonds carrying joint and several guarantees. With Option 3, instead, there would be partial replacement of national bonds with Eurobonds that carry several but not joint guarantees.
The absence of joint guarantees in Option 3 means that each member state would be responsible for its own share of Eurobonds. This in turn has important implications, as it weakens the benefits, but also lowers the risks associated with issuing Eurobonds.
The first clear benefit of Eurobonds is that the creditworthiness of low-yield member states would reduce the cost of borrowing for lower rated member states. Joint guarantees would strengthen this effect, leading to a stronger shift of benefits from higher to lower rated countries. Without joint guarantees, instead, this effect would be quite small.
The downside of the reduced cost of borrowing is the increased potential for moral hazard. Since the debt would be jointly guaranteed, at least under Options 1 and 2, member states could free-ride on the fiscal discipline of their partners. That is, the incentive for fiscal discipline at national level would be strongly reduced.
For this reason, Options 1 and 2 should be undertaken in association with reforms to strengthen fiscal integration and ensure greater coordination and centralised monitoring of national macroeconomic policy frameworks.
Another relevant benefits that could emerge under Option 1 and, to a smaller extent, Option 2 is that Eurobonds would improve the creditworthiness of commercial banks that hold large amounts of national sovereign bonds. This should in turn strengthen the banking system and lead to greater financial stability.
Eurobonds could also be expected to make the market for national sovereign bonds more liquid and hence less volatile. This should then lead to a decrease in the liquidity premium demanded by international investors and ultimately make EU financial markets globally more attractive.
Options 1 and 2 however would require a change in the Treaty of the EU. Their implementation would therefore take a long time. They would also possibly encounter significant opposition in national parliaments given the widespread anti-European sentiments that have emerged in several countries as a consequence of the euro crisis.
Option 3 does not require changing the Treaty. Therefore, it could be implemented more rapidly, which would be certainly an advantage if Eurobonds were to play any role in solving the euro crisis.
Voices from Paris (and Rome, and Madrid) and echoes from Berlin
The current political stalemate arises because different countries seem to weigh the pros and cons of Eurobonds differently.
France emphasises that by lowering the costs of borrowing, Eurobonds would shield the most indebted countries against the risk of default and create the fiscal space necessary to implement structural reforms.
Germany is instead reluctant to underwrite the debt of its neighbours as this might well compromise its own creditworthiness. The risk of moral hazard seems to be particularly unacceptable to German authorities as it would jeopardise fiscal stabilisation efforts in countries prone to fiscal profligacy.
Another critical factor of dissent concerns the impact that Eurobonds would have on the macroeconomic performance.
The French President Francois Hollande mentioned the Brady Bonds to support the claim that the Eurobonds can actually spur economic growth. Chancellor Angela Merkel seems to be of a radically different opinion as she argued that Eurobonds are unlikely to make any contribution to growth recovery.
On balance, it seems very unlikely that Germany could ever consider accepting Option 1 before that full fiscal integration in the EU is achieved. However, there might be scope for some compromise on the other two options.
German politics might be important in this regard. Merkel needs a two-thirds majority in the Bundestag to ratify the fiscal compact. To achieve this qualified majority she needs the support of the social-democratic party SPD. SPD (which is ideologically closer to Hollande than to Merkel) could then pressure the government to accept negotiations on Eurobonds or, at least, on the issuance of project bonds for financing large infrastructure projects.
Eurobonds as a signal
In spite of the recent events, the odds are still that the euro will survive, even without Greece. Stronger fiscal integration, and possibly a full fiscal union, will then become a necessity in the years to come and Eurobonds will have to be established.
In this respect, the conflict between France and Germany does not seem to be about the “if”, but about the “when”. For France Eurobonds are a starting point in the process of fiscal integration, for Germany instead they represent its conclusion.
The current disagreement is on their short-term use in the context of the crisis. The cure for the euro crisis involves a combination of fiscal austerity and faster economic growth. Can Eurobonds contribute to that?
The legal constraints make Option 3 the only really feasible one in the short term. It is probably true that the issuance of Eurobonds would not do much for growth in the short term.
Relaunching growth in countries like Italy requires reforms (of labour market legislation, of the public administration, of the legal environment for business) that Eurobonds would not make much easier to design and implement.
However, it is also true that Eurobonds under Option 3 would still provide some positive effects in terms of reduced cost of borrowing, greater financial stability, and greater attractiveness of EU financial markets. The risk of moral hazard would be relatively low as the absence of joint guarantees would still provide countries with strong incentive to maintain fiscal discipline at the national level.
But there is another benefit that the Eurozone could expect from an agreement on the issuance of Eurobonds.
Investors and non-EU partners are voicing growing concerns with the halting response of the Europe to the crisis. An agreement on Eurobonds would send a signal that EU countries are able to find common ground and to exert the leadership required in this situation.
It might not be much, but it would still help restore confidence in Europe, its institutions, and its currency. And confidence is what is missing right now around Brussels.