Another Suggestion: Conditional Eurobonds

The debate on the pro and cons of Eurobonds started immediately after the outbreak of the Euro crisis. They were considered as a silver bullet to overcome the looming credibility gap between those Euro area member countries which had accumulated structural weaknesses in their economies and in particular in their financial system including indebtedness of their public finances. Pooling the public debt in a common Eurobond pool would have softened the rising interest rate burden by lending credibility to a now common debt pool from those economies like Germany which were in a much better shape.[1] However, a major opposition came unsurprisingly from those countries with triple AAA-ratings which would instead have to pay the higher interest for their own public debt. Since even they face rising debt-to-GDP-ratios well above the Maastricht treaty ceiling of 60 percent it would have cost them billions of Euros in transfer payments to its weaker Euro area partners. Furthermore with steadily decreasing ratings of the GIPS-Countries these transfer payments would have increased steadily. In the end the overall benefits of the pooling their public debt via Eurobonds would have become counterproductive. The interest rate savings for the whole Euro area could have turned to an additional interest rate burden.[2] So the option to use Eurobonds as a mean to overcome the current credibility crisis failed to raise sufficient support.

The Problem of Moral Hazard

Another argument related to this debate concerns the problem of moral hazard.[3] Those countries who had failed in the past to keep their structural imbalances and fiscal deficits under control would have fewer incentives to take the necessary steps for adjusting these weaknesses if they would be bailed-out. Policy makers act too often opportunistic to keep their constituencies happy. Without the market pressure of rising interest rates to refinance their public debt policy actions would have been delayed and softened. However, Eurobonds are now issued already by the EFSF to cover the emergency loans given to the three Euro area countries which came at first under financial stress, i.e. Greece, Portugal and Ireland. The main difference to the initial proposal is that the amount of financial support obtained is limited and made conditional on structural reforms of the crisis countries. Without pain no gain is the principle.

Blue Eurobonds?      

To get around the resistance of the creditor countries of the Euro area Jacques Delpla and Jakob von Weizsäcker came up with a modified approach.[4] To restrict the amount of pooled debt they considered to limit the pool to 60 percent, i.e. the debt ceiling of the Maastricht treaty, for each country. These – so called blue bonds – would be than be issued by a common European Debt Agency. However, these blue Eurobonds would have been unconditional, i.e. without any strings on prudent behavior attached to them for those countries of the Euro area under financial market stress. Furthermore it was unclear how this would have influenced the interest rates for those debts in excess to the 60 percent ceiling. Would they have decreased or increased interest rates for them and by how much? The questions raised could not easily answered in advance.[5] Finally this proposal has also been put aside from the political agenda.

ESBies an appropriate solutions?

Last year a further solution for the Eurobonds problem has been published by a group of leading economists.[6] Instead of splitting up the total public debt into two shares of blue and red bonds, i.e. those below and above the 60 percent ceiling, they considered a securitization approach. Euro-Safe-Bonds (ESBies) would be securitized assets formed from the total public debt of the Euro area countries. The senior tranche would obtain the highest debt rating of triple AAA while a junior tranche would be treated as a risk buffer by offering higher interest payments due to the higher risk associated with the liability in case of sovereign defaults of countries of the Euro area. Since the risk of a common default of the whole Euro area is considered to be close to nil, the senior tranche shares would be shielded from the default risk to a high degree. However, as we have learned from the subprime crisis in the US the securitization model has conceptual weaknesses.

The tranching of securities is model based with default risks taken from past performance. With the emergence of an extraordinary event and a systemic crisis the assumptions of the standard risk models used for tranching securitizations broke down and made those assets illiquid and without a market valuation since these markets ended in a sudden freeze. Since only a limited number of countries, i.e. in maximum all seventeen are included in the risk pool, the risk clusters to huge risk concentration. The correlation structures between those risk clusters is also depending on the changing correlation due to unknown contagion effects in case of a real looming sovereign default crisis. Therefore the suspicion about the potential fragility of a securitization of these assets cannot be easily dismissed in the financial markets. Hedge fund managers would test these assets as they have done before with other securitizations.[7] Therefore this solution faces as well a credibility gap. Furthermore this approach is as well unconditional and does not address the moral hazard problem.

Taking moral hazard seriously

The proposal outlined here instead takes the moral hazard seriously by make the issue of risk pooling conditional on good performance. The key argument of all Eurobond approaches is that there is a need of sufficiently large volume safe assets in the financial markets because these are the fundament to lend as well to riskier assets in the market. Pension funds and life insurance companies are even legally obliged to invest a large amount of the monthly revenues into such assets. If there is a shortage in supply the excess demand in this market drives down interest rates to artificially low levels. This is even not in the interest of those countries that benefit from these low interest rates, as e.g. Germany whose current ten year Bunds were sold at interest rates of 1,66 percent. This could as the experience of the current crisis countries of the Euro area have shown lead to imprudent fiscal policies. The artificially low interest rates decrease the fiscal burden in public finances of such country and create a money illusion or better creditworthiness illusion. Since this extremely low interest rates are only idiosyncratic, i.e. tend not to last for long, the however could lead to the built up of a deficit position which becomes critical when the interest rates even return to normal. Rising public debt combined with rising interest rates in the refinancing of such debt burden lies at the core of the current fiscal crisis of the Euro area. It could happen again. Due to opportunistic behavior of incumbent governments to lend support from their electorate they spend the interest savings for social benefits or tax reductions. When the interest rates swing back to normal the combination of higher debt plus rising interest rate payments in refinancing such debt works a accelerant in the looming sovereign debt crisis. Due to market failure in the beginning of the Euro area to lower nominal interest rate of those countries with significant higher inflation history this triggered a debt bubble in these countries not only in the public but as well in the private sector of their economies. The seemingly persistent lower interest rate levels for all Euro area countries however was not to last. Instead in bringing down their public deficits and investing in their productive capital these countries used those windfall gains from extremely low interest rates to overspend in consumption. When capital markets became suspicious about this an interest rate gap emerged between those with a less inflationary history like Germany. The key argument against Eurobonds as an instrument to enforce interest rate convergence by Eurobonds is exactly that. It would again create the wrong incentives to return to the imprudent fiscal behavior. Without conditionalities to keep this in check Eurobonds could become a source of another indebtedness cycles.

Eurobonds based on conditionalities set by financial markets

What the EFSF has established is exactly that. It issues Eurobonds to such countries in need, but with conditionalities attached to it. These are restructuring programs which are regularly monitored and financial support is only given if lenders currently represented by the troika of (EU, IMF, ECB) and debtors agree about the fulfillment of the conditionalities. Under such extreme conditions as now this seems to be the only solution with neglecting the problem of moral hazard.

What would be a further alternative approach towards Eurobonds based on conditionalities is the possibility to establish a European Debt Agency (EBA) where only those countries with triple AAA-ratings would pool their debt. This would be the core of a safe asset supply of the Euro area. The entry condition to this Eurobond club would be based on the triple-AAA rating. The exit condition as well. Those losing this status would have to begin to issue their own government bonds outside this Eurobond system of the EDA. This would have a strong impact to maintain fiscal discipline controlled by rating agencies and the financial markets. It would not be a useless exercise because it would eliminate already the fragmentation of the public debt between those countries that have sufficient support from the financial markets. Furthermore it would be the carrot beside the stick of the EFSF based on much more specific conditionalities to lend access to low interest bearing refinancing for countries who have failed in the past to follow this line of policy. Based on this first tire of core safe assets one may even make use of securitization techniques for buying up less safe assets at a discount and pool them with a fraction of these super safe assets in a tranching between senior, mezzanine and junior tranche like Brunnermeier et al. have proposed. This could grow the size of super safe assets by adding-up the tire one core plus the senior tranches. However the EDA would only be controlled by those Euro area member states who have reached the triple AAA status. For the financial markets this kind of system would have the benefit that they would be offered a homogenous large pool of super safe Eurobond assets. Currently this would include beside Germany, Finland, Luxembourg and Austria. My guess is that such a situation would lead to a string encouragement for countries like France to recover their triple AAA status as soon as possible. Since membership is not guaranteed permanently this would enforce fiscal discipline permanently. The risk of losing the triple AAA would always be looming a Damocles sword over each member country. Since the membership is out of control of the policy makers market discipline rules.

One might object that this is not a quick fix to the current pressing problems, but one has to consider that it offers a positive perspective for those countries now under the severe pressure of restructuring. If they succeed they could obtain the benefit, but this would not be granted permanently. They have again and again to commit to market discipline to maintain their status. It offers as well a gradual opportunity to become a member of the club and if all would succeed in the end to establish a complete Eurobond market for the Euro area. But this would be based on the credible financial stability due to sound economic fundamentals and under the permanent control of the financial markets.

[1] Intereconomics (2009): Forum: Common Euro Bonds: Necessary, Wise or to be Avoided?, with articles from Paul De Grauwe/Wim Moesen, Wim Kösters und Thomas Mayer, in: Intereconomics, May/June 2009, p. 132–141.

[2] Erber, G. (2012), Eurobonds und Transferleistungen innerhalb der Eurozone, in: Ifo Schnelldienst, 2012, vol. 65, issue 01, p. 14-19.

[4] Delpla and Jakob von Weizsäcker (2010), The Blue Bond Proposal, in: Bruegel Policy Brief 2010/03.

[5] Jakob von Weizsäcker/Michael Hüther (2011), Können Euro-Bonds den Euro retten? Pro und contra, in: Die Zeit, Issue 25. August 201,  Nr. 35.

[6] Brunnermeier, Markus K, Luis Garicano, Philip R Lane, Marco Pagano, Ricardo Reis, Tano Santos, Stijn Van Nieuwerburgh, and Dimitri Vayanos (2011), “European Safe Bonds: ESBies,”

[7] John Paulson is already testing the German Bunds by short selling them on the market speculating on rising assets prices due to contagion effects from the crisis in Spain and Italy. See Sam Jones (2012), Paulson goes short on German Bunds, in: Financial Times, April 17 2012.


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