Eurobond Faces Major Obstacles

How would Eurobonds work and why are they unpopular in the economically stronger north of Europe?

Without appearing too philosophical, it may be safe to state that the economic and political choices currently facing Europe’s leaders are those of choosing a future identity.

With the debt ceiling troubles in the United States and the unconvincing resolution to the European debt crises, markets have moved dramatically the last few weeks. As the share prices of core euro banks are losing a large amount of value and the cost of sovereign debt has increased spectacularly, there are grave concerns over the current outlook. There are questions of how long the euro can muddle trough without forcing a drastic change in its whole economic and political structure. As George Soros said in an interview recently, “financial markets have a very safe way of predicting the future. They cause it.”

The pressure from markets have a number of consequences for the countries most affected. Outside of the fad of so-called austerity economics, the countries most in need of running deficits are, due to markets current risk aversion, unable to do so. This not only hinders their ability to take advantage of automatic stabilizers that in downtimes smoothen demand and reduces the pressure of unemployment; it also takes away the choice of stimulating the economy which could make the contraction and the structural changes that are necessary to emerge from it less painful.

For a more technical and immediate problem, the pressure recently put on France may reduce its credit rating. If that there were to happen, the AAA rating of the European Financial Stability Facility, which derives its funding from eurozone countries and thus its creditworthiness from them, may be at risk, possibly increasing the cost of funding for the vehicle.

With uncertainty in the markets and the immense pressure sovereign debt is currently under, the proposition of a so-called Eurobond has been recommended from a variety of sources. The Eurobond would be a financial vehicle backed by the entire euro area. As such, instead of each country auctioning its debt and paying the interest markets supply to them, all countries would use the same vehicle to finance deficit spending, thus paying the same price.

This was practically a reality prior to the 2007 financial crisis when peripheral countries were able to borrow at close to the same price as Germany. Interest rates for countries as Greece, Ireland and Portugal rose sharply in the wake of the financial turmoil when markets began to worry that they might not eventually be able to pay back their debts. These countries, in fact, teetered on the brink of bankruptcy and had to be bailed out by their fellow eurozone nations.

Since most countries in the single currency area are economically stable, a Eurobond would enable the least competitive among them to receive funding from the markets, substantially lowering the costs for countries that are currently in trouble.

There are objections of the sort that a Eurobond, much like when the Germans replaced their mark with the euro, is to sacrifice the benefits of a prudent economy, and possibly not only raising the cost of their own borrowing, but effectively subsidizing the economies of southern countries at their expense. This would create a moral hazard where peripheral economies, loath to implement structural reforms, would be able to borrow on the good credit of others.

While an abstract objection, none of the more serious propositions of how a Eurobond would be structured resemble that description. Most suggestions have come up with ways to embed into the bond tools that would enforce the fiscal rules of the Stability and Growth Pact that few countries have ever lived up to, including Germany and France.

One particular suggestion would see the creation of “blue” and “red” bonds, whereby the blue bonds backed by all euro countries could only be issued up to an amount equaling 60 percent of GDP — a safe amount of debt to handle. Red bonds, by contrast, would not be backed and cost more. This would encourage countries to keep the size of their debt within limits as the interest rates on red bonds may well be punishing.

No matter the potential structure of a Eurobond, there are two great obstacles. Under the Maastricht Treaty, which created the eurozone, subsidizing other euro countries is effectively forbidden as it would disrupt the “systems competition” envisaged by the currency’s founders. They wanted to incentivize countries in the single currency area to pursue structural changes in their labor laws and entitlement programs so as to remain competitive. Amending the treaty would be highly undesirable given the enormous strain imposed on European governments by past treaty revisions. Considering present circumstances however, this may not be the most pressing issue.

A more urgent problem is the resolute German resistance to eurobonds. The German attitude reveals not only a resistance to the risk of having to pay more to borrow but calls into question the future of the currency union. As far as Berlin is concerned, the eurobond is a question for future generations. Before it could become reality, there has to be a higher degree of economic and political integration first.

There are signs that this is indeed what will follow from a recent meeting in Paris where Chancellor Angela Merkel and President Nicolas Sarkozy announced that they would work to harmonize tax rates between their countries and urge fellow eurozone governments to meet regularly to coordinate fiscal policy.

Some see this as the emergence of a core euro bloc that is integrating at a more rapid pace within the European Union. This could ultimately mean two tiers of eurozone members — a stronger middle, run by Germany and France, and those countries that are currently on life support who would be kept out of the integration process until they are ready.

While the energy displayed by Merkel and Sarkozy is commendable and shows that the euro area has the political will to find a solution that both reassures and deals with its democratic deficit, one wonders how long the currency union can muddle trough without implementing major reforms that would calm the markets.

Leave a reply