POLICY INSIGHT No.59 OCTOBER 2011
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abcd a POLICY INSIGHT No.59 OCTOBER 2011 Resolving the Eurozone crisis: Time for conditional eurobonds John Muellbauer1 Nuffield College, Oxford and CEPR he Eurozone is now in an existential crisis. lynch-pin of a successful resolution. This can create Weak fiscal discipline; profound differences the incentives for the fundamental structural Tin labour market, credit, and housing reforms still outstanding in the countries whose institutions; failures in financial regulation and a sovereign debt markets are now under pressure. common interest rate have led to unsustainable Conditional eurobonds are eurobonds with a internal imbalances in the common currency area. collective underwriting guarantee which limits These are visible in divergences in competitiveness, the country risk faced by investors and where unsustainable government, and private debt to administratively set spreads determine the annual GDP ratios as well as in other symptoms such as side-payments at below AAA-rated countries pay to persistent balance of payments deficits. On top of the AAA-countries, currently Germany, France, the this comes the financial fraud committed by Greek Netherlands, Austria, Finland and Luxembourg. politicians and civil servants from pre-entry to These spreads would compensate the taxpayers in 2009 that in scale dwarfs that of financier Bernard these countries for their risk in underwriting the Madoff. This marks Greece out as a special case, bonds of the riskier countries and would be paid in currently an important distinction. proportion to the outstanding government bond issuance of the receiving countries. The spreads It has often been argued that a monetary union would be set annually conditional on a set of will disintegrate without a fiscal union. But the clear performance targets determined by a new Eurozone lacks the democratic institutions for a European monetary and fiscal authority (EMFA). fiscal union, and a fiscal union without draconian centralisation is thought to pose dangers of Limiting the country sovereign debt risk faced by perverse incentives. A resolution of the Eurozone’s investors (other than in the special case of Greece) existential crisis needs to address this fundamental would immediately restore confidence in Eurozone issue. It needs to create the right incentives through sovereign debt markets where the bond market a mixture of carrots and sticks to enable the poorly vigilantes are envisaging substantial probabilities performing economies to return to economic of worst case scenarios. A sensible limit on risk growth and to avoid a future existential crisis. might be to underwrite 85% of sovereign debt. It needs to discourage moral hazard and arrive Then, the worst case scenario would involve a debt at a fair distribution of burden sharing between write down of 15%. This figure is discussed further taxpayers in different countries and holders of below. sovereign and bank bonds. A common currency rules out currency depreciation but the history of To illustrate with a hypothetical example, successful currency depreciations offers important Portugal’s 10-year government bonds currently signposts: how to mimic the consequences of such face a spread of around 8% relative to German 10- a depreciation without actually abandoning the year bunds. After receiving a political commitment euro. to structural reform from the Portuguese government, the EMFA might set the spread at International efforts to correct past failings in 5% for new borrowing in the first year but with financial regulation are well underway. This article the promise that, conditional on measurable and argues that conditional eurobonds, coordinated satisfactory progress, the spread would be reduced nominal wage cuts linked with limited debt in the following years. This immediately takes off writedowns and bank recapitalisation are the some of the pressure exerted by highly risk averse financial markets on the economy of Portugal and 1 I am very grateful to Philip Lane, Rui Pedro Esteves, Paul on the holders of its sovereign debt. At the same De Grauwe and John Duca for helpful comments on earlier drafts but absolve them from blame. time it creates a strong reform incentive with early CEPR POLICY INSIGHT No. 59 CEPR POLICY INSIGHT No. To download this and other Policy Insights, visit www.cepr.org OCTOBER 2011 2 rewards. It also encourages early fiscal discipline: rate. In July 2011 the premium was eliminated in why borrow expensively now when there is a good new European lending to “programme countries”. chance of being able to borrow more cheaply in This eliminates conditionality altogether so that future? This makes conditional eurobonds quite government behaviour is constrained only by different from conventional eurobonds. As Kopf advance agreement and may be subject to relapses, (2011) and Gros (2011) have argued, conventional unless programme countries expect to have to eurobonds suffer from incentive problems, creating apply for further tranches of emergency funding. the risk of a future, even larger crisis. The conditional eurobonds proposed here are It is important that the spreads apply to new different from the “blue bond/red bond” proposals borrowing even though the collective underwriting of Delpla and von Weizsäcker (2010), which are of sovereign debt applies to all outstanding debt. unlikely to reduce funding costs as Kopf (2011) This is not a worry since a substantial fraction of argues, and also suffer from incentive problems. outstanding debt typically needs to be refinanced The closest previous proposal for eurobonds is every year, so the high-debt countries, especially that of De Grauwe and Moesen (2009) – see also those with short maturities, still have a strong De Grauwe (2011) for further discussion. As this incentive for fiscal reform but without suddenly article went to press, Charles Goodhart alerted me being crippled by having to pay higher coupons to previous proposals for eurobonds with country on outstanding debt. As far as the debt-issuing risk premia by Dr. Wim Boonstra, chief economist countries are concerned, new debt is issued under of Rabobank. De Grauwe and Moesen propose a variable coupon contract. This is different from that low yield countries such as Germany would conventional bonds where the coupon is fixed be compensated by high yield countries such as at the outset, though for private investors, the Greece. They illustrate by taking the February 2009 conventional fixed coupon structure is maintained. long bond yields of 5.7% for Greece and 3.1% for Since the annual spread paid to the AAA countries Germany to calculate the premium of 2.6% by is fixed anew every year irrespective of the duration which Greece would have to compensate AAA- of the bond issued, the EMFA does not need to countries for being allowed to issue eurobonds. specify different spreads at different maturities, Since then, these yield spreads have rocketed which simplifies its task. The yield curve on suggesting that the market at a particular point eurobonds as a whole would still be determined by in time may not be the ideal judge to determine the market. the size of the premium. Under the conditional eurobond proposal here, the premium would be set This incentive structure also has a by the EMFA and its conditionality on performance major benefit in decentralising Eurozone would create clear reform incentives. governance, thus greatly reducing the This incentive structure also has a major benefit in problem of missing democratic institutions decentralising Eurozone governance, thus greatly reducing the problem of missing democratic From the issuing country’s point of view, institutions that would have to legitimate a tough there would be an incentive to issue debt at central fiscal authority. Although individual that maturity where the first year payment is governments would not have the freedom to set minimised since, with the same spread for all the targets, they would make the policy choices to maturities, this minimises the funding cost. This achieve the targets to reduce their future financing would undoubtedly induce shifts in the yield curve costs. of outstanding euro denominated sovereign debt. Such shifts would occur in any case because of the To appreciate the nature of the required targets, the new underwriting guarantee and would be affected nature of the multiple tensions in the Eurozone by the details of how a (max 15%) debt write-down needs to be understood. The first of these is the would occur, for example, whether it would it affect problem of competitiveness. It also sets the scene only the principal or be applied in proportion both for the coordinated nominal wage cuts discussed to coupon payments and principal. further below. There is a parallel between the spreads proposed here and the funding cost of the Irish bail-out Competitiveness package requested by the Irish government in Divergence in unit labour costs is a key indicator November 2010 and eventually agreed at a premium of stresses within the Eurozone. Using the OECD of 3% for a 7.5 year loan from the EU and IMF, Main Economic Indicators data, Figures 1 and 2 see Lane (2011). The difference, however, is that below, show unit labour cost indices for core and this premium does not alter with Irish economic periphery countries, rebased at 100 in 2000. Figure performance. It thus misses both the carrot of 1 shows a sharp rise in unit labour costs in 2008 lower premia in future years that is conditional on and 2009 as output fell far more than employment performance, and the stick of a higher first year in Austria, Belgium, Finland, France, Germany and CEPR POLICY INSIGHT No. 59 CEPR POLICY INSIGHT No. To download this and other Policy Insights, visit www.cepr.org OCTOBER 2011 3 the Netherlands, followed by a considerable fall with an Irish government determined to address in 2009-11 as output recovered, except in France. fundamentals, and a labour market where insider Figure 1 raises questions about France, with the power and restrictive practices rule, with a Greek worst performance in this group since 2000, while government very slow to address fundamentals.