The tricky path toward greater fiscal integration, take two
A FEW weeks ago I blogged on a proposal by Oxford University’s John Muellbauer for euro bonds (to which he kindly replied with interesting comments, see here). Now seems a good time to return to the subject: the European Commission has just released a Green Paper on euro bonds. For your reading pleasure, here are some key quotes: The more extensively credit risk would be (sic) pooled among sovereigns, the lower would be market volatility but also market discipline on any individual sovereign. Thus fiscal stability would have to rely more strongly on discipline provided by political processes. Stability bonds would provide all participating Member states with more secure risk access to refinancing, preventing a sudden loss of market access due to unwarranted risk aversion and/or herd behaviour among investors. Any type of stability bond would have to be accompanied by substantially reinforced fiscal surveillance and policy coordination as an essential counterpart, so as to avoid moral hazard and ensure sustainable public finances. This would necessarily have implication for fiscal sovereignty, which calls for a substantive debate in euro area member states. The first thing to note is the fantastically aspirational name these euro bonds are given: "stability bonds". The Commission has three proposals ranging along the continuum of moral hazard.Proposal 1, the mother solution, would convert all national bonds into euro bonds with, in the jargon, "joint and several guarantees". This essentially means that "hard" Europe is completely on the hook for the debts of their brethren. It would quickly sort out Europe’s sovereign debt and banking crisis, but most likely end in disaster, even in the Commission's opinion: "member states could effectively free ride on the discipline of other member states, without any implications on their financing costs". This solution needs, again in the words of the Commission, a "very robust framework for delivering budgetary discipline and economic competitiveness." But would it actually work? I’m not optimistic. For one, the necessary treaty changes would take years to negotiate and ratify. And then a huge bureaucracy would have to be built to monitor compliance. Proposal 2, which is in the vein of the blue bond/red bond that I mentioned in my previous post, would convert national bonds into euro bonds up to a threshold (say 60% of GDP). What the dynamics of the "red" national bonds would look like is unclear. The larger the coverage of the "blue" bonds, the more risk would presumably be concentrated in the residual national ones. The cost of new borrowing (assuming the country is above the ceiling) would be dependent on national bond yields and so market discipline is retained. The paper discusses whether the ceiling should be flexible and linked to policy compliance. This brings in a sort of conditionality similar to that found in Mr. Muellbauer’s proposal: if a country does what it is told then more of its (presumably) high coupon national debt would be refinanced as low coupon euro debt. But the important part is how to deal with non-compliance. When considering any of these proposals, it is necessary to consider extreme circumstances. The proposal says that the flexible ceiling would act as an automatic stabiliser of the credit quality of the euro bonds: the respective share of wayward countries would be reduced as their ceilings were reduced. But this is hard to believe. If a country faced an extraordinary situation with widening budget deficits, rising debts, spiralling payments and so on—might the European Commission not be inclined to raise rather than reduce its ceiling on a temporary basis? The paper admits that if the ceiling was in any way perceived as being soft or liable to political pressure, the disciplining effect of the blue/red approach disappears. Proposal 3 is the weakest and is a simple "several" guarantee of euro bonds (as with proposal 2) up to a threshold. Countries would be on the hook "pro-rata", meaning that if one country defaults, all bonds take a proportional right down. In the absence of any "enhancement", such as directly collateralising respective shares with national assets, the credit quality of this euro bond would be at best a weighted average of the credit qualities of the euro-area members. The benefit of this proposal is that it would not require any treaty changes, but I’m not all that enthusiastic. In order to have any hope of keeping yields low, these bonds would have to enjoy credible seniority over the residual national debt. If they didn't, the yield on this bond could be much higher than the stronger euro states would ever be prepared to pay. Even with seniority it is very uncertain how these bonds would trade. In my last post I complained that Mr. Muellbauer’s proposal put too much faith in the ability of a European debt agency to impose his "side payments" on euro-zone countries in the manner he proposes. But these concerns will likely have to be brushed under the carpet. If Europe is going to whether the storm, it will have to trust in such new institutions. Side note - I also worried about the consequences of only backing 85% of national debts. Mr. Muellbauer makes the interesting point that if struggling countries managed to reduce unit labour costs by X%, "then its existing sovereign debt could be written down X% up to the maximum of 15%. This would roughly mimic what happens in successful currency depreciation". He writes: Far from causing panic in the sovereign bond markets, this would result in a sharp fall in yields. For example, Italian 20-year government bonds are currently yielding around 8% vs Germany’s 2.6%. This discounts far, far more than a maximum 15% write down on existing Italian debt.