The Eurozone is growing again, but it remains the worst economic performer of the major advanced economies, still barely reaching its pre-Crisis GDP levels. Public opinion on the euro has recovered, but it remains vulnerable to another shock, and the refugee crisis has boosted populist nationalistic sentiments. The rules and buffers created in the last few years to enable the Eurozone to withstand another sudden stop of credit and market-driven panic are welcome steps, but they are widely recognised as inadequate. As France’s Finance Minister Emmanuel Macron has said, “Without any change, the Eurozone cannot survive” (Giugliano and Gordon 2015). Mario Draghi, president of the ECB, has also declared that a “minimum requirement” for survival of the Eurozone is for its member states to “invest” in “mechanisms to share the cost of shocks,” so that “all countries can retain full use of national fiscal policy as a countercyclical buffer” (Draghi 2014).
The diversity of European economic cycles, economic structures, and political dynamics is a strength of the Eurozone, but for it to be sustainable arrangements are required that distribute risks and ensure that all countries can use fiscal policy to cushion economic downturns. Such arrangements are urgently needed to ensure that, when the next recession arrives, markets don’t force countries to adopt the procyclical fiscal policies – sharply raising taxes and cutting spending while in a recession – that inflicted so much economic and political damage during the recent Crisis.
A solution that would address this need for countercyclical fiscal policy while minimising moral hazard concerns would be the creation of a system of stability bonds in the Eurozone, to be issued by a new European Debt Agency (EDA) to partially finance the debt of Eurozone countries up to 25% of GDP (see Ubide 2015). These stability bonds should be initially backed by tax revenues transferred from national treasuries, but ultimately by the creation of Eurozone-wide tax revenues, and used to fund the operations of national governments. They could also be used to implement Eurozone-wide fiscal stimulus to complement the fiscal policies of the member states. Such bonds would strengthen the Eurozone economic infrastructure, creating incentives for countries to reduce their deficits but not forcing them to do so when such actions would drive their economies further into a downturn. They would permit the Eurozone to adopt a more appropriate fiscal policy during recessions, minimising hysteresis effects (see Fatas and Summers 2015).
Detailed proposals for joint Eurozone issuance of bonds have emerged in recent years, but they all present some shortcomings that the stability bonds described here would try to overcome. The European safe bonds (ESBies) proposed by Brunnermeier et al. (2011) are based on financial engineering, which can’t constitute a durable policy solution. The PADRE framework proposed by Paris and Wyplosz (2014) is a debt restructuring mechanism funded by the securitisation of future ECB profits, which would fundamentally dent the ECB’s independence. The debt redemption fund proposed by Bofinger et al. (2011) is a temporary mechanism to ease sovereign funding costs in the near term, but with a return to the rules-only framework afterward. The eurobills proposed by Phillipon and Helwig (2011) limit joint issuance to one-year maturity, thus truncating the yield curve. The blue and red bonds proposed by Delpla and Von Weizsacker (2010) are the closest to an ideal framework, but they are backed by guarantees, not revenues, and the share of joint bonds (60% of GDP) is too large for the current stage of Eurozone fiscal and political integration.
The so-called Five Presidents’ Report by Juncker et al. (2015) sets out a long-term vision for the Eurozone, including a medium-term (2017–2025) objective of creating a fiscal stabilisation function for the Eurozone, coupled with further steps toward reinforced central powers over budgetary and economic policy matters. Such steps would pave the way toward a long term fiscal and economic union with a central budget and fiscal capacity, the power to tax and issue debt, and a treasury for the Economic and Monetary Union (EMU), all coupled with the transfer of more national sovereignty to the EMU. The proposals in the Five Presidents’ Report are welcome, but they are too vague, and the Eurozone cannot wait until the medium term. The debate on eurobonds failed during the Crisis because they were perceived to be a way to share the cost of the Crisis and relieve Eurozone periphery countries from their need to reform. These two problems are now largely solved. With the exception of Greece, all periphery countries have market access at reasonable rates, and reform programmes are well advanced. But the global economy is fragile, and the probability of a global downturn during 2017–25 is very high. Europe’s economy and societies are too weak to endure another recession in which fiscal policy cannot adequately respond to cushion the downturn. The work toward a fiscal stabilisation function must start well before the next recession hits.
The Five Presidents’ Report identifies three principles that should guide the stabilisation function:
- It should not lead to permanent transfers;
- It should not undermine incentives for sound fiscal policymaking at the national level; and
- It should improve the economic resilience of the EMU and of individual member states.
The system of stability bonds proposed here is a way to start the process of completing the EMU while meeting these three principles and addressing the shortcomings of the proposals described earlier.
The EMU was created as a ‘stability union,’ defined by a no-bailout clause and the individual responsibility of each state. However, the Eurozone Crisis demonstrated the contrary – a stability union can be achieved only by means of a joint fiscal capacity. It will not be easy to establish stability bonds, though, especially if some countries such as Germany feel they would be tantamount to giving a free credit card to misbehaving Eurozone members.
Accordingly, certain rules should accompany their use to discourage abuses. Each country’s debt (in excess of the 25% of GDP financed by stability bonds) would be subordinated to the stability bonds, creating a strong incentive for all countries to continue to undertake the reforms needed to improve the resilience and sustainability of their economies. And countries would enact legislation to transfer authority over national accounts and fiscal data to an independent Eurozone statistical agency, to prevent data fraud and avoid a repetition of the Greek fiasco. Sceptics in Europe should see the system of stability bonds as a way of reducing the rollover risks of member states’ debt and of minimising the disastrous impact of sudden stops, all while keeping market discipline at the centre of fiscal and economic policy.
Rather than encouraging bad behaviour, stability bonds could be structured to minimise moral hazard, improve governance, and ensure that fiscal policy can support growth during the next recession. They would serve as a risk-free asset that would improve the transmission mechanism of monetary policy, support the diversification of the balance sheets of Eurozone banks, and catalyse the creation of cross-border banking groups, thereby promoting private risk-sharing via equity holdings, one of the key missing pieces of the Eurozone financial union.1 They can play a decisive role in resolving the vicious sovereign-bank link, which has devastated the Eurozone economy, and in creating the environment for a credible enforcement of the no-bailout clause, thus completing the economic infrastructure of the monetary union and fulfilling the spirit of the Maastricht Treaty. The result will be higher potential growth for all countries in the Eurozone – including Germany itself.
Bofinger, P, L P Feld, W Franz, C M Schmidt and B Weder di Mauro (2011) “A European redemption pact”, VoxEU.org, 11 November.
Brunnermeier, M, L Garicano, P R Lane, M Pagano, R Reis, T Santos, D Thesmar, S Van Nieuwerburgh and D Vayanos (2011) “European Safe Bonds (ESBies)”, VoxEU.org, 25 October.
Delpla, J and J Von Weizsacker (2010) “The Blue Bond proposal”, Bruegel Policy Brief, Brussels: Bruegel.
Draghi, M (2014) “Stability and prosperity in monetary union”, Speech at University of Helsinki, November.
Farhi, E and I Werning (2014) “Fiscal unions”, NBER, Working Paper 18280.
Fatas, A and L H Summers (2015) “The permanent effect of fiscal consolidations”, INSEAD, manuscript.
Ferdinando G and S Gordon (2015) “Macron calls for radical reform to save euro”, Financial Times, 24 September.
Juncker, J C, D Tusk, J Dijsselbloem, M Draghi and M Schulz (2015) “Completing Europe’s economic and monetary union,” Brussels: European Commission.
Philippon, T and C Hellwig (2011) “Eurobills, not Eurobonds”, VoxEU.org, 2 December.
Ubide, A (2015) “Stability bonds for the Euro Area”, Peterson Institute for International Economics, Policy Brief 15-19.
1 This would allow supervisors to grant capital credits to banking groups that would diversify equity holdings across Eurozone countries. See Farhi and Werning (2014) for a theoretical discussion of the catalysing effect of public risk-sharing for private risk-sharing.