Time for euro bonds – but with conditions

John Muellbauer 12 October 2011



The Eurozone is now in an existential crisis.1 Weak fiscal discipline, profound differences in labour market, credit, and housing institutions, failures in financial regulation, and a common interest rate have all led to unsustainable internal imbalances. These are visible in divergences in competitiveness, possibly unsustainable government debt-to-GDP ratios as well as in other symptoms such as persistent balance-of-payments deficits. However, the financial fraud committed by Greek politicians and civil servants from pre-entry to 2009 marks Greece out as a special case.

It has often been argued that a monetary union will disintegrate without a fiscal union – for which the Eurozone lacks the democratic institutions. A resolution of the Eurozone crisis needs to address this fundamental issue. It needs to create the right incentives through a mixture of carrots and sticks to enable the poorly performing economies to return to economic growth and to avoid a future existential crisis. It needs to discourage moral hazard and arrive at a fair distribution of burden sharing between tax payers in different countries and holders of sovereign and bank bonds. A common currency rules out currency depreciation but the history of successful currency depreciations offers important sign-posts – how to mimic the consequences of such depreciation without actually abandoning the euro.

Conditional Eurobonds

In my new CEPR Policy Insight (Muellbauer 2011), I argue that conditional euro bonds, coordinated nominal wage cuts linked with limited debt write-downs, and bank recapitalisation are the lynchpins of a successful resolution. They can create the incentives for the fundamental structural reforms still outstanding in the countries whose sovereign debt markets are now under pressure. Conditional euro bonds are euro bonds with a collective underwriting guarantee that limits the country risk faced by investors and where administratively set spreads determine the annual side-payments that the below–AAA rated countries pay on new debt issues to the AAA countries, currently Germany, France, the Netherlands, Austria, Finland and Luxembourg. These spreads would compensate their taxpayers for the risk in underwriting the bonds of the riskier countries and would be paid in proportion to the outstanding government bond issuance of the receiving countries. The spreads would be set annually conditional upon a set of clear performance targets determined by a new European monetary and fiscal authority.2 

Limiting the country sovereign debt risk faced by investors (other than in the special case of Greece) would immediately restore confidence in Eurozone sovereign debt markets where the bond market vigilantes are envisaging substantial probabilities of worse scenarios. A sensible limit on risk would be to underwrite 85% of sovereign debt. Then, the worst case scenario would involve a debt write-down of 15%. This would actually benefit the European banks holding such longer-dated debt, including the ECB itself.

Incentives for fiscal decentralisation and reform

This incentive structure also has a major benefit in decentralising governance, thus greatly reducing the problem of missing democratic institutions that would have had to legitimate a tough central fiscal authority. Although individual governments would not have the freedom to set the targets, they would make the policy choices to achieve the targets to reduce their future financing costs.

The European monetary and fiscal authority would need to design a set of rules linking these spreads to performance on observable indicators. Four indicators are discussed in the policy brief: unit labour costs, the sovereign-debt-to-GDP ratio, the current-account-to-GDP ratio and the World Bank’s “Doing Business” indicators. I argue for a weighted combination of the first three with most influence for unit labour costs. But the World Bank indicators3 offer an excellent guide to areas of regulatory reform.

Successful currency depreciations offer guidance on the policy mix required by the Eurozone. One highly successful depreciation was that of the UK’s departure from the exchange rate mechanism in 1992. Competitiveness was restored; interest rates fell; in an economy with hardly any foreign denominated debt, the financial sector at the brink of a financial crisis recovered; but with unemployment and spare capacity high, and falling house prices creating deflationary pressure, the gains in competiveness endured and substantially helped the recovery in the UK’s growth rate. Foreign holders of UK gilts and other UK fixed interest suffered a write-down in terms of their currencies.

How to reduce coordination problems in a nominal wage cut

A coordinated cut in nominal wages and a linked debt write-down would mimic a successful exchange rate depreciation. The 17% decline in Ireland’s unit labour costs from 2008Q2 to 2011Q1, which transformed Ireland’s growth prospects, suggests that nominal wage cuts are possible.4 They pose two practical problems. How to support workers’ living standards if falls in prices lag behind cuts in wages, and how to solve the coordination problem? It may be rational to cut my wages if others cut too and it prices fall, but not otherwise. A temporary cut in VAT followed by phased increases would help both. It would support living standards and put pressure on firms to cut prices on the day the VAT cut comes into force. As firms’ costs fall, subsequent price increases when VAT gradually rises would be moderate. Further, by making an automatic link between falls in unit labour costs and sovereign debt write-down, the whole society is given an incentive to choose the cooperative solution. The debt-write down would have to be limited to a maximum, suggested to be 15%, to limit the risk for holders of the country’s sovereign debt. Such write-downs increase confidence in future financing ability and distribute costs more fairly between tax payers and bond holders.

Greece, however, is a different case. It seems that only by virtually holding a gun to the head of the government can the necessary reforms be carried through. Once the Greek government can demonstrate that it can govern and face down the strike of the tax collectors, for example, it seems likely that a larger debt-write down will have to be agreed, and this will need appropriate recapitalisation of European banks by their respective governments, including of Greek banks by its government.


The key points of the solutions proposed here for the Eurozone’s crisis are as follows: replace the international bond market vigilantes, currently amplifying risk for the Eurozone and world economies, by a tough new internal vigilante, the European monetary and fiscal authority. This body would set relative risk prices for Eurozone sovereign debt according to transparent rules with the right fiscal incentives without centralising fiscal policy. This also incentivises fundamental reforms, including cuts in nominal wages as in Ireland supported by temporary reductions in VAT, as a first step to correcting divergences in unit labour costs. These risk prices would compensate the core Eurozone countries for underwriting the sovereign debts of the periphery. Linking nominal wage cuts with strictly limited sovereign debt write-downs also has beneficial incentive and burden-sharing outcomes.


Boonstra, W (2011) “ Can Eurobonds solve EMU’s problems”, Rabobank Economic Research Department, August.

De Grauwe, P and W Moesen (2009), “Gains for All: A Proposal for a Common Eurobond”, Intereconomics, May/June.

De Grauwe, P (2011) “The governance of a fragile eurozone”, CEPS working document 346, May..

Delpla, J and J von Weizsäcker (2010), “The Blue Bond Proposal”, Bruegel Policy Brief, May.

Lane, P (2011) “Overview on the Irish Crisis”, WorldFinancialReview.com, 30 September.

Kopf, C (2011), “Restoring financial stability in the euro area”, CEPS Policy Briefs.

Muellbauer, J (2011) “Resolving the Eurozone crisis: Time for conditional Eurobonds”, CEPR Policy Insight No.59, October.

1 The full Policy Insight provides more details and reasoning.

2 The conditional euro bonds here proposed are different from the ‘blue bond/red bond’ proposals of Delpla and von Weizsäcker (2010), which are unlikely to reduce funding costs as Kopf (2011) argues, and also suffer from incentive problems. The closest previous proposal for euro bonds is that of Boonstra (2011) who advocates central financing of all EMU deficits with high debt countries paying higher interest rates into a common fund to compensate the low debt countries. De Grauwe and Moesen (2009) proposed a Eurobond with interest rate differentials, also see De Grauwe (2011) for further discussion. Their proposal however, lacks the incentive structure of conditional euro bonds.

3 Currently Greece is ranked 109 out of 184 countries, Italy 80, Spain 49, Portugal 31 but Ireland’s 9 is the Eurozone best.

4 See Lane (2011) for an excellent account of the Irish crisis.



Topics:  Financial markets Global crisis International finance

Tags:  Eurozone crisis, eurobonds

Senior Research Fellow, Nuffield College; Professor of Economics, Oxford University; Senior Fellow, Institute for New Economic Thinking


CEPR Policy Research