Safe Conditional Eurobonds

Posted by on 18 April 2012

The debate on the pros and cons of Eurobonds started immediately after the outbreak of the Euro crisis. Pooling the public debt in a common Eurobond pool would have softened the rising interest rate burden.[1] However, a major opposition came unsurprisingly from those countries with triple AAA-ratings which would instead have to pay the higher interest. With steadily decreasing ratings of the GIIPS-Countries these transfer payments would have increased as well. In the end the overall benefits of the pooling their public debt via Eurobonds would have become counterproductive. The initial interest rate savings could have turned to an additional interest rate burden.[2]

The Problem of Moral Hazard  

Another argument related to this debate concerns the problem of moral hazard.[3] Those countries who had failed in the past to keep their structural imbalances and fiscal deficits under control would have fewer incentives to take the necessary steps for adjusting these weaknesses. Without the market pressure of rising interest rates to refinance their public debt policy actions would have been delayed and softened.

Blue Eurobonds?      

To get around the resistance of the creditor countries of the Euro area Jacques Delpla and Jakob von Weizsäcker came up with a modified approach.[4] To restrict the amount of pooled debt they considered to limit the pool to 60 percent, i.e. the debt ceiling of the Maastricht treaty. However, these blue Eurobonds would have been unconditiona. Furthermore it is unclear how this would influence the interest rates for those debts in excess to the 60 percent ceiling. Would they have decreased or increased interest rates for them and by how much? The questions raised have no easy answer in advance.[5]

ESBies a better solution?

Last year an addtional solution has been proposed.[6] Brunnermeier et al. considered a securitization approach of Euro-Safe-Bonds (ESBies). The senior tranche would obtain the highest rating of triple AAA while a junior tranche would be treated as a risk buffer by offering higher interest payments. However, as we have learned from the subprime crisis in the US the securitization model has conceptual weaknesses.

The tranching of securities is model based with default risks taken from past performance. With the emergence of an extraordinary event and a systemic crisis the assumptions of the standard risk models used for tranching securitizations broke down. Since only a limited number of countries are included in the risk pool, the risk clusters around few risk concentrations. The correlation structure between those risk clusters depends on the changing correlation due to unknown contagion effects in case of a looming sovereign default crisis. Therefore the suspicion about the potential fragility of a securitization of these assets cannot be dismissed. Hedge fund managers would test such assets as they have done before with other securitizations and assets.[7] Therefore this solution faces a credibility gap. This approach is again unconditional and does not address the moral hazard problem.

Taking moral hazard seriously

My proposal takes moral hazard seriously by making Eurobonds conditional on persistent good performance. The key argument of all Eurobond approaches is that there is a need of a sufficiently large volume of safe assets in the financial markets because the offer the opportunity to lend as well to riskier assets in the market.

Rising public debt combined with rising interest rates in the refinancing led to the current fiscal crisis of the Euro area. Even extremely low money market interest rates due to the ECB interest rate policy could avoid the current crisis. If the interest rates swing back to normal the combination of higher debt plus rising interest rate payments in refinancing such debt works as an accelerant. Due to a market failure at the introduction of the Euro to lower nominal interest rate for all countries close to the German level this triggered a debt bubble in countries with a significantly higher interest rate histories. Instead in bringing down their high public deficits and investing in their productive capital from such savings these countries used these windfall gains to overspend in private and public consumption. When capital markets became suspicious about such developments a rapidly widening interest rate gap reemerged. Without conditionalities to keep such failures under control unconditional Eurobonds could become a source of another future crisis. What the EFSF has established is exactly such conditionalities. It issues Eurobonds, but the countries have to commit to restructuring programs which are regularly monitored.

Eurobonds based on market conditionalities

A further alternative approach towards Eurobonds based on market conditionalities is to establish a European Debt Agency (EDA) where only countries with triple AAA-ratings would pool their debt. This would be the core of a large homogenous safe asset supply. The entry and exit condition to this Eurobond club would be rating-based. Those losing their status would have to begin to issue their own government bonds again or turn to the EFSF. This would have a strong impact to maintain fiscal discipline controlled by rating agencies and the financial markets. Furthermore it would be the carrot beside the stick of the EFSF. Currently the EDA would include beside Germany assets from Finland, Luxembourg and Austria. Such a situation would lead to a strong encouragement for countries like France to recover their triple AAA status as soon as possible. Each single country could follow their own trajectories.

[1] Intereconomics (2009): Forum: Common Euro Bonds: Necessary, Wise or to be Avoided? in: Intereconomics, May/June 2009, p. 132–141.

[2] Erber, G. (2012), Eurobonds und Transferleistungen innerhalb der Eurozone, in: Ifo Schnelldienst, 2012, vol. 65, issue 01, p. 14-19.

[4] Delpla and Jakob von Weizsäcker (2010), The Blue Bond Proposal, in: Bruegel Policy Brief 2010/03.

[5] Jakob von Weizsäcker/Michael Hüther (2011), Können Euro-Bonds den Euro retten? Pro und contra, in: Die Zeit, Issue 25. August 201,  Nr. 35.

[6] Brunnermeier, Markus K, Luis Garicano, Philip R Lane, Marco Pagano, Ricardo Reis, Tano Santos, Stijn Van Nieuwerburgh, and Dimitri Vayanos (2011), “European Safe Bonds: ESBies,”

[7] See Sam Jones (2012), Paulson goes short on German Bunds, in: Financial Times, April 17 2012.