Finance and Economics；Free exchange；Joined-up thinking

Can a limited version of Eurobonds help solve the euro crisis?

Anyone labouring under the illusion that the euro crisis could be solved by liquidity provision from the European Central Bank (ECB), however munificent, has been disabused. By encouraging banks to stock up on domestic government debt, the ECB's loans have reinforced the pernicious links between weak banks and weak governments. That connection is currently hurting Spain. Meanwhile, a German-inspired “fiscal compact” to insert public-debt brakes into national laws does nothing to help countries such as Italy climb out of the debt pit.

“Eurobonds”, shorthand for euro-area sovereign debts that are jointly guaranteed by the 17 member countries, could provide a solution. In aggregate, the public finances of the currency block compare favourably with countries such as America which can borrow at dirt-cheap rates (last year's euro-wide budget deficit was 4.1% of GDP, less than half America's 9.6%). But replacing all national government bonds with collectively underwritten debt is a non-starter. A fully mutualised euro-zone debt market would be enormous—at 8 trillion Euro(10.5 trillion dollar), not far short of America's—and thus very liquid.

That would lower average borrowing costs a bit. But the big gains through lower yields would go to the block's fiscal sinners (the Signori), while the good guys (the Herrs) would be charged more to tap the markets than they are now. Such a move risks undermining the euro area's public finances in the long run by taking pressure off renegades. To prevent that, national budgets would have to be tightly controlled at a euro-zone level, entailing much deeper political integration than is currently conceivable.

Any feasible plan for Eurobonds will therefore have to be on a partial basis. That means limiting the scope of joint guarantees to specific portions of member states' sovereign debt, or setting a defined lifespan to the guarantees. One idea is to confine the maturity of Eurobonds to short-term debt. Wim Boonstra, chief economist of Rabobank in the Netherlands, advocates a facility for euro-zone countries to finance themselves for four years through jointly-guaranteed debt of up to two years in maturity. This plan would exclude Greece, Ireland and Portugal while they are receiving rescue finance, but it would take the heat off Italy and Spain and provide their banks with a safe common asset. One snag is that it encompasses the very maturity at which their governments already find it easiest to borrow. Another is that by encouraging countries to issue debt at shorter maturities, the programme would create a bigger refinancing hump at the point when it was wound up.

A much more ambitious scheme from Bruegel, a Brussels-based think-tank, first outlined in 2010, would use the original Maastricht-treaty cap for public debt of 60% of GDP—more honoured in the breach than the observance—to carve a dividing line between jointly-guaranteed debt and the rest. National borrowings below the 60% level could be switched into “blue” Eurobonds, while the remaining “red” debt would remain the responsibility of individual states. The blue bit would cover around 5.5 trillion Euro—a lot more than Mr Boonstra's plan, and it would be for keeps. The main objection to this colour-coded proposal is that the resulting pressure on countries to reduce their red debt could backfire. The now-riskier tranche of borrowing would turn toxic, with yields on it soaring as borrowers priced in the higher risk of default. In the ensuing panic, the guarantee would probably have to be extended. The limit for blue debt would turn out to be as binding a constraint as the original Maastricht ceiling.

A third proposal—from the German Council of Economic Experts, an independent advisory group—recodes the colours and changes the intent. Eurobonds would replace national debt above, rather than below, 60% of GDP. This scheme would be smaller than Bruegel's, covering around 2.3 trillion Euro, and since its purpose is to redeem debt above the 60% threshold, the fund issuing the Eurobonds would eventually wind up—though that would take 25 years. The ultimate objective is manageable national rather than permanent joint debt.

Let's try another colour scheme

Since Greece, Portugal and Ireland cannot transfer debt into the fund while they are being bailed out, the German plan can be interpreted as a roundabout rescue for Italy. With public debt at 120% of GDP, Italy would transfer almost 1 trillion Euro into the fund as existing national debt came due and was replaced by the issuance of joint bonds. The next-highest amount—over 500 billion Euro—would come from Germany, whose fiscal standing is not in doubt (unless sapped by having to finance too many bail-outs).

The plan would need to be tweaked to help countries such as Spain, whose public debt is not far above the 60% limit but is rising sharply and may surge even more if its weak savings banks need extra help. Another issue is whether the discipline needed to pay off debt over such a long period can be sustained. But the plan should avoid the perverse effects of Bruegel's “blue-red” proposal. Yields on existing national bonds in a country such as Italy—those with maturities extending beyond the transfer period of up to four years—will be higher than those issued through the redemption fund, but overall borrowing costs should be reduced as investors see a credible path to debt reduction and fret less about a euro break-up.

Of the three schemes, the German plan has most to commend it. It insists on tough conditionality: states being helped will have to provide the fund with collateral and earmarked tax revenue. It is also open about the fact that German borrowing costs will rise, by up to a percentage point. That is an awkward truth, but Germans will also pay if the single currency fails. From a poor starting-point, the German proposal is the least bad way forward.