The Italian finance minister, Mr. Tremonti and his Luxembourgian counterpart, Mr. Jean-Claude Juncker, in an article which appeared in the Financial Times on 5 December, launched the proposal of establishing a European Debt Agency, which should replace the European Financial Stability Facility, when this expires in 2013. The proposal is not new. The original one goes back to Jacques Delors in the 1980s, and has been recently rejuvenated by the recent Monti Report to President Barroso (Monti 2010, see also Basevi 2006). Initially the idea was intended to provide a new debt instrument for financing pan-European infrastructures.
According to the Tremonti and Juncker version, a new European debt instrument should gradually replace national public debts. Governments should issue half of their new issues in the form of Eurobonds, until these reach 40% of the GDPs of each member country (and of the Eurozone as a whole). Countries that face serious difficulties in accessing capital markets may – in exceptional circumstances – cover 100% of their issues with European debt.
The proponents argue that the Eurobonds would achieve two important objectives:
- Creation of a bond market comparable, in size and liquidity, to the US Treasury Bill market; and
- Termination of speculative attacks against sovereign debts in the Eurozone.
Despite these proclaimed virtues, the proposal was immediately rejected by Chancellor Merkel and President Sarkozy.
The plan’s critics have argued that the new bonds would weaken the market incentives for fiscal discipline, by allowing spendthrift governments to borrow at lower costs, and would penalise virtuous countries, whose borrowing costs would likely rise.
This moral hazard problem is important, but two issues deserve far more attention – fiscal sovereignty, and default.
The Eurobonds and fiscal sovereignty
Public debt has a positive market value only if those who buy it believe that the state will be able to repay it in the future by running budget surpluses. Since the current European budget is by no means large enough to repay a debt equal to 40% of European GDP, one of the following must be true. Either the bonds will have no market, or, if they do, it must be because investors believe that the new bonds will be eventually reimbursed by the budget surpluses of virtuous countries (or by a high European-wide tax).
But why should the Germans be willing to pay high taxes for financing the high Greek, Irish, and Portuguese social spending, which their fellow Europeans cannot afford? In liberal democracies there can be “no taxation without representation”. Hence the following must be true.
The Eurobonds require a fiscal union where high debt countries lose (entirely or partially) their fiscal (and hence political) sovereignty. Minister Tremonti represents a European country, Italy, which is second only to Greece in terms of its debt-to-GDP ratio. Would he be willing to give up fiscal sovereignty in order to accomplish his proposal?
The Eurobonds and default
The original idea, as mentioned, was intended as a means of financing infrastructure and was advanced in a context of financial stability. Today, it has been revived as a mechanism for resolving sovereign debt crises. The proposal shares some features with the so-called “Exchange Offers” employed successfully in the crises of Pakistan, Ukraine and Uruguay over the past decade.
This is how such deals work. The Sovereign debtor, threatening to default, proposes to the creditors that they accept “voluntarily” the new bonds in exchange for the existing securities. The new securities are worth less (the loss is called haircut), but are senior relatively to the old ones, as they are given priority in the repayments.
- If well planned, the offer may be convenient for creditors, who, by accepting it, lose less than they would by refusing and prompting a default.
- The offer is clearly convenient for the sovereign debtor, since it reduces the value of his debt and allows him to continue to access the international capital markets at reasonable rates (which would not be the case if it became insolvent).
This procedure, however, does not require an international guarantee, as in the case of the Eurobonds. More importantly, the conversion of old into new debt makes sense only if made as soon as possible (clearly, before default). By contrast, the European agency in the Tremonti and Juncker proposal would become operational only after 2013.
Were it to be approved in these terms, the effects would be to ignite the default of countries at risk (this is exactly what seemed to be happening). It would also be following Mrs. Merkel’s statements on the need to bail in the private sector – which is essentially what the proposal would accomplish.
Who would ever want to hold Greek, Irish, Portuguese debt today, knowing that in 2013 this debt will be downgraded to a junior debt, and thus knowing he would suffer today a capital loss for sure? (See also Gros 2010 on this point). The answer is no one, unless the European Debt Agency (which does not exist yet) could commit to convert the old into new debt at par in 2013, which would obviously make the new debt instrument completely useless for solving the Eurozone debt crisis.
The Tremonti-Juncker project is a good idea for financing infrastructure and increasing market liquidity in good times. Yet it requires a large loss of fiscal sovereignty by high debt countries. Because of its timing, it’s a bad idea for solving the debt crisis of Europe.
Monti, Mario (2010),“A new strategy for the Single Market – at the service of Europe’s economy and society”, Report to the President of the European Commission José Manuel Barroso, May.
Basevi, Giorgio (2006), “Un’Agenzia europea del debito pubblico”, I mercati finanziari internazionali. Nino Andreatta e la politica economica, a cura di Paolo Onofri, Il Mulino, pp. 113-18.
Gros, Daniel (2010), “The Seniority Conudrum”, VoxEU.org, 5 December.
Originally published at VOX and reproduced here with permission.