As interest spreads within the euro area widen, the stalemate on eurobonds continues. While Mario Draghi calls for a “brave leap” towards fiscal union, leaders in Germany and its satellites are understandably wary because of voter opposition.
Eurobonds imply a common guarantee on the sovereign debt of euro area members and can be an effective instrument to reduce interest rates. Eurobonds would, however, hugely increase the financial liabilities of the core countries and thus require a giant leap of faith by Angela Merkel. Instead of jointly guaranteeing the principal of sovereign debt, a more cautious and feasible step towards fiscal union is to introduce burden-sharing in the interest expenses on sovereign debt. Interest rate pooling will not release the full benefits of a common liquid market in eurobonds, but still have plenty of economic and political advantages to offer.
Let us consider the following starting points:
- The high interest rates for Spanish and Italian government bonds threaten debt sustainability. With sluggish nominal GDP growth, Spain and Italy may fall into a debt trap.
- Interest spreads only partly reflect reform efforts and fiscal discipline; they also result from recession, break-up fears and risk aversion in financial markets.
- The AAA-countries can borrow at artificially low interest rates partly because of a safe haven effect.
- Joint liability of public debt is now politically a bridge too far.
These points suggest an obvious European compromise, which would introduce solidarity in sharing the interest burden, but step away from full joint liability of the principal. To this end an interest stabilization mechanism could be set up to recycle the interest windfalls from the AAA-countries to Spain and Italy. In its most extreme form, interest expenses would be pooled and reallocated according to a country’s share in total euro area debt. This would equalize the ratios of interest expenses to total debt. Variations are possible which dampen instead of equalize these ratios. The burden sharing is temporary and could be stopped when there is no longer any need or when a country backtracks on structural reforms.
An interest stabilization mechanism would send the message to financial markets that the euro area doesn’t allow Spain and Italy to fall into the debt trap. In this way, it can be instrumental in keeping bond markets open to these countries.
More important is the political message that an interest stabilization mechanism would send. The AAA-countries would finally recognize that the spreads are a European problem instead of a problem for some countries and a windfall for others. Spain and Italy will feel heard and helped. For AAA-countries, the advantage is that the financial commitment is much smaller than that of eurobonds. Merkel may not be able to explain to her voters why Germany should be liable for Spanish debt. But she should be able to explain that a German bond yield of 1.4% is ridiculously low and that recycling the windfall is the right thing to do