The ECB’s Outright Monetary Transactions Programme (OMT) has offered welcome relief for many eurozone countries struggling with high debt levels. But the destruction of capital market discipline bears considerable risks, write Clemens Fuest and Friedrich Heinemann. To address this, the authors propose the introduction of a new form of junior government bonds, “accountability bonds”.
Clemens Fuest is president of the Centre for European Economic Research in Germany (ZEW). Friedrich Heinemann is head of the corporate taxation and public finance department at ZEW
During the early phase of the euro crisis, many observers believed that investor panic may lead to excessive government bond risk premia and, as a result, to excessive borrowing costs for highly indebted governments. Governments might thus be pushed into bankruptcy, although they would be solvent if investors were more optimistic and charged lower interest rates. The fate of countries, and maybe the eurozone as a whole, seemed to depend on volatile investor sentiment, which may largely deviate from economic fundamentals.
Therefore many observers called for debt mutualisation, either by introducing Eurobonds or by allowing the European Central Bank (ECB) to act as a lender of last resort. However, critics warned that debt mutualisation would lead to another form of inefficiency. The borrowing costs of individual countries would then no longer depend on their own economic performance or the sustainability of their public finances, and the cost of overborrowing would be borne by other countries.
When the European Central Bank announced its OMT programme, the result was exactly that. The danger that investor panic would push countries into bankruptcy was averted. But this came at the cost of reducing the interest rates of highly indebted countries in the eurozone far below the level that was justified by their economic fundamentals – and even below the pre-crisis level. The interest rate difference between Italian and German ten-year government bonds, for instance, which was more than 500 basis points in November 2011, declined to 130 basis points in January 2015, although the economic fundamentals had not changed much. Various studies of government bond markets show that while spreads exceeded the level that could be explained on the basis of economic fundamentals in the early years of the crisis, they are now below this level.
While the decline in interest rates is a welcome relief for many eurozone countries struggling with high debt levels and low economic growth, the destruction of capital market discipline bears considerable risks. In particular, it rewards countries which build up excessive debt and punishes those that make efforts to improve their economic performance and put public finances on a sustainable footing.
Moreover, conflicts about fiscal policy arise within the eurozone as countries like Germany are increasingly concerned that they may have to bear the cost of fiscal laxity in other countries. Capital markets no longer hold individual member countries of the eurozone accountable for their policies. The far-reaching ECB involvement has thus put government bond markets back into the unhealthy equilibrium of the euro’s first decade with an almost complete interest rate convergence. The undifferentiated market conditions between 1999 and 2007 were key for the development leading to today’s crisis. They encouraged some countries to neglect structural reforms and pile up excessive public (and private) debt. Without a new approach, Europe risks making the same mistake a second time.
What can be done to correct this? We propose the introduction of a new form of junior government bonds to which we refer as “accountability bonds”, because they restore a situation in which markets can contribute to holding governments accountable for their fiscal and economic policy decisions.
Junior bonds would differ from senior bonds in the following respects: First, they would be excluded from government bond purchases of the ECB. Second, they would stop being serviced if either the issuer country enters an ESM programme or if the debt-to-GDP ratio of the issuer country exceeds a defined level like, for instance, 120% of GDP. Temporary exceptions to this debt level rule could be granted to countries whose current debt levels are higher.
Each national government in the eurozone would be obliged to issue a share of its debt in the form of junior bonds. The volume of this share could be made conditional, depending on the extent to which the country complies with the fiscal rules of the Stability and Growth Pact (SGP). Countries with debt levels below 60% of GDP and fiscal deficits below 3% would not be required to issue junior bonds at all. Countries with higher debt levels would be expected to set their current deficits so as to reduce the gap to the 60% threshold, as required by the SGP, by 1/20th each year. If they exceed this deficit level, they could be required to issue half of the excess debt in the form of junior bonds.
This rule would imply that countries with higher deficit levels than allowed by the SGP would lose at least some of the implicit subsidy to overborrowing created by the current implicit debt mutualisation in the eurozone. Investors into accountability bonds would demand substantial risk premia. As a consequence, this scheme would assist the reformed SGP through automatic market-based penalties. Excessive deficits would be fined immediately through higher interest payments.
How is this proposal related to the “blue bond/red bond” proposal made by Jaques Delpla and Jakob von Weizsäcker? Their proposal had the objective to stabilise financial markets through the introduction of partial debt mutualisation up to a level of 60% of GDP per country. But countries with higher debt levels would be obliged to issue red bonds, i.e. junior bonds where no debt mutualisation would be granted. This was proposed in a situation when no OMT programme existed and when markets were uncertain about whether or not the ECB would bail out insolvent countries. Now the ECB has guaranteed that it will do just that, so that the degree of debt mutualisation in the eurozone is much higher.
The accountability bonds proposal has the objective to moderate this debt mutualisation and to restore appropriate incentives for fiscal policy. Contrary to the blue bond/red bond proposal, it is based on the understanding that debt mutualisation, even for debt levels below 60%, must not be permanent.