Goodbye Eurobonds

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Despite growing calls to introduce Eurobonds as a way out of the euro zone's debt crisis, August 2011 might well be remembered as the month during which the idea of Eurobonds was murdered by the Italian political system, argues Daniel Gros, director of the Centre for European Policie Studies (CEPS).

Daniel Gros is director of Brussels-based think-tank CEPS. This commentary was republished in partnership with Eurointelligence, an Web-based service for economic commentary and analysis of the euro area.

"The current upheaval in financial markets has reinforced the voice of those who call for the introduction of Eurobonds as the only way to end the euro debt crisis. However, August 2011 might well be remembered as the month during which the idea of Eurobonds was murdered by the Italian political system.

The basic facts of the Italian drama are well known: in early August, when interest rates on Italian government debt soared and the Italian banking system got under pressure, the ECB [European Central Bank] started buying Italian debt on the understanding that Italy would quickly adopt a multi-annual programme to reduce its deficit and promote growth. This understanding was made explicit in a letter sent by the present and future presidents of the ECB to the Italian government. Initially it appeared that the country would react in a matter of days.

But as the pressure from financial markets abated somewhat the government, under pressure from different parts of the ruling coalition, continued to change its mind on what taxes to increase and what expenditure to cut. Growth-enhancing measures went out of the window and the revenue assumptions underpinning the budget plans became ever more shaky.

The ECB had thus little choice but to stop buying Italian bonds, whose yields then soared again. This finally convinced the government that it had no choice but to toughen the budget again so as to ensure renewed support by the ECB.

Given this experience it is instructive to speculate what might have happened if Eurobonds had already been implemented by early 2011.

What variant of Eurobonds? Imagine first that Italy could still have issued substantial amounts of Eurobonds. In this case the Italian government would have continued to defend its position that Italy's fundamental position was sound (relatively low deficit and strong domestic savings); and that there was therefore no need to implement a strong fiscal adjustment now.

There are always valid arguments to delay action. The Italian government might even find a Nobel prize laureate who would support the notion that any attempt to implement a fiscal adjustment now would be self-defeating, because it would depress demand so much that in the end the deficit would not improve. 

Defenders of Eurobonds would say that 'the EU' (i.e. the Eurogroup of finance ministers) might have imposed the adjustment anyway. This is possible, but not likely, because in the absence of a clear market signal the need for action can always be disputed. But what would have happened even if 'the EU' had ordered Italy to do a fiscal adjustment now?

It is quite possible that the government might not have been able to find a majority in parliament. What then? Fines? Why would the prospect of fines, which only embarrass the government, suddenly produce a consensus on reforms?

What if Italy had already exhausted its allocation of Eurobonds (or the EU had not allowed it to issue any more)? In this case the price of all the Italian 'non-Eurobonds', i.e. those Italian bonds not guaranteed by its partners, would have tanked even more as financial markets would perceive that these bonds would be first in line in case of trouble. 

Total Italian government debt is about 1.800 billion euro. If one assumes that Eurobonds might have been issued for about one half of this, one would still be left with 900 billion euro, enough to drive large parts of the EU's banking system into insolvency should the country default on it. 

With or without Eurobonds, the ECB would have faced the same unpleasant choice: intervene in the secondary market or risk a collapse of the European banking system.

The Italian 'summer theatre' of 2011 illustrates once more that the problem is not that a government will openly defy its eurozone partners, but rather that its parliament is so divided that the government cannot push through the measures that are required.

Greece has already shown that countries default not because they deliberately choose to, but because society at large is so divided that it is impossible to make the necessary adjustment to ensure orderly debt service. 

This leads to the final thought: What would happen to the 'Eeurobonds' issued by a country which does not comply with conditions set in Brussels or Frankfurt? Would financial markets really believe that Germany would honour its guarantee if the country concerned had not abided by its own obligations? The German government might well argue that the country had destroyed the essential elements ('Geschäftsgrundlage' in German) for Eurobonds.

Depending on the exact legal basis for Eurobonds, i.e. what jurisdiction would apply, this uncertainly could very well lead to significant yield differentials between the Eurobonds issued by different member states.

Eurobonds are an appealing concept in theory, but cannot be implemented in today's Europe, [which is] characterised by a large debt overhang and the absence of a credible system to enforce even the weak elements of economic governance [that] we have now."

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