Eurobonds are needed to anchor macroeconomic stability and offer a safe path out of the coronavirus storm.
The abrupt increase in sovereign-yield differentials amid the escalating Covid-19 crisis in mid-March served as a stark reminder of the vulnerabilities of the euro area. Within just a few days, the spread between ten-year Italian and German sovereign bonds climbed to 2.8 percentage points, while the Greek spread jumped to 4.1 points.
In crisis times like these, sovereign debt is of pivotal importance as safe assets. Due to their countercyclical price movement, safe sovereign bonds serve as an anchor of macroeconomic stability. In an economic downturn or after an exogenous shock, a flight to safety increases the price of these bonds, simultaneously lowering their yield. The lower financing costs increase the fiscal space, while the higher price improves the banking system’s balance sheets.
If, however, government bonds are not perceived as safe assets—because investors expect payment difficulties or even default down the road—an exogenous shock such as the coronavirus may lead to capital flight from the respective sovereign debt, thereby increasing financing costs and feeding the financial ‘doom loop’ between the banks and the state.
It is debatable whether the president of the European Central Bank, Christine Lagarde, acted wisely when she said that ‘we are not here to close spreads … there are other actors to actually deal with those issues’. Yet, despite the unfortunate timing, she raised a valid point: it was the responsibility of governments in 2010 to dispel fears of a Greek default and it is their responsibility to have each other’s back in today’s crisis. In the same vein, Lagarde called upon euro-area governments to act and issue eurobonds, a demand also formulated by groups of economists on March 20th and March 21st, as well as by nine of the 19 euro-area governments on March 26th.
Signal of determination
By implementing the €750 billion Pandemic Emergency Purchase Programme—capable of being enlarged and free of the conditionality attached to outright monetary transactions—the ECB once again rose to the task and eliminated the immediate need for governments to act. The crisis is dramatic, however, and governments rapidly need to announce stimulus packages to stabilise expectations, in addition to financing the immediate ongoing expenses. Issuing mutually guaranteed bonds would signal their determination to overcome this crisis together and dissuade expectations of austerity, once the immediate problems of lockdown have unwound.
Unfortunately, the window of opportunity to deal constructively with the twin problem of high public debt in some euro countries and a lack of safe assets in the euro area as a whole has closed for the time being. Nonetheless, the proposals for sovereign-bond-backed securities (from the ESRB, Bénassy-Quéré et al and Theobald and Tober), capitalised e-bonds, purple bonds and a debt-redemption fund (earlier from the German Council of Economic Experts and Parello and Visco) provide useful pointers for issuing mutual euro-area sovereign bonds.
In the current emergency, we recommend that the ECB play an important role as the institution that has proved to be most functional at the European level and already holds a substantial portfolio of sovereign bonds which can be transformed into euro-area bonds. At all events, conditionality in the form of procyclical austerity measures must be avoided.
This flaw of programmes of the European Stability Mechanism (ESM) in the euro crisis is again looming large. The proposals currently being discussed only envisage a waiver of conditionality for a very limited volume of ESM loans.
Our proposal calls for the introduction of EUR-bonds (‘your bonds’) and EUR-bills in the amount of 20 per cent of euro-area gross domestic product, in the following manner. The Eurosystem—the ECB and the national central banks of the euro area—uses its existing portfolio of sovereign bonds to create sovereign-bond-based securities (EUR-bonds). It would do so at the behest of the euro-area governments and in its capacity as a fiscal agent, much as the Federal Reserve Bank of New York assists the United States government in issuing and auctioning its treasury bills and bonds.
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At the same time, the governments issue national bonds up to the amount of 20 per cent of domestic GDP. The ECB then issues EUR-bonds and buys national sovereign debt on the secondary market to replace the EUR-securities sold, as it would when securities mature.
Unlike sovereign-bond-backed securities or European Safe Bonds, EUR-bonds are not issued in different tranches with varying risk characteristics. There is no formal guarantee, albeit an implicit one, and lengthy treaty change is not required.
The governments simply agree, in this time of crisis, to ask the ECB to package their bonds into EUR-bonds as a signal and an instrument of solidarity, unity and determination. The ECB could even buy these bonds on the secondary market as part of its purchase programme. Ideally, however, EUR-bonds would be purchased by banks and other investors as safe assets, whereas the ECB would focus its purchasing programmes on eliminating any sovereign-yield differentials which may persist—despite the signals sent out by euro governments in issuing debt together.
EUR-bonds are created by combining euro-area sovereign bonds in the same proportion as the national subscriptions to the ECB’s capital. Accordingly, a EUR-bond with the nominal value of €1,000 is backed by €264 of German sovereign debt, €204 of French, €170 of Italian, €120 of Spanish and so forth.
The risks of default—and thus of moral hazard—will be higher the longer euro-area governments wait to act in unison and present a common front to financial markets, as well as unity to citizens. Taking Italy as an example, even a sovereign yield spread of only 2 percentage points would in itself add €7 billion per year to Italy’s financial burden if the debt ratio rose by 20 percentage points.
In the medium term, the debt ratios of all euro-area countries need to converge to allow for a large market of safe assets, which stabilises the area and reinforces the international role of the euro. Countries with the highest government-debt ratios need stronger growth supported by active European policy instruments, such as a European unemployment reinsurance scheme, revenue-side consolidation in the form of capital levies and more transparent, stringent and growth-friendly fiscal rules.
In the short run, decisive measures are required to allow the economy in all parts of the euro area to recover from the virus shock—and, in so far as possible, foster the structural transformation required to stop global warming.