Monday, November 21, 2011

Schäfer on Eurobonds as a solution to the Euro-crisis

Eurobonds, A Bridge Too Far
By Hans-Bernd Schäfer

The concept behind Eurobonds

Nowadays so called Eurobonds have been proposed as a solution to the current European debt crisis. Eurobonds would invoke joint liability among all member states of the European Monetary Union for a loan received by any member state. Thus the term “Eurobond” is surely misleading. It suggests the introduction of Euro denominated bonds whilst its actual purpose is the introduction of collective liability for government debt among all members of the Euro zone. Eurobonds should thus rather be called “joint liability bonds”.
What would be the consequence of converting all Euro zone public debt into Eurobonds? The interest rates for Greek, Irish, Portuguese, Spanish and Italian government bonds would fall dramatically as a result of a diminishing insolvency risk. However, the interest rates of German or Dutch bonds would rise for the exact opposite reason. Overall, this would imply a vast relief for the crisis struck countries. Those states which are currently paying between up to seven per cent interest on their new debt would perhaps manage to cope with three or four percent, probably with the exception of Greece. Proponents of the Eurobond suggest this as the ultimate liberation of the current crisis. Consequently the rich and solvent states would have to pay higher interest rates, since the additional risks would be priced into the new interest rates. For example, in the event that the introduction of Eurobonds were to raise interest rates on German government bonds by just one percentage point above the current level without Eurobonds, this would amount to 20 billion Euros per annum of additional debt financing. This amount is equivalent to 1 percent of the total German government debt at the end of 2010. It would certainly not place Germany in a precarious debt situation; however it is more than seven times the amount of combined federal and national spending on student loans in 2010 and it is equivalent to an increase of VAT taxes of 2 per cent points.
This is still a conservative estimate. The interest rates on the Eurobonds which were launched by the European Commission and for which all member states are liable, are currently 0.6 percent above interest rate levels on German government bonds. However, the risk on the part of the guaranteeing states would increase by a multiple in the event of converting all government debt within the Euro zone. Moreover, it is uncertain how financial markets would assess Germany’s insolvency risk once it accepts joint liability for the debt of other countries. Additionally, these estimates are based on the assumption that the interest rates on private loans remain constant, which is hardly reasonable. Private borrowers will certainly not be drawn into joint liability for the debts of other states. However, once the government assumes additional liability and thereby exposes the entire German economy to an additional country risk, this will lead to an increase of the interest rates on private loans. Therefore Eurobonds would burden both taxpayers and recipients of state benefits as well as private borrowers in Germany. The impact on German tax levels as well as the state's ability to maintain pension and other social benefits, are barely comprehendible once these risks are realized, as the combined public debt of Ireland, Portugal, Spain, Italy and Greece is now around 3.6 trillion Euros, about 150 per cent of Germany’s gross national product.

Would this save the Euro? It all depends on how much fiscal autonomy will remain with the member states within the Euro zone. If everything else remains unchanged, any state may go into debt to any desired extent. The European criteria for stability will not be met, because sanctions are unlikely to be upheld as witnessed in the past. This creates huge incentives in some countries to continue borrowing beyond any measure, because in the event of a state bankruptcy, the costs can be offloaded to the more solvent nations. In the short term Eurobonds would certainly bring relief, but in the long run this would lead to a financial chaos within the Euro zone, provided any member state is able to continue raising its budget deficits without being controlled by fellow member states.

Is this too pessimistic a viewpoint? Are we not simply observing a transposition of the homo economicus model of rational selfish people onto states, which are bound by bonds, contracts and multiple forms of cooperation, all of which is based in good faith? It would be grossly negligent to defend such a thought and it would certainly not be representative of what we have witnessed in Europe, ranging from the fate of the Stability and Growth Pact to the fraudulent misrepresentation in Greece.

The problems pertaining to uninhibited new loans by means of Eurobonds are also acknowledged by the proponents thereof. Many are therefore proposing the introduction of a common financial policy among the EU member states, which is to be lead by a European minister of finance. In essence, the aim is to abolish national autonomy in terms of public borrowing in member states. Hence any member state would not be granted additional debt without the consent of the other states of the Euro zone. In the event of deviation on the part of any member state, this would invoke the other member states to prevent it from doing so. If many states were to deviate, this would invoke the most creditworthy countries, i.e. especially Germany and the Netherlands to prevent the other states from increasing their debt. Hence Brussels would have to implement and maintain strict financial discipline among the member states in much the same way as a clan society maintains an iron mechanism in order to uphold conformism and group liability as a complement thereof. Germany, the largest and most creditworthy economy in Europe, would thus have to assume the role of a hegemonic preceptor. This role is neither sought within Germany nor outside Germany, yet such discipline would remain clearly inevitable similar to the laws of a clan. It would also result in a fundamental change of the underlying European treaties, all of which would have to be ratified by the member states, not to mention the possibility of referendums in some member states. The German chancellor Merkel has just launched a plan to amend the treaty of Lisbon and to impose strict financial discipline on all countries in the Eurozone. To avoid the problem of German political dominance she proposes theat the European court of justice and not the European council should dcide, whether a member state has breached the contract and about sanctions to the breaching country.
Juncker’s proposal

Most proponents of Eurobonds are wary of this consequence. Although they make specific proposals regarding Eurobonds, their suggestions remain very cloudy when it comes to sacrificing their national budgetary autonomy. Luxembourg’s prime minister and chairman of the Euro Group Jean-Claude Juncker proposed to convert all non-government debt into Eurobonds up to a volume of 60 per cent of a state’s national product. Hence a country which has e.g. 120 percent of state debt would be able to convert half of its debt into Eurobonds. The remaining half would continue to have the underlying state as sole debtor. According to this suggestion, creditors would then have to accept the default risk on the latter half of the debt in the event that it reaches an unsustainable level. Consequently, creditors would grant no further debt unless being compensated for the excessively high risk premium, thereby implementing an automatic debt brake mechanism. Arguably, Juncker’s proposal would create an incentive to the extent that half the debt of the highly indebted countries, namely Ireland, Portugal, Greece and Italy would be served at reduced interest rates whilst interest would only moderately rise in the credit-worthy countries. The burden on the German taxpayer would be less heavy than if all government debt within the Euro zone were converted into Eurobonds. Germany would nonetheless have to face higher payments.
Juncker’s proposal could indeed assist in resolving the crisis, provided that the Eurobond guaranteed debt is treated as preferred debt over the state guaranteed debt. Moreover, in the event of an insolvency of a member state, there should be no support mechanism. The debts of the insolvent state would have to be partially cut at the expense of its’ creditors and at the expense of the future creditworthiness of the debtor state.

Orderly insolvency criteria are needed

However, the above is an illusion within the institutional framework of the European Union, and thus continues to be the prime weakness of this proposal. In fact, it is rather to be feared that the troubled debtor states will continue to become excessively indebted whilst the underlying creditors, i.e. banks, hedge funds, pension funds and private investors will continue to serve these debt levels because they can rightly so speculate that the over-indebted state will be backed by the other member states, as witnessed in the past, to avoid conflagration. For the procedure of a state insolvency within the Euro zone is not performed by rules of law and legal principles of an independent tribunal. Instead, the decisions taken by finance ministers are highly political. Until the meeting of the EU heads of state on 26 October 2011, the troubled states have represented the majority and in conjunction with the financial lobby, they have successfully prevented any state bankruptcy with a debt cut on the part of the debtor states. The underlying costs and risks have been transferred by the creditors and debtor countries to the European Central Bank and the member states, thereby putting the citizens of the Euro zone at risk. There is no indication that this will be much different after the introduction of Eurobonds. Also, there is no evidence that the debtor nations would engage in orderly, non-politicized state insolvency proceedings, as a result of which creditors were to be assigned the liability for a risky expansion of the government debt. They are of course weary of losing their political leverage.

The European Central Bank has already jeopardized its reputation of independence and on the basis of political pressure has purchased government bonds which are not eligible as collateral. From May 2010 until mid-November 2011, these purchases have totalled more than 180 billion EUR. In the event of a write-off, this will be borne directly by the taxpayers as well as the recipients of state benefits because the member states will be restrained from the central bank’s profits, or even worse, would have put up money if the central bank were to face insolvency.

The European Stabilisation Mechanism (ESM) which was passed by the heads of state and government of the Euro zone during March and July 2011 added even more scepticism. The ESM does follow the proceedings of a state insolvency and also provides for loan assistance as well as allowing creditors to participate in sovereign bankruptcy cases, yet all decisions are left with the ministers of finance and therefore remain politicized. In fact, Germany does have a veto position in the decision on loans and could enforce the participation of creditors and the restructuring of sovereign loans. However, this power can only be used in exceptional cases, unless it wants to permanently isolate itself within Europe.

Moreover, the recently declared intentions on the Franco-German summit in Paris in August 2011 are not credible. They propose a debt brake by national constitutional law in the Member States of the Euro zone according to the German model. In the past, the German Federal Constitutional Court was unable to prevent the constant expansion of government debt in spite of the existing constitutional standards. The test is still pending as to whether this will be possible in the future, based on the newly introduced constitutional debt brake. At this stage, the only credible regulation would be to effectively withdraw the underlying nation’s free disposal with regard to their national budget deficits. What has been suggested to this date is merely a re-phrasing of the failed Stability and Growth Pact.
Solidarity of EU states
Solidarity among EU member states is certainly attainable without Eurobonds. In fact, solidarity is undisputed and has been enshrined as a legal principle in the European treaties. The EU structural funds and agricultural fund are examples of this principle. However, the European Treaties explicitly do not provide for group liability in favor of banks and other creditors.
Instead of jointly assuming national debt through group liability, the insolvent debtor countries should be motivated by the remaining EU states to openly declare their insolvency, to file for bankruptcy, and to engage in negotiations in order to reduce their debt burden to a sustainable level. According to the standards of a market economy, the underlying costs would have to be borne by the creditors, who ultimately accepted the associated risk. The respective debtor countries would certainly have to accept a significant burden during the process of restructuring their debt, not least because they would have to engage in a lengthy process of regaining their initial reputation. According to the solidarity principle, the insolvent states should certainly receive assistance by the remaining EU states. Should a state insolvency cause the collapse of financial institutions, the latter should also file for bankruptcy. If customers’ bank deposits could not otherwise be saved and if the money supply is at risk, European countries should jointly save such financial institutions by using taxpayers’ money, but they should not protect the bank’s shareholders. The decision to forgive Greece half of its debts is a step in the right direction.

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