Eurobonds as Hardy Perennial

Europe’s heads of state or government have launched a new conversation about reforming the financial structures of the European Union in order to prevent another economic and financial crisis like the one that consumed the last decade.  They have a number of ambitious proposals on the table — to complete the European Banking Union, to strengthen the European Stability Mechanism, and to enhance political accountability at the European level.  Not all of these proposals are sure to be adopted, and progress is likely to be incremental.  The goal of ensuring financial market stability is nevertheless apparent.

The political constraints on what can be accomplished are apparent as well.  Those constraints can be seen both in the proposals on the table and those that have been left off.  A clear discussion of debt mutualization, Eurobonds, or some kind of synthetic European safe asset is an obvious example.  Although the European Commission has been considering such proposals at least since the publication of its Green Paper in November 2011, and while European Commission President Jean-Claude Juncker has shown some willingness to raise the subject, the heads of state or government are more reluctant.

The worry is that any such instrument — whether backed by a joint-and-several commitment of the member state governments or created by market participants out of existing sovereign debt — would create excessive levels of moral hazard.  Worse, many who are skeptical of the idea express the fear that any form of debt mutualization would put the European Union on a slippery slope toward a fully-fledged transfer union.  Whether such concerns are technically accurate is beside the point: National publics in key member states are convinced that Eurobonds would do more harm than good.

This popular perception is unfortunate.  Although there are legitimate concerns about debt mutualization, Eurobonds, and synthetic safe assets, most of those can be addressed with appropriate financial engineering.  Moreover, there are certain advantages that only some kind of pan-European safe asset can offer in terms of sheltering savings in times of distress and so insulating member state economies from the threat of a ‘sudden stop’ as foreigner investors try to liquidate their assets and repatriate their capital.

The problem of sudden stops was manifest in the recent crisis.  The evidence can be found in sudden movements in the position of different central banks in the real time gross payments mechanism that underpins the single currency, called Target2.  According to that data, Ireland experienced a sudden stop first in 2008 and again in 2010; Greece was hit in 2008 and 2010 as well; Italy suffered from a sudden stop in 2011; and, Spain was affected in 2012.  ECB President Mario Draghi finally brought a halt to these sudden capital outflows with his famous ‘whatever it takes’ speech during the summer of the Spanish crisis.  Since then, the outright monetary transactions he promised have never been used.  The open question is whether they would be successful in stemming a market panic in the event they are tested.  Some more stable, institutional solution is desirable.

Europe’s heads of state or government may not want to discuss this problem of spontaneous financial market disintegration during the current round of institution-building.  They may prefer to place more emphasis on national responsibility for financial prudence instead.  If history is any guide, however, they will ultimately have to reconsider.  Integrated financial markets without a common safe asset are fundamentally unstable.  Hence debt mutualization, Eurobonds, or some kind of synthetic safe asset will have to be part of the reform agenda so long as financial market stability is the goal.

This piece was originally published in Spanish by Funcas. For the published version, go here.