Are Eurobonds Necessary?

A Response to the INET Euro Council Report

(This article, originally written by Beatrice Weder di Mauro, was translated from German. You can find the article as it appeared in Handeslblatt, a leading German business paper, here)

Are you sick of hearing them? The warnings about the looming downfall of the euro zone? Are you tired of the crisis and convinced that we need no longer listen to economists? After all, the world has kept on turning, Europe hasn’t crumbled. The economists are just arguing.

Unfortunately it’s easy to adopt this attitude. But sadly it’s also easy to observe that many warnings have since proven correct, that the crisis has got progressively worse, even though larger and larger “weapons” are being rolled out and employed. Already for the second time in recent months, the European Central Bank (ECB) has seen itself forced to intervene on a massive scale. First to ensure the liquidity of the banking system, and most recently to absorb some of the refinancing costs of European states. Now hopes are rife once more that it will be sufficient for the ECB to ensure cohesion while largely relieving policy-makers of this responsibility. It could hardly be called a solution.

The INET Council on the Euro Zone Crisis (ICEC), made up of 17 economists convened by the Institute of New Economic Thinking, faced the task of presenting a viable solution. As a guiding principle the Council tried to recommend only the minimum economic interventions required and to distinguish between long-term goals and what was necessary in the short term. For there are two separate challenges to be dealt with: first, paying off the financial burdens that have arisen due to the failed euro-zone regulations, and second, improving this system of regulations.

In the long term, the euro-zone regulations should not include a communalization of debt. Eurobonds are not necessary; instead any crises of banks or states that may arise should be managed via an insolvency and restructuring regime. In each case, this does require temporary interim financing attached to certain conditions. However, in the long term the restructuring fund for financial institutions should be financed as part of a banking union through contributions from the banks themselves. Above all, these insolvency and restructuring regimes should prevent crises by eradicating misdirected incentives to build up excessive debts. However, they would clearly have the opposite effect if they were introduced with short notice. To have a stabilising effect, past burdens on the books of the financial and the public sector must first be reduced.

This is why more extensive interventions are necessary in the short term to make this debt reduction possible both economically and politically. Over the next five years the problem countries must move forward with massive consolidations and structural reforms, and this during a time of economic stagnation and high unemployment. The majority of these adjustment costs are unavoidable and not attributable to euro-zone membership.

However, that is not true of bond spreads. A new report from the International Monetary Fund (IMF) shows that the spreads of almost all problem countries are only 10-20 percent attributable to the country itself. The Italian and Spanish spreads, for instance, are 80-90 percent determined by the euro zone. Crucial factors here, alongside interwoven financial and trade flows, are contagion effects and market expectations regarding euro-zone cohesion. In plain terms, the Spanish and Italian spreads are largely “made in Greece und Germany” and cannot be safely reduced, even if the countries conduct themselves impeccably.

Because large spreads increase the burden of adjustment, it follows that the euro zone should create instruments to keep them in check. The ICEC opted primarily for a fiscal solution, namely the debt repayment pact proposed by the German Council of Economic Experts. Compared to ECB interventions, this plan has the advantage that it not only reduces the spreads in the short term but also prescribes debt reduction and therefore forms a bridge into the long-term regime.

It was in no way a given that the ICEC would function. If argumentative economists can reach agreement for Europe’s benefit, this should be seen as a sign of hope for Europe. And a reason to sit up and take notice after all.