Don't Got Your Back

Last week, amid continuing turbulence in European bond markets, German Chancellor Angela Merkel and French President Nicolas Sarkozy met in Paris in the latest attempt to bring the nearly two-year-old euro crisis under control. As was expected, the results were dismal. The best the conservative leaders of the two most important countries in the Eurozone could muster was a proposal that would enshrine balanced-budget rules in the national constitutions of member states and a typically vague pledge to move toward a common "economic government," giving Brussels greater powers of intervention in national budgets. Most disappointingly, they both ruled out issuing a common eurobond to cover the borrowing needs of fiscally vulnerable countries, a measure that economists and policy-makers have been touting with growing urgency as the only way to lift the threat of default.

Sarkozy's explanation was particularly troubling for those who worry about the leadership deficit in Europe. "Maybe someday there will be a eurobond," the French president waxed prophetic, "but it will be the end of a process and not the beginning." In other words, first the profligate countries of the European periphery will put their fiscal houses in order and then, once Greece and Portugal display Teutonic virtue in their public finances, Germany will agree to guarantee their bonds.

The first thing to note about this view of things is that the point of the eurobond, in which one member's bond issue is jointly guaranteed by all the others, including the most financially irreproachable ones, is to reduce the borrowing costs of countries currently viewed with suspicion by the markets. If countries like Greece or Italy become as competitive and fiscally sound as Germany, they will not need to issue eurobonds because their borrowing costs will have already gone down.

The problem, of course, is that the German medicine of harsh austerity and structural reforms for the troubled countries of Southern Europe has proved to be a spectacular failure. Fiscal contraction is leading to significant slowdowns or recessions throughout Europe. In the countries under joint European Union-International Monetary Fund tutelage, this has led to a vicious cycle: Governments have been forced to undertake further fiscal contraction in the face of weakening economic activity, which has led to further deterioration of their growth performance, and so on. As a result, rating agencies and investors, who demanded austerity to maintain confidence in beleaguered countries, have lost whatever confidence remained because of the slowdown caused by the austerity meant to solve the problem. Borrowing costs have exploded and the crisis keeps spreading.

It is this cycle that the issuance of eurobonds would break. Giving Greece, Portugal, or Ireland AAA backing would enable those countries to return to the markets and to borrow at reasonable interest rates (under 4 percent for 10-year bonds is a good benchmark; Greece's current rates hover near 18 percent). This would give them the breathing room to make the reforms necessary to restart growth, and a chance to bring their debt down to sustainable levels.

There are three main objections against the eurobond. The first is that it would increase the borrowing costs of the fiscally prudent to support their spendthrift neighbors. The second involves moral hazard: The argument is that giving the fiscally unsound countries access to low-cost borrowing would undermine the political will for reform and lead them to return to the bad old ways. The third is that it is disallowed by current EU and German law.

On the first point, it is unclear how much the borrowing costs of the fiscally virtuous would rise as a result of a eurobond issue. The Munich-based Ifo Institute for Economic Research in a recent report said that the annual tab could reach 47 billion euros for Germany. But the Kiel-based IfW Institute put the cost at no more than 10 billion per year. Meanwhile, Peter Bofinger, a prominent economic adviser to the German government, argued in a recent interview with a local German newspaper that rates on eurobonds would only be slightly higher than those of German bonds and probably lower than U.S. bonds. As he pointed out, the larger and more liquid the eurobond market that is created, the more likely it is that this will be the case. Additionally, he said, the elimination of the threat of default in countries like Italy and Spain would represent a reduction of risk for Berlin that should make it embrace the idea of the eurobond.

The moral-hazard problem is dealt with by both concrete proposals that have been put forth for the issue of eurobonds: the Juncker-Tremonti plan and the Bruegel plan. The former, named after the Prime Minister of Luxemburg and the Italian minister of Finance, proposes that eurobonds cover no more than 50 percent of a member state's annual borrowing needs and no more that 40 percent of its gross domestic product (GDP) in total. The plan presented by Bruegel, a European think tank, allows borrowing through eurobonds to go up to 60 percent of GDP but bars countries that repeatedly flout the dictates of the Eurozone's Stability & Growth Pact on fiscal management from participating in the scheme. Thus, member states retain the incentive to improve their fiscal position and avoid mounting borrowing costs on the part of their debt not covered by the eurobonds. One worry here is that the adoption of eurobonds would lead to increased pressure for reform from Germany and its cohorts, heightening tension between North and South.

Finally, there is the not insignificant hitch that the Lisbon Treaty -- the quasi-constitution of the European Union -- and the German Constitution would both need to be amended to allow for the pooling of fiscal sovereignty involved. An amendment to the Lisbon Treaty would need to be validated by 27 national parliaments, a process guaranteed to be lengthy and far from certain to succeed. The change in the German law would require a referendum, which, given the current state of public opinion, would be even less likely to pass. All the more reason why Chancellor Merkel should embark as soon as possible on a spirited campaign to explain to the public the real costs and benefits of eurobonds, for both Germany and Europe, instead of insisting on her current course of narrow-minded -- and ultimately self-destructive -- economic nationalism.

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