Toxic eurobonds that divide versus benign eurobonds that bind

So, a eurobond of sorts is now being issued by the EFSF (the European Financial Stability Facility), to the initial tune of a mere €5 billion, as part of the Irish banks’ bail-out. The public is, thus, justified to be puzzled by the headlines of Germany’s insistence that no eurobonds will be issued in the context of arresting the current euro crisis. So, what is going on? In short, the debate is not on whether the ‘centre’ should finance the periphery. Nor on whether eurobonds should or should not be issued.

  • Exhibit A: The ECB has already spent €96 billion supporting Greek banks, more than €130 billion on Ireland’s bankrupt banks, €120 billion on Spanish banks and a pitiful €50 billion on their Portuguese equivalents.
  • Exhibit B: The issue of the EFSF eurobonds mentioned above.

So, if Germany is not opposing the ECB’s expenditure of half a trillion euros supporting failed banks and, however grudgingly, is backing the issue of EFSF eurobonds to support the Irish state’s foolhardy attempt to salvage its banks’ shareholders, what is Germany opposing exactly? The answer is: The type of eurobond that binds eurozone’s  economies. While it has no qualms with eurobonds that divide, it is steadfastly opposed to eurobonds that unite.

A careful examination of the EFSF eurobonds shows not only that they are divisive but, also, that they are toxic (at least not less so than the financial instruments of mass destruction that brought us the Crash of 2008): Let’s start by noting that the liability of the €5 billion current issue will be shared by all N eurozone countries (not already in the EFSF) in proportion to their GDP. In principle, these N countries will each borrow a portion of the total and retain that slice of debt as its own.

Naturally, each will pay market interest rates depending on its own creditworthiness. The total amount will then be sliced up following the logic of a CDO into synthesised bonds, with each bond containing different slices of German, French, Belgian etc. debt. Note that each of these slices within the same bond carries its own, country-specific, risk. Just like the CDOs founded upon US subprime mortgages, so do the EFSF bonds are nothing less than replete with synthesised risk.

But what makes EFSF bonds even worse is that the structure of these eurobonds is heavily dependent on the underlying risk. Lest we forget the lessons of 2008, financial disasters strike when bankers and authorities neglect the effect of their instruments and trades on the solvency of the underlying assets in question. It is in this sense that EFSF’s eurobonds are, clearly, part of the euro crisis rather than a solution to it. To see this, consider the destructive dynamic inbuilt within the EFSF bonds: Suppose Portugal exits the markets, as it is bound to, and runs to the EFSF for loans. The EFSF will have to issue new debts, on behalf of the remaining eurozone countries. This means that, with Portugal out of that group, a greater burden will be shared by the N-1 countries remaining as pillars of the EFSF. This means that the markets will immediately focus on the new ‘marginal’ country: the one that is currently borrowing at the highest interest rates within the EFSF in order to loan the money to Portugal. Immediately, it’s own spreads vis a vis the German bond rates will rise until that country (Spain in all probability) is also pushed out of the markets. Then there will be N-2 countries left to borrow of EFSF’s behalf and the markets will focus on the newer ‘marginal’ country. And so on, until the band of nations within the EFSF is so small that they cannot bear the burden of total debt on their shoulders (even if they wish to). At that point, led by Germany, these remaining. solvent, states they will leave the euro.

In short, while the EFSF bonds may well be thought of as Eurobonds, as long as they synthesise debt without uniting it, they are a recipe for the euro’s destruction, as opposed to an instrument by which to arrest the euro crisis.

What is the alternative to these, in effect, toxic Eurobonds? Eurobonds that heal and unite, is the simple answer. Which means? It means Eurobonds issued directly by the ECB. Full stop. No splicing and slicing, no inbuilt domino effect, no sense in which the German taxpayer borrows on failed states’ and bankrupt banks’ behalf.

So, why does Germany insist on toxic Eurobonds that divide, instead of healthy Eurobonds that unite?

The official answer is that the solvent, surplus eurozone nations refuse to put their money is a joint account with profligates from Europe’s south. Only this is not a convincing reason. Our Modest Proposal, and the Juncker-Tremonti plan, proposes strict limits for ECB issued euro that are Maastricht-compliant. This limit on the size of the ECB-issued Eurobonds annuls the fear of an open ended joint account from which the Periphery can draw at will at the expense of the surplus countries. Germany’s refusal to engage at all with such proposals (coupled with its acquiescence to the current, huge levels of ECV support to bankrupt banks) reveals that the joint account allegory is just a smokescreen that conceals Germany’s true objection. And what is the underlying reason for this objection?

It is simply that Germany (and the other surplus states) have not decided on whether they want European unity or not. The question is not whether they want the German taxpayers to pay for Europe’s collective bill. The question is whether they continue to be interested in the very idea of a United Europe. Until they make their minds up, the eurozone will be stuck in a downward spiral of disintegration and stagnation. And the toxic Eurobonds will proliferate until a new Credit Crunch descends upon us.


  • Prof. Varoufakis,

    What do you think about the consultation paper to be published by Michel Barnier, the EC single market commissioner? It will recommend haircuts for EU bondholders.

    Is he completely oblivious to how bond investors will react to such a law, given their internal policies on credit risk? Does he want to permanently shrink the pool of eligible euro-zone bond investors? Your euro-bond idea may become a necessity if existing euro-zone debt becomes untouchable by most investors.

    • Dear Mark, I am as baffled as you are. It is hard to decipher his move. But then again, the idea seems to resonate with the provisions in the new European Financial Stability Mechanism (the permanent successor to the current EFSF) for pre-agreed haircuts with new investors in member states’ bonds. As you imply, haircuts across the board will kill off all remaining demand for bonds issued by peripheral eurozone states. I would not put it past them to have precisely this in mind. And then what? How does Spain roll its debt over? It will have no alternative but to seek loans from the EFSF or EFSB. But the latter are not sufficiently endowed to provide such loans. And this means, as you say, that either they will opt for something along the lines of our proposal or they will have to let the euro crash and burn. Could it all be a conspiracy to adopt … our proposal? I am damned if I know!

    • Is he misreading the strength of the current euro-zone macroeconomic data? Maybe he thinks that a window of opportunity exists to introduce harsh restructuring measures.

      Also, maybe he is repeating the mistakes of the United States in 2007. Policy makers did not understand the consequences of a deterioration in the credit quality of various asset classes.

    • Very possibly. Only he has even fewer excuses to do so that Paulson had in 2007 in the US. Reality is staring him in the face on a daily basis. Take Ireland. It did its utmost to restructure well before markets demanded restructuring. And where did this take Dublin? Into the steely bosom of the EFSF. As I said, I cannot even begin to imagine what he is up to. The only consolation is that with evert such step we come closer to some sort of catharsis…

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