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Eurobonds: Not a question of ‘whether’ but one of ‘who will issue them’ and ‘who will back them’

05/09/2011

by Yanis Varoufakis and Stuart Holland

Ever since the Crisis erupted, Europe’s leaders have reacted to the suggestion that eurobonds are sine qua non with a familiar repertoire of responses. First came denial of the need for eurobonds, coupled with a snub for those who proposed them. More recently, we witnessed depression at the realisation that all other means have failed to stem the Crisis. Now, as the powers-that-be realise that the idea of eurobonds is winning ground (even within their hitherto loyal commentariate), they adopt subterfuge: they are creating a straw eurobond so as to knock it down. Will this tactic delay the final stage (of acceptance) so much that it will be too late to save the eurozone (as Wolfgang Munchhau fears)? It may well come to that. In a bid to prevent such a calamity, we are hereby clarifying precisely the kind of eurobond that can help the eurozone overcome the Crisis.

The current EFSF-issued eurobonds

Unbeknownst to most, eurobonds already exist. The bonds issued by the European Financial Stability Fund (EFSF) to fund the Irish and Portuguese bailouts are precisely that: eurobonds. The reason why they are not referred to as eurobonds is that each one of them consists of slices of debt each backed by one member-state (each slice having a size that is proportional to the corresponding member-state’s national income). In this sense, the EFSF bonds are structured in a manner that maintains, as much as possible, the facade of bilateral loans: each creditor member-state has guaranteed a slice of a loan for a particular debtor member-state.

Elsewhere, we have explained why this bond structure is toxic, why the facade of the bilateral loans is but a facade[1] and, lastly, how embedded in this bond structure is the dynamic of the chain reaction which threatens the eurozone with a major implosion. Because of this negative dynamic, some have (erroneously) suggested that the EFSF bonds need to become ‘proper’ eurobonds by eliminating the different slices within each bond; by moving to another arrangement whereby all member states guarantee jointly the whole bond.

The wrong eurobonds

Opponents of eurobonds scream blue murder at the idea of jointly backed EFSF-issued eurobonds, remonstrating that such an arrangement would lead to interest rates that are too high for the surplus countries and not low enough for the deficit ones. We submit that they are quite right to scream blue murder at this suggestion. Such eurobonds would be unhelpful and potentially as poisonous as the current heterogeneous CDO-like EFSF-bonds.

Only the other day Moritz Kraemer, managing director of EMEA sovereign ratings, had this to say (according to Reuter’s): If the eurozone is to band together and issue common debt, with each member-state guaranteeing its own bit, then the resulting eurobond would resemble a chain whose creditworthiness would be the same as that of its weakest link. Here are his precise words: “If the euro bond is structured like this and we have public criteria out there then the answer is very simple. If we have a euro bond where Germany guarantees 27 percent, France 20 and Greece 2 percent then the rating of the euro bond would be CC, which is the rating of Greece.”

Mr Kraemer is spot on. If this is how our new eurobonds are to be structured, we deserve all the trouble that we shall get  into. Of course, there is no reason why they ought to be structured that way. Consider, for instance, a small amendment: For example, the new EFSF eurobonds may be both jointly issued and severally backed. This means that each member-state is responsible for all the debt; not just for its ‘bit’. To give a simple parallel, consider a group of five students that rent a flat. If the rental agreement says that each student will be responsible only for her share of the rent, then the landlord truly has reason to fear that the probability that the rent will be fully paid each month is a function of the creditworthiness of the most impecunious of the five renters. But, if the rental agreement specifies that each of the five students is to be held responsible for any shortfall in the monthly rental payments, then things are quite different and the landlord can sleep more easily at night. In this case, the landlord’s rental income security will edge closer to some weighted average of the five students’ capacity to pay (as opposed to being equal to the financial capacity of the poorest of the five students).

In short, if the EFSF is to offer jointly issued and backed eurobonds, the result will be a disaster and the new bonds will be reduced to junk bonds even before they hit the markets. If, on the other hand, they are jointly issued and severally backed, then the interest rates will be closer to that of the AAA-rated member-states albeit not close enough. Thus, if this is the type of eurobond we can have, it is a bad idea to push for them. Alas, both types of eurobond discussed in this section are different versions of the straw eurobond that Mrs Merkel and opponents of a rational resolution to the euro crisis are parading around only to knock it back triumphantly.

The right eurobond: ECB-issued and backed

Readers of this blog, especially those familiar with our Modest Proposal for Overcoming the Euro Crisis, will not be surprised by our suggestion (which we have been making for some time now) that eurobonds must be issued and backed by the ECB. Period. They must not be backed by member-states. They should not be issued by the EFSF. They ought to involve no organisation other than the ECB which will, in a revenue-neutral manner, use the funds it borrows through the issue of its own eurobonds in order to service the Maastricht-compliant debt of all eurozone members who wish to participate in this overall debt reduction scheme. Under this scheme, first put forward by our Modest Proposal, the interest rates that the ECB will be able to fetch at the money markets will be at or even below that of Germany’s bunds and, to boot, will have no impact on the interest rates at which Germany and the surplus countries will be able to issue new debt.

Since we have explained fully this proposal a year or so ago, as part of our Modest Proposal, we shall not repeat our arguments here. Readers may read our justification of the claims made above arguments HERE and HERE and HEREWhat we shall, however, do below is (a) answer some practical questions put to us by a reader (regarding the transfer of the Maastricht-compliant debt to the ECB, by means of the ECB-issued eurobond) and (b) comment on a recent proposal by Tom Palley (featured in a Financial Times Op-Ed).

Two questions on our Modest Proposal’s eurobond mechanism (see our Policy 1)

Here we try to answer two excellent questions put to us by reader Migeruet  regarding the mechanics of the transfer of the Maastricht-compliant debt to the ECB. Readers not familiar with the Modest Proposal and related arguments are advised to read up on them before proceeding.

Question 1: Given that when a bond is transferred to the ECB, as part of the transfer of the Maastricht-compliant debt to the ECB, it remains an asset of the original bondholder, and that there may be other financial intermediaries involved (such as a bond broker holding and servicing the bond for a non-financial-institution investor), what prevents the bond from being traded in the secondary market? And, if the bond is no longer tradeable in the secondary market, does it not become an illiquid asset which causes a number of problems?

Our response: The asset remains that of the original bondholder but, according to our Modest Proposal, is now is in an untraded ECB debit account – unlike the Breugel proposal for a European debt agency. The point of it becoming an illiquid asset is to address and avoid the central problem of market volatility which threatens defaults and risk for both governments and bondholders. This thereby protects bondholders from a financial meltdown against which they cannot individually protect themselves. There is mutual advantage as the bond transfer to the ECB (that is financed by means of ECB-issued eurobonds) would make the original bondholder more secure.

Question 2: How does the debit account of, say, the Italian Treasury with the ECB, to which the ECB would debit the bond service payments giving Italy time to pay back, not constitute an “overdraft facility” or at least be construed as a “credit facility” in violation of Article 123 of the Treaty on the Functioning of the European Union?

Our Response: The ECB would not be offering either an overdraft facility or net credit on the debit account. This is easy to understand once one grasps the difference between a debit and a credit card. Just like an individual cannot overdraw on a debit card, under our Modest Proposal member-states cannot overdraw on their debit account with the ECB. Note also the relevance of the distinction between stocks and flows. We are not proposing overdraft facilities with the European Central Bank (for this would be a ‘flow’) but a transfer of debt to it (a ‘stock’).  Nor are we proposing “the purchase directly… by the European Central Bank or national central banks of debt instruments”. Our Modest Proposal merely recommends a debt conversion without any debt purchase. This policy was not anticipated by the Maastricht or other Treaties but, by the same token, it is not constrained by Article 123 of the Lisbon Treaty.

Thomas Palley’s Proposal

Thomas Palley has put forward (see here) an interesting alternative to our Modest Proposal. Here is a summary of what he proposes:

  1. The eurozone establishes a European Public Finance Authority (EPFA) to  be governed by member-countries, with votes allocated on a per capita basis. The EPFA would then issue eurobonds jointly and severally guaranteed by member-states who would cover the EPFA’s interest on a per capita basis. In other words, the total interest would be serviced by each member-state in proportion to its population size – not is creditworthiness.
  2. The ECB buys the EPFA’s bonds and then trades them through standard open-market operations. The money raised by the EPFA is then used to buy existing member-state debt, again on a per capita basis. The idea here is that low debt countries (Palley gives the example of Luxembourg) will receive their share of EPFA funds as cash and they could buy EPFA bonds to cover their contribution to the EPFA’s interest obligations.
  3. The EPFA issues new eurobonds each year on behalf of member-states in deficit. How much funding will each deficit member-state get? This, Palley argues, can be decided democratically by EPFA’s governing council in accordance to the EPFA’s statute. “Member-states that manage to go into surplus could use the new funds to retire debt or create a sovereign wealth fund.”

On the positive side of Palley’s proposal, it highlights the importance of enabling the ECB to manage bond interest rates by means other than the current utterly unfunded (and thus controversial) bond purchasing scheme. Additionally, his proposal shows that it is possible to unite the eurozone financially without creating a fiscal union (since, under this scheme, there will be no unfunded financial transfers from/to any member-state).

On the negative side, however, Palley’s proposal fails the test of Ockham’s Razor: It is our view that Policy 1 of our Modest Proposal offers a much simpler, less politically controversial, more efficient solution: Enable the ECB to issue its own bonds not in order to buy member-state bonds but to finance the servicing of these bonds up to the Maastricht-compliant level (of 60% of GDP).[2]

More precisely, our first criticism of Thomas Palley’s interesting and helpful proposal is that the creation of the EPFA undoubtedly requires Treaty Changes which will never come about before the euro has collapsed. Additionally, the very notion of making the ECB pay for these EPFA-issued bonds at rates considerably higher than the yields of German bonds (for reasons already explained above), in order to buy back the debt of the deficit countries, will prove not only politically unpalatable but also financially ineffective (courtesy of the interest rates of the EFPA’s bonds being significantly above Germany’s bunds). Lastly, if these EPFA bonds receive only a moderate credit rating (as they surely will), how and by which means can the ECB be instructed to purchase them (please note the difference between being given the right to purchase them and being instructed to buy them)?

Which brings us to Ockham’s Razor, the principle that, when faced with competing hypotheses or alternatives, one ought to favour the candidate which comes with the fewest new assumptions. Our Modest Proposal demands one main assumption: That the ECB’s reputation will be enhanced (or at least remain intact) in the money markets if it stops its unfunded bond purchases and, instead, issues eurobonds whose intertemporal servicing it passes on to member-states (through suitable debit accounts). In contrast, Thomas Palley’s proposal requires three new assumptions: (1) That the EFPA (and in particular its democratic governance structure) can be instituted before the euro crisis brings the euro down; (2) That the ECB can be forced to buy the EFPA’s eurobonds (whose credit rating will be perpetually insecure for reasons that Mrs Merkel will be only too happy to point out).

Conclusion

To conclude, there seems to us only one way in which the euro debt crisis can be resolved: The ECB must issue its own eurobonds in order to fund the servicing of the Maastricht compliant debt while, at the same time, it debits the member-states for the full intertemporal cost of this conversion loan (to be paid in the fullness of time and at interest rates slightly higher than the rock bottom yields of the ECB’s eurobonds).


[1] The reason this is a facade is that as one  member-state after another moves from the group of creditor to the group of debtor member-states, the bilateral loan structure breaks down badly.

[2] It is clear to us that Thomas Palley has not considered the possibility of the ECB issuing bonds not in order to buy back bonds but, rather, in order to service bonds (up to the Maastricht-compliant level). We say this because in his FT Op-Ed he presents his scheme as an alternative to: (a) one in which the eurobonds are jointly and severally issued by something like the EFSF (a policy we have already rejected as a non-starter above) and (b) to another in which the ECB issues eurobonds in order to buy the bonds of member-states. The Modest Proposal, in sharp contrast, has been suggesting for a year now that the ECB-issued eurobonds should NOT be used in order to buy back debt and, instead, to service it. The difference is  gigantic. Had

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