Would Eurobonds be Enough?
George Soros writes a piece on Project Syndicate, that is both pedagogical and very clear in outlining a possible answer to the current EMU crisis. He starts with a diagnosis of the EMU imbalances that rejects the “Berlin View”, and argues for the existence of structural imbalances
Normally, developed countries never default, because they can always print money. But, by ceding that authority to an independent central bank, the eurozone’s members put themselves in the position of a developing country that has borrowed in foreign currency. Neither the authorities nor the markets recognized this prior to the crisis, attesting to the fallibility of both.
When the euro was introduced, the authorities actually declared member states’ government bonds to be riskless. Commercial banks could hold them without setting aside any capital reserves, and the European Central Bank (ECB) accepted them on equal terms at its discount window. This created a perverse incentive for commercial banks to buy the weaker governments’ debt in order to earn what eventually became just a few basis points, as interest-rate differentials converged to practically zero.
But interest-rate convergence caused economic divergence. The weaker countries enjoyed real-estate, consumption, and investment booms, while Germany, weighed down by the fiscal burden of reunification, had to adopt austerity and implement structural reforms. That was the origin of the euro crisis, but it was not recognized at the time – and is not properly understood even today.
Perfectly explained. Soros then goes on to explain why Eurobonds would be important in the current situation (in passing, he blames Germany for refusing to consider their introduction). While not necessarily implying transfers from rich to poor countries (that Germany fears like the plague), they would reduce the burden of debt on peripheral countries, without creating perverse incentives to free ride; furthermore, confidence and investment would return, thus allowing these countries to rip at least some benefits of the austerity that so far only caused unspeakable pain.
It is hard to disagree with Soros’ diagnosis, that I find accurate in explaining the causes of the crisis, and in identifying Eurobonds as an important tool for crisis resolution. I do believe nevertheless, that they are only part of the solution. Eurobonds should be accompanied by two additional measures.
- The first is a revision of the Treaty to allow the ECB to trade these bonds both in primary and secondary markets, so as to guarantee that they will be never defaulted upon. This function of lender of last resort has been cruelly missing in Europe, and as Soros points out, this de facto led EMU countries to borrow in foreign currencies. The OMT program has been very effective in defusing speculation, but the ECB had to tweak its mandate and to attach conditionality to it, thus limiting its scope in case of necessity (I discussed this risk the day after the program was announced). Let me add that abandoning the strict inflation mandate for a Fed-type double mandate would be a plus.
- The second element is what scares Germany, but is in my opinion necessary in any well functioning monetary union: a supranational transfer mechanism capable of at least partially shielding countries from asymmetric shocks. The Commission proposal for a euro-wide unemployment benefit, to be financed by a fund to which countries would contribute proportionally to their position on the cycle, would be a welcome first step in this direction. If well designed, such a tool would of course also imply zero net contribution for countries over the business cycle. As such it should be more acceptable to current creditors (that are, let’s not forget it, potential future debtors). A fully fledged European fiscal policy would of course remain a first best, but it would need to be accompanied by the transfer of sovereignty to the European level. This is not going to be in the cards for many years to come
To summarize, Eurobonds should be supplemented by a real lender of last resort, and by some sort of federal level transfer mechanism to dampen asymmetric shocks. That would embed the monetary union in a federation-like institutional framework, requiring very little additional transfer of sovereignty. A surrogate of the United States of Europe, waiting for the real thing to become more realistic.