Euro Bonds Are Not Enough: Eurozone Countries Need a Government Banker
The eurozone’s public finance crisis continues to fester, reflecting both political and intellectual failure. The intellectual failure is the crisis has been interpreted exclusively as a debt crisis when it is also a central bank design crisis resulting from the euro’s flawed architecture. The flaw is the inability of eurozone governments to harness the central bank’s power to assist government finances. This systemic weakness explains why U.S. and U.K. government bonds are weathering the storm, whereas Spain confronts default rumors despite having roughly similar debt and deficit profiles.
The euro solved the problem of exchange rate speculation by creating a single currency but in doing so made countries vulnerable to bond market speculation. That is because European Central Bank (ECB) support buying of member country bonds is prohibited under the “no bail-out” provision. This prohibition is appropriate as buying one country’s bonds would subsidize it relative to others. However, it means country governments lack access to central bank help to ward off speculative bond market attacks; to finance budget deficits; and to conduct quantitative easing (QE) programs of the sort conducted by the Federal Reserve and Bank of England.
One proposal to address the crisis is the idea of a “blue bond”. Countries would have the right to issue blue bonds up to sixty percent of their GDP that would be guaranteed collectively by euro member countries. This would significantly lower interest rates charged to troubled countries, helping them attain solvency. In effect, financially strong countries would de facto lend their creditworthiness to weak countries.
The blue bond proposal would undoubtedly help solve the current crisis. However, there are two problems. First, it relies on an implicit transfer from the strong who take on a guarantee liability but get nothing in return. That is a political non-starter. Second, it does not solve the structural problem of lack of a government banker. That leaves eurozone governments vulnerable to future crises, and it also maintains persistent market pressure on government finances that will ultimately destroy Europe’s social democratic project.
A second proposal is a “euro bond”. The ECB would issue euro bonds and countries could elect to have the ECB use the proceeds to buy their existing debt up to sixty percent of their GDP. Individual countries would then be responsible for their share of the interest on euro bonds. This proposal would also help solve the current crisis but it too has problems. First, perversely, higher income countries could transfer relatively more debt under the sixty percent of GDP rule. Second, and more importantly, it too fails to address the government banker problem.
I have advanced a third proposal that solves both the debt crisis and government banker problems. Stage one would have eurozone countries establish a European Public Finance Authority (EPFA) that would be governed by member countries, with votes allocated on a per capita basis. EPFA would then issue bonds that the ECB can buy and sell through standard open-market operations. These bonds would be collectively guaranteed and countries would cover EPFA’s interest on a per capita basis. Bond proceeds would be used to buy existing country debt, again on a per capita basis. Countries with low levels of existing debt (like debt-free Luxembourg) would simply receive their share of EPFA proceeds as cash and they could buy EPFA bonds to cover their EPFA interest obligation. This debt swap would solve the debt crisis; create conditions for the ECB to engage in open-market operations to manage government bond interest rates; and create conditions for QE policies.
Stage two would have EPFA annually issuing new bonds to help finance government budget deficits. The amount issued would be democratically decided by EPFA’s governing council, presumably acting on instructions from national governments. New issue proceeds would be deposited with governments to spend as they wish. Those wishing to run surpluses could retire debt or create a sovereign wealth fund. Three features are important. First, EPFA would never spend money and all spending would be determined by governments. Second, the ECB could assist budget financing by managing bond interest rates just as the Federal Reserve and Bank of England do. Third, the eurozone would have a democratic financial union but no fiscal transfer union.
The critical feature is EPFA bonds have no taint of “national identity”, enabling the ECB to trade them without violating its “no bail-out” clause. Moreover, there are no financial transfers between countries and the per capita rule means all countries are treated equally.
The EPFA proposal solves both the debt crisis and government banker problem, and it does so without imposing unfunded obligations or unilateral transfers on any country. It therefore meets all German objections. Moreover, the EPFA proposal creates the financial space for eurozone countries to grow and continue with their social democratic projects should voters choose. This makes it more democratic than existing arrangements which impose financial constraints that restrict space for democratically determined social and economic policy.
This article was originally published in the FT Economists’ Forum on August 31, 2011. It has been corrected for an earlier error about the interest costs to the ECB of the euro bond scheme.
Copyright Thomas I. Palley