The sovereign debt crisis in the euro zone has shaken bond markets everywhere. At their latest meeting in Brussels, euro zone governments strengthened their commitment to central bank support for the bonds of member states that come under siege. This monetary solidarity is useful, but some degree of fiscal unity is also needed. The core point of disagreement among governments is how far to go toward making euro bonds a sovereign responsibility of the currency union itself and how to enforce fiscal discipline on individual nations if bonds become a joint responsibility.
The following plan pushes individual nations toward fiscal prudence and reduces the risk that shocks destabilize euro bond markets in the future. It does so by strengthening the impact of market forces in non-crisis times rather than relying on rigid rules and penalties, which are likely to be clumsy at best and onerous across sovereign states. The plan also aids the transition from the present crisis and moves gradually toward a limited form of fiscal unity for the euro zone.
The proposal creates a two tier framework for sovereign borrowing. The first tier consists of bonds issued to cover annual deficits up to some specified size limit—say 2 percent of a nation’s GDP (and to roll over maturing bonds of this tier). Such a percentage is sustainable in the long run and consistent with steady or declining ratios of debt to GDP. Call these Eurobonds. Any borrowing above this limit must be done by issuing second tier bonds. Call them national bonds. The euro bonds are the responsibility of the borrowing nation but backed by the currency union and issued by its bond authority. The national bonds are conventional, backed and issued by individual nations.
Some analysts and politicians have suggested a different kind of two tier system based on ratios of bonds outstanding to GDP. When the ratio is above a specified limit, bonds carry a risk premium. However at present this ratio ranges widely, from over 130 percent to under 30 percent. There is no reasonable starting point and little guidance on what level is optimal. For any chosen target, there is little if any incentive for countries so far above it that attainment is many years away, and no incentive for countries already below it.
The large incentive effects of the plan presented here are present in each annual budget cycle. With euro bonds senior to national bonds in the conventional sense, a lending nation under duress would suspend payments on national bonds and renegotiate them if necessary before suspending payments on euro bonds which, in any case, would have the backing of the euro authority. With some debt consisting of euro bonds, any prospective risk of nonpayment would now be born entirely by the smaller number of national bonds outstanding, so the loss to each national bond would be greater. The interest differential between euro and national bonds is correspondingly widened, increasing the incentive to reduce deficits.
These economic incentives will be buttressed by political effects that may be even more potent. With only conventional national bonds, there is little evidence of how much is being charged for incremental borrowing. In the new framework, the marginal cost of incremental borrowing will be clear and conspicuous for each nation.
The 2 percent limit on national borrowing is in the useful range for the longer run once economic conditions are more normal. Deficits of that size would be sustainable and would gradually reduce debt to GDP ratios in most countries. In the mid-2000s, most small euro nations were near budget balance, with Greece and Cyprus conspicuous exceptions. Germany, France and Italy had deficits in the 3 to 4 percent range and Spain, Belgium, the Netherlands and Ireland were all near balanced budgets. Today deficits across the euro area average 6.5 percent.
Because of present economic and bond market conditions in the euro zone, incentives to reduce deficits are already compelling. So the size limit could start higher, say at 4 or 5 percent, and decline over several years to the eventual 2 percent. Countries now confront high borrowing costs because markets question their ability to meet interest payments. By financing part of any new debt with euro bonds the proposed system would immediately reduce interest costs and lower the risk of nonpayment. Though euro bonds are initially a very small part of the total, the effects would be considerable, reflecting all future benefits of the dual tier framework.
The introduction of the new framework need not favor troubled economies over more stable ones. Member nations whose deficits would not otherwise reach their limit on euro bond issuance could do so by using euro bonds to retire outstanding national bonds. And since Eurobonds only gradually become a feature of the currency union, the benefits of this modest degree of fiscal union are achieved without politically divisive fiscal cost.