The Case for Eurobonds

The current economic situation is challenging because it is bringing issues to the fore that are outside the range of experience of the present generation of politicians as well as of recent generations of leaders.

One would have to go back to the 1930s to find politicians who actually had real-life experience with the sort of problems we face today.

In the 1930s, three conditions were present:

• There was a collapse of confidence in — and between — banks, which paralyzed the economy.
• There was a gold standard (currencies had a fixed exchange rate with gold, and the supply of gold was limited). This, like the euro, precluded countries from devaluing currencies or printing money as ways of inflating away debts — and thus making savers pay for the mistakes of debtors.
• There was also a slowdown in the rate at which people spent money (“velocity” is the economic term for this), and that meant there was less bang for each buck that was printed.All of these things are happening today, 80 years later.

  The advantage of the gold standard was that it provided a fixed measure of value. And a banking system needs a fixed measure of value, which each bank can hold as capital, and which provides it with a guide as to how much it can lend.

  Since 1971, when the United States ceased to exchange dollars for gold at a fixed rate of exchange, the world has lacked a fixed measure of value upon which to found its banking systems. It has had to improvise.

  In the absence of gold, sovereign debts of wealthy governments were pushed into assuming gold’s role as a fixed measure of value, on the assumption that governments always repay their debts at face value — and if a bank holds enough government bonds it is thus, by definition, a sound bank.

  The difficulty was that, unlike gold, there is no natural limit on the amount of government debt. Indeed, the United States, and other governments, issued large amounts of debt to investors, like the Japanese and Chinese, who wanted to save for a rainy day — and who were prepared to buy the debt at prices that were ridiculously favorable to the issuer.

  That, in turn, led to an over-expansion of the United States and other western economies on the basis of credit fueled by an oversupply of government bonds — and a consequent, artificially inflated, capital base of western banks.

  More recently, the very clever people in the bond markets have discovered, to their apparent amazement, that government bonds are not as good as gold after all. If you have too much of a good thing, it ceases to be good.

  Here is how their eyes were opened.

  The Greek government produced deceptive public accounts to allow them to issue more debt than they can afford to service. Governments generally, and many businesses, simply borrowed too much, at artificially low interest rates. Some, like Italy, got comfortable with unsustainably high debts because interest rates charged were so low. Others, like Ireland, expanded services permanently on the basis of tax revenues that were inherently temporary and volatile.

  Then, the majority party in the U.S. House of Representatives threatened, deliberately and unnecessarily, to default on government debts just to make a political point. This led to a downgrade in the rating of U.S. Treasury bills, because it revealed that U.S. credit was vulnerable to the weaknesses in the design of U.S. political institutions and to an adamant refusal by politicians to face fiscal realities.

  Suddenly, the basis for confidence in the entire financial system, the notion that government bonds were as reliable as gold, appeared to be inherently unreliable. The underpinning of the system, which had survived since 1971, appeared vulnerable.

  The fact that none of the highly educated people in the rating agencies, the banks and the accounting firms saw the risk of such errors happening (and thus did not adjust their interest rates accordingly) was a result of the “tunnel vision” specialization that passes for economic and financial education in some leading universities nowadays.

  Economics focused insufficiently on economic history, and finance was taught as if it were a branch of mathematical engineering rather than something influenced profoundly by psychology and politics.

  This critique is fine as far as it goes. But is there a solution?

  I think we will only get our economies going again if we can restore belief in a fixed measure of value that will provide a capital base for banks — the role that gold performed in the past and which the sovereign bonds of wealthy countries did until recently.

  That is where the proposal for a eurobond could be helpful. It is not a short-term fix, but it could fill the gap left by the loss of confidence in government bonds generally. It might work as follows.

  All 17 euro area governments could agree that they would all mutually guarantee the repayment of a new collective eurobond, and that in addition, it would have first call on, say, a fixed share of all VAT receipts.

  They might also agree that, while no euro area country would be obliged to issue eurobonds, it could do so provided three conditions were met:

• That its budget law, and five-year projections, had been approved in advance by the European Commission, and
• the eurobond could only be issued to cover a limited proportion of its total borrowing, as long as its overall debt/GDP ratio was more than, say, 60%, and
• the eurobond issued by a country would have seniority over any other bonds it might issue.This would have a number of advantages.

  It would guarantee a minimum borrowing capacity to all euro area states. Because of the collective guarantee, the interest rate on the euro bond would be less than that on most national bonds.

  It would, however, penalize countries for allowing their debt/GDP ratios to be over 60% of annual GDP, because they would be forced to borrow commercially and pay higher rates of interest on the extra borrowing above that figure. This would be a strong incentive to them to reduce their debt level as quickly as possible to 60% or below. That would be a much better disciplining mechanism than retrospective fines, which are the form of discipline the EU now supposedly relies on.

  Because it would be guaranteed by all euro area governments, and have a prior call on VAT receipts, the new eurobond would have real credibility globally, as well as within the EU. It would probably have more credibility than U.S. Treasuries because it would be guaranteed by 17 governments, whereas U.S. Treasuries only can call on the tax base of one country, whose majority party in the House adamantly refuses to raise taxes under any circumstances.

  Banks that held such new eurobonds would have something of real and certain value in their capital base, on the strength of which they could confidently base their lending decisions. In that way, credit would start flowing again, jobs would be created and permanent structural damage to our economies avoided.

  However, some will argue that Germany, and other countries with good credit ratings, would find it difficult to agree to eurobonds because they would involve an exposure for their taxpayers. But the conditions are so strict that this is a minimal risk.

  The advantages outweigh the risks in that eurobonds provide a workable way to use markets, rather than just administrative measures, to incentivize countries to get their finances in order, and also provide a new solid base for the recapitalization of banks.

  Others may argue that the proposed conditions are so strict that the eurobonds will not be attractive to countries in difficulty. That might be the case if such countries thought that bailouts would be indefinitely available on easy terms. But that is clearly not going to be the case. That being so, eurobonds become attractive, notwithstanding the conditions imposed.

  In short, eurobonds would help Europe to provide part of the world’s economic solution — rather than being the world’s economic problem.