After the burst of 2008 European Union came to know a big challenge: the sovereign debt crisis. Countries like Greece, Portugal and Spain revealed their structural weaknesses by leveraging way above the 2006 figures, as can be seen in graph 1, and the main concern of European leaders today is to bring these countries back to the sustainable path again and stem a bleeding Europe.
It wasn’t a long time ago when European countries could borrow money from financial markets more or less ate the same price but, once uncertainty emerged in the markets, investors start doubting on the ability of some countries to repay their loans. With rising levels of public debt along with persistent fiscal deficits and negative Balance of Payments, the southern countries, known as “PIGS”, suffered a raise in their borrowing costs (see graph 2) until markets shut the door to Greece and Portugal. Due to the loss of value of balance sheets with high exposure to these Governments’ debts the banking system resented and, despite the attempts to revert the course of the events, Euro lost strength against its main opponent, the US Dollar.
For the last year, ECB did magic with monetary policy and has been successful in tightening credit-default-swap spreads. The Euro has climbed and ECB’s bond buying plan seems to be perceived as the positioning of the Central Bank as of lender of last resort to EU Governments. But as The Economist recently wrote: “Mr Draghi’s magic is powerful, but it won’t work without help from the politicians.” Almost everyone’s speech, of the most influential personalities in Europe, is about the need for fiscal consolidation and so Europe relies its hope on the “European Fiscal Compact”, a stricter version of the “Stability and Growth Pact”, entering into force in January 2013. Christine Lagarde, Managing Director of the International Monetary Fund, adds that “The euro area also needs greater fiscal integration (…) To complement its fiscal compact, the area needs some form of fiscal risk-sharing. A number of financing options are to support such risk sharing, including the creation of euro area bonds”.
Eurobonds are also called Stability Bonds as they represent one of the potential solutions of the sovereign debt problem and liquidity constraints Euro-area member states are facing. The idea is that the more risky countries would borrow from the markets at lower interest rates benefiting from better ratings of stronger countries. However, the debate around this issue is enormous as it would potentially lead already highly indebted countries to incur in even more debt thus raising the borrowing costs of countries like Germany, Austria, Finland and Netherlands. So, Eurobonds could be serving the wrong purpose. To decrease the moral hazard Eurobonds could the issued at a decentralized national level instead, but it would still require a tight coordination and surveillance among the member states as it is Europe’s reputation at stake and we probably cannot afford another similar crisis.
If fiscal policy coordination turns out to be efficient in decreasing moral hazard, the creation of a jointly issued debt can turn Eurozone stronger and more competitive, and at the same time stabilize public finances of weaker countries. According to the European Commission, “Stability Bonds would make the Euro-area financial system more resilient to future adverse shocks”, which all countries would benefit from, even if in the short-run some might seem to lose. With all its pros and cons, once thing is for sure: if Eurobonds are to be implemented Europe will sooner or later need a political union.
Sofia Oliveira, #552
– GREEN PAPER on the feasibility of introducing Stability Bonds, European Commission, 2011