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Conditional Euro T-Bills as a transitional regime



The Special proposes a temporary programme of short-term Eurobonds (Euro T-Bills). We argue that a temporary regime of conditional Eurobonds, if well designed, can create long-term stability and present policymakers with the right incentives. The system would offer benefits to all participating countries and the ECB would be able to once again focus entirely on the execution of monetary policy.

Appeared as part of SUERF Study 2013/2: States, Banks and the Financing of the Economy: Fiscal Policy and Sovereign Risk Perspectives, June 11, 2013.

Introduction and summary

Since early 2010, tensions within the Eurozone have risen sharply. What started with a Greek confession that both projections for and past realizations of government debt and deficit statistics were blatantly off the mark, developed into a Euro crisis of systemic proportions. The driving force has predominantly been a lack of resolve of Eurozone leaders to stand firm for the Economic and Monetary Union and provide a blanket guarantee for all the sovereign debts of its members. Hence each individual rescue package was received with caution, providing only a patch for the ultimate solution and ] hence only temporary relief in financial markets.

In a floating exchange rate regime, the weaker members of the union would have experienced a currency crisis, with the resulting collapse of the currency providing much of the desired boost to export price competiveness to rebalance their economies and current accounts. In the euro straitjacket that is the one outcome that is impossible. And thus government bond markets acted as the natural pressure valves, with speculators adding insult to injury by exploiting these institutional fault lines. As a result sovereign bond yields have risen sharply for the weaker members of the currency union and fallen to extremely low levels for its stronger members.

Naturally, the discussion about Eurobonds once again found its way to the top of the European political agenda. Their introduction would remove the fault lines and bring the Economic and Monetary Union a major step closer to completion. The problem is that the generic term ‘Eurobonds’ conceals a multitude of variations. Some (e.g. Mario Monti) see the issuing of Eurobonds as an instrument to stabilize the EMU. Others (e.g. François Hollande) would want to use Eurobonds to boost economic growth. Others still (e.g. Angela Merkel) mainly consider Eurobonds as a measure which would undermine discipline in weaker countries and which will push up interest rates sharply for strong member states. It is for this reason that German and Dutch political actors in particular are entirely opposed to the use of Eurobonds other than as a closing piece of crisis resolution. It is unfortunate that this discussion is generally not very analytical in nature.

Rarely is the question raised of whether it might be possible to design a Eurobond system in such a way as to boost stability and increase budgetary discipline while also offering tangible benefits to the financially stronger states. After all, everything depends on the way a Eurobond programme is shaped.

Building on the work of Boonstra [1] (2011-a, 2011-b, 2012), this article proposes a temporary programme of short-term Eurobonds (Euro T-Bills). This idea was launched by the European League for Economic Cooperation (ELEC) and was presented in draft form to the Commission in November 2011, and in its definitive form in January 2012 (Bishop et al. 2011, 2012). The idea is a reaction to the ‘green paper’ on the topic published by the European Commission (EC 2011). We argue that a temporary regime of conditional Eurobonds, if well designed, can create long-term stability and present policymakers with the right incentives. The system would offer benefits to all participating countries and the ECB would be able to once again focus entirely on the execution of monetary policy.

Why do we need Eurobonds?

The crisis cannot be resolved by the efforts of individual member states

In late 2009 it came out that Greece had provided incorrect information about its government finances. In early 2010, German finance minister Wolfgang Schäuble suggested that this meant the Greeks would need to leave the Eurozone. This triggered a process of monetary disintegration within the Eurozone. Capital flight from the supposedly weaker countries to those in a stronger position put great pressure on the Economic and Monetary Union. Despite several European summits, during which meaningful steps were taken to strengthen European governance, the problems are not over yet until the Eurozone also features a credible and readily deployable crisis mechanism [2].

By now, most countries in Southern Europe have seen new governments come to power which are expected to start up a credible process of reforms and restructuring. Nonetheless, they still have a long way to go before public finances will have been put sufficiently into order. Countries like Spain and Italy which, although facing major challenges with their public finances, ought to be able to overcome their current challenges unsupported by the other Eurozone countries. However, they are falling prey to market sentiment which risk them suffering from a liquidity crisis that turns into a solvency crisis. This illustrates the unintended fault lines along the boundaries of national sovereign bond markets that were created in the design of the euro.

On average, the government finances of EMU member states compare favorably from an international perspective (figure 1). Moreover, the current account of the Eurozone balance of payments is more or less balanced. Therefore the EMU as a whole does not suffer from any significant savings deficit. Inasmuch as the EMU has a financial problem at all, in theory it should be able to solve this with its own means. What is clear, however, is that this externally balanced situation conceals significant differences between countries within the EMU.

Figure 1: Public finances in an international perspective
Figure 1: Public finances in an international perspectiveSource: IMF, Reuters EcoWin, Rabobank

Figure 1 shows that within the EMU the spread in government deficits and debts is considerable. The EMU contains a number of states with very weak government finances. The US does that, too, in fact. But in contrast to the US, the EMU does not have full political and economic union. There is no overarching budgetary policy, the member states’ individual labor markets remain heavily segmented along national lines and the relative national debt and surplus positions are still sensitive subjects. Within the EMU, therefore, it is not the average quality of government finances that matters; instead, the weakest links have a disproportionately large effect on the EMU’s overall strength. For as long as this remains the case, which is moreover associated with fragmented bond markets and the absence of cross-guarantees, the EMU will not be able to extract itself from the danger zone. After all, financial markets have free rein within the Eurozone and they may cause imbalances to spiral out of control to such an extent as to risk tearing the Eurozone apart altogether. The Greek crisis has shown that even a small country (2.3% of EMU GDP in 2011) that finds itself in trouble can wreak havoc for the entire Eurozone. The fragmentation of bond markets means financial markets have the possibility of speculating against the continued existence of the Eurozone. This fragmentation is the Eurozone’s most important design flaw.

The crisis needs a collective Eurozone effort

We are in need of a collective Eurozone effort first and foremost because we cannot risk letting the European integration project fail. For one because the economic fallout is probably going to generate a prolonged depression on the continent. Moreover, this will at best result in a structural setback in the functioning of the single market, though more likely put that process firmly into reverse.

Of course, a collective solution may involve the ECB purchasing unlimited amounts of sovereign debt of Eurozone member states. At the start of the year, financial markets had temporarily been put at ease, in large part due to the European Central Bank (ECB). Its Securities Markets Program (SMP) allowed it to temporarily prevent interest rates for sovereign bonds in weaker member states from rising to unsustainably high levels. With the Long Term Refinancing Operation (LTRO), started in December 2011, the ECB has moved to issuing longterm (three year) liquidity to the banking sector. Through these actions it was able to assuage the worst stress in the markets, and buy politicians some time to implement the agreed measures. Fundamentally, however, nothing changed and over the summer of 2012 the ECB was forced to move to bolder action and announced its OMT (Outright Monetary Transactions, September 6, 2012), in which it pledges to buy potentially unlimited amounts of short denominations of Eurozone sovereign bonds if the relevant sovereign has agreed to a Memorandum of Understanding (MoU) with its Eurozone partners and receives financial support from the ESM. Politicians have been bought yet more time to implement their permanent crisis solution. If the fragile sentiment on the financial markets turns negative again, however, as it did during spring 2012, there is a possibility that policymakers would not even have the time to convert their plans into policy.

A collective solution must have democratic legitimacy

Not only may ECB actions restore confidence only temporary, ECB solutions effectively mutualize debts without the consent of the national constituencies. Eurozone leaders may actually prefer this solution as it is more palatable to them in short-term political terms. In the longer run however, the widening of the democratic deficit – the distance between the degree of European solutions relative to what national constituencies prefer – may come back to haunt their successors in the pursuit of the European cause.

Eurobonds provide a collective European solution wherein the mutualization of the debts of Eurozone countries is highly transparent. The challenge is to design then in such a manner as to be acceptable to the populations at large.

Within European policy circles, a majority is emerging in support of Eurobonds as a tool to resolve the crisis. The problem with this, however, is that there has been a lot of noise around the topic for a number of years now, which has confused the issue. Our argument is that the introduction of effective Eurobonds can restore calm to the financial markets without introducing moral hazard. First, however, a definition is required of what makes Eurobonds effective Eurobonds.

The Eurobonds debate

Eurobonds are bonds issued by a central European agency in order to finance the participating member states’ national debt [3]. Although the first proposals to introduce Eurobonds can be traced back to 1989, the debate has only switched to a higher gear since 2009 (Eijffinger, 2011). Eurobonds are also known as Stability Bonds (EC, 2011) or EMU Bonds (Boonstra, 1989, 1991; Bishop et al., 2011). They allow weaker member states to access funding for their sovereign debts at lower interest rates than the current market rates. Nonetheless, this carries the risk of removing a powerful external incentive for the countries in question to improve their fiscal policy. Because of this perceived moral hazard, the use of Eurobonds has so far been rejected outright by Germany and the Netherlands. However, in the 1999 to mid-2008 period, the financial markets actually barely differentiated at all between strong and weak member states (figure 2). Therefore such an external incentive was in fact absent for a long time in any case. This meant policymakers were not being disciplined, harmful developments both in the realm of government finances and in the real economy were allowed to flourish, and the situation in a number of states became badly unhinged. The idea that strong euro countries are consistently rewarded with low interest rates therefore rests on a false impression of economic reality.

Figure 2: Eurozone interest rates differentials
Figure 2: Eurozone interest rates differentialsSource: Reuters EcoWin

Only after the collapse of the American investment bank Lehman Brothers did markets start to factor in differences in risk. After the Greek troubles started in the autumn of 2009, these differences became increasingly apparent. Therefore it was only in times of crisis that financially stronger states enjoyed more advantageous funding compared to weaker states. However, this advantage has been cancelled out almost entirely by the cost of the bailout packages, losses incurred on government bonds issued by problem countries and the costs of the recession in Southern Europe, which has impacted on the northern countries too.

Given the hesitant response to the crisis and the tensions on financial markets, it remains to be seen whether policymakers will be given the time to adjust policies in the right direction. A well designed system of Eurobonds could help to rein in financial markets. The problem is, politicians are quick to adopt outspoken positions in the debate surrounding Eurobonds (whether for or against) without first asking questions such as: what do we want to achieve by introducing Eurobonds? Is this feasible, and if so, under what conditions? This failure to analyze the situation is regrettable, because the common term ‘Eurobonds’ hides a multitude of proposals with significant differences between them.

Criteria for Eurobonds

We are personally of the opinion that before adopting a position regarding Eurobonds, the question should be asked which criteria these should meet and what the intended outcome would be. This involves the following points:

1. Generate benefits for all countries, weak and strong alike.

Any Eurobond program should produce noticeable benefits for all participating states, i.e. it should not just help the weaker member states, but also offer advantages for the stronger ones. Only if this is the case will Eurobonds enjoy broad political support. The benefits for the weaker member states will be clear from the subsequent criteria. As a tangible benefit for the stronger member states, the design should aim to create a sufficiently deep and liquid Eurobond market such that a sufficiently large liquidity premium may be expected.

2. Guarantee all counties access to funds at reasonable terms, yet at the same time embed strong incentives for fiscal discipline and limit moral hazard to a minimum.

If it wants to be successful in neutralizing the (speculative) threat of financial markets, the Eurobond program should produce the effect that all countries be given access to funding at all times under reasonable conditions. However, having taken away the disciplining effect of financial market pressure – even if only in place during crises – a Eurobond program should reinstall a disciplining mechanism on policymakers; it should strongly discourage moral hazard but rather increase budgetary discipline where possible.

The funding guarantee can best be given if the program operates under a joint-and-several guarantee. A solution to the problem of moral hazard might be found in the use of ‘Conditional Eurobonds’ (Muellbauer, 2011). These would reduce moral hazard through an internal allocation mechanism, with which states would finance their sovereign debt through a central agency, but they would pay this agency a premium on top of the agency’s funding costs, depending on the quality of their government finances. This would provide the right incentives because good policy would soon translate into reduced premiums and vice versa. These premiums could be used to build up central buffers and to address any disappointing results. And ultimately, if countries continue to fail to address required budgetary and economic reforms, they should be able to be ejected from the program.

3. Contain a time-consistent exit-threat.

A regime would preferably be self-funding, so that any possible problems in the future might be addressed without having to bother the stronger member states with them (Boonstra, 2011-b, 2012). A pre-funded resolution fund would help here, as it takes away the political haggling over who picks up what part of the bill. Recall that quite a number of Northern European politicians have voiced their desire to make / let Greece exit the euro, but the costs they inflict on all remaining members refrains them from doing so.

There are disadvantages of throwing countries out of a Eurobond scheme too, although these are limited. Should the unwelcome step be necessary of phasing out a member state, this will cause unrest. However, given that the other states will be able to continue participating in the scheme under a joint-and-several guarantee, the chances of a serious risk of contagion are slim. After all, market participants will no longer be able to speculate against the continued existence of the EMU by bringing individual (remaining) countries into acute liquidity problems. These countries would still be safe under the umbrella of collective guarantees. Therefore the bargaining position of transgressor states would de facto be seriously undermined by the introduction of Eurobonds. Where Greece initially considered its bargaining position to be strong because of the justified fear of contagion regarding other Eurozone members should the country have to leave the Euro, this would no longer be the case under a program that features the joint-and-several guarantee among those remaining in the currency union.

4. It should realistically address the time-lags needed for necessary Treaty changes.

A temporary regime, such as proposed by Bishop et al. (2011, 2012), might work. This would be acceptable to constitutional courts (with the German constitutional court for instance arguing that from ESM onwards, any permanent and open-ended mutualization of risk should be put to the constituency through a referendum. The open-endedness may be overcome by focusing on part of the yield curve only, as a start. The temporary character, by the way, would also reinforce the exit threat to the countries that participate; even in the case that direct expulsion of a country is politically unfeasible, it may be relatively easy not to take this country on board in the successor of the temporary program. And you can learn; as out-of-the-box solutions have to be tested in practice, unintended design flaws may be part of it.

Only a Eurobond program which meets all these criteria would be acceptable to all member states. As of yet however, to a greater or lesser extent, most existing proposals do not meet these criteria.

Substantial fringe benefits…

We think that a Eurobond program fitting all the above requirements would automatically strengthen financial stability by breaking EMU member states’ strong financial links between national governments and local banking systems. And it would do so much more effectively than through the intended banking union as currently Eurozone banks on average are suffering more from sovereign risks than the other way around (see box 1).

Box 1: Eurobonds as a means to break the sovereign-bank nexus

The proposals for a Eurozone banking union under the sole supervision of the ECB are intended, inter alia, to break the link between sovereign and banking sector risks. In the vicious sovereign-banking sector risks circle, concerns over sovereign debt sustainability generate worries over the stability of national banking sectors that are loaded with their national’s sovereign debt, which in turn increases the contingent risks to sovereign debt sustainability.

At the current juncture, though, we have the impression that sovereign risks weigh more on national banking sectors than vice versa. The Irish banking risks have been effectively quarantined. The Spanish banking sector risks are substantial from a Spanish point of view, but rather limited from a European perspective. And banking sectors in countries like France, Italy, Portugal, and Greece are certainly suffering more form sovereign risk than vice versa.

So if the desire is to decouple these risks, should we not really be doing this from the sovereign side? The lack of eagerness to do so may stem from the fact that Eurozone leaders want to prevent from having to bail out local banking sectors as has been done in Ireland and is currently underway in Spain. This is not a particularly convincing argument as the real estate related problems in these countries’ banking sectors, which have their origins in local conditions, are relatively contained from a European perspective. Nevertheless, it is still politically much more acceptable to have banks in strong countries support banks in weak countries than to have to risk tax payers’ money via loans and/ or loan guarantees. Hence a banking union may be preferable over Eurobonds from a political perspective.

Will a banking union work to rend the vicious circle between sovereign and banking sector risks? The banking union criteria are roughly the following:

1. All banks must be subject to the same set of rules, and the ECB is put forward to pick up this baton.

2. All Banks should be treated equally if things go bad.

A European resolution mechanism is required, probably pre-funded through a levy on banks (the latter aspect again to limit the risk to have to put tax payers’ money on the line in the future).

It’s not so clear why a deposit guarantee scheme at the European level would be needed as well at this point, unless the aim is to also open up European deposit markets for European competition, as in that case a European scheme guarantees deposits that may be scattered all over the currency union.

3. All banks should all have the same starting position.

Here is the crucial bit. Before a banking union can be created, all banks should arguably be in compliance with the same rules pertaining to capital and liquidity buffers, such as Basel III / CRD IV (with potentially extra capital requirements for systemically important banks). They may have to be recapitalized by their national governments before they are allowed into the banking union, for instance.

But how do you get starting positions equal when banks are still using predominantly their own national’s sovereign bonds in their liquidity buffers, whilst stress in Eurozone bond markets continues to play up time and again? Certainly here you would in fact need Eurobonds as the major vehicle for liquidity management, as the current home bias has created and strengthened the strong link between banking sector risk and the risks to their sovereigns bonds.

Creating Eurobonds to begin with would thus generate much of the benefits in terms of risk reduction now envisaged through the creation of the banking union, and it may be much simpler put in place. 

Incidentally, the Eurobond program will free the ECB of its interventions in the market for national debt. The ECB would be allowed to direct its attention back to its primary goal: the execution of monetary policy with the ultimate aim of maintaining price stability.

… though certainly not manna from heaven

However, it is also important to realize that Eurobonds are not a magic solution to all of Europe’s financial troubles. After all, regardless of the program’s design, Eurobonds do have their limitations as well. Most emphatically they are not an alternative to putting public finances in order and restoring competitiveness. Even with Eurobonds most EMU member states will need to put their government budgets in order and restore their competitiveness and potential for growth. At most, Eurobonds might contribute to creating the circumstances under which such policies of stability can be executed. We should realize, however, that all this also can be said of the interventions by the ECB.

It should also be clear that a permanent Eurobond program cannot be put in place in the short run. The introduction of Eurobonds represents a far-reaching redesign of the Eurozone and this requires that time be taken to work out the details and complete all the necessary political, legal and constitutional procedures. This task should not be undertaken lightly. All the same, we are pressed for time: even though the ECB’s LTRO ‘bought’ three extra years, and the ECB’s pledge to intervene potentially without limit under its OMT on the shorter end of the sovereign yield curves, financial markets could still spoil things. The developments of the first half of 2012 have certainly demonstrated that. This is why a working group from the European League for Economic Cooperation (ELEC) is proposing to start with a temporary programme (Bishop et al., 2011, 2012).

Euro T-Bills: a transitional regime

The ELEC working group proposes that those states which participate for the duration of the program should be able to provide all the funding their governments need through collectively guaranteed short-term Eurobonds (Euro Treasury-Bills). This guarantee should be a joint-and-several guarantee, i.e. every member state guarantees the national debt of all other member states. Obviously, this is only possible when accompanied by a strict set of budgetary rules, incorporated in national law, to which participating countries would have committed, as well as effective and automatic sanctions for states that breach the agreements. Therefore the proposed T-Bill programme complements the new budgetary rules and Fiscal Compact agreed upon in late 2011. Furthermore, not every member state will be able to participate from the start. Conditions for participation and all the other parameters of the program are derived from the criteria outlined above.

1. Only solvent states with approved policy plans can participate from the start

The program is open to all solvent member states of the Eurozone, underscoring the fact that the Euro T-bills are not merely support-in-disguise for the weaker EMU member states and thereby partly speaking to the criteria that the program should be beneficial for strong countries as well as for weak countries. The solvency criterion is understood to include all countries which have so far managed to get by without financial support from the other member states. Countries which are already in need of financial support (Greece, Ireland and Portugal) therefore cannot yet take part [4]; the EFSF is open to them. Incidentally, should Eurobonds be introduced, there would be no need to increase the size of that fund nor the size of its successor, the ESM. Only once these countries have brought their public finances in order, and have overcome their problems, might they qualify for entry. In addition to do this, the intended policies of the participating countries must first have already been approved under the European semester. These policies should lead up to eventually fulfilling the criteria outlined in the Stability and Growth Pact (SGP). Finally it is essential that all the large states participate, including Germany.

2. Funding through short-term Euro T-Bills

Through the program, participating countries can cover all of their funding needs (financing deficits and rolling over existing debts) over the next four years (2013-2017) through collectively guaranteed (cross-guaranteed) short-term bonds (Euro T-Bills). These will have a maximum maturity of 2 years and will be issued by a new agency, the EMU fund. Participating countries would not issue any further short-term bonds themselves. However, they would be free to issue longer-term government bonds without a collective guarantee. Accordingly, if the program were to be discontinued after four years, the last Eurobonds would be repaid after two more years, i.e. in 2019, at the latest. As such, all participating countries are guaranteed access to funds at reasonable rates.

3. Discipline through extra premiums

States whose budget deficit exceeds 3% and/or states with a national debt exceeding 60% of GDP would be liable to pay a premium on top of the necessary costs to finance the agency, thus embedding disciplining incentives and discouraging moral hazard behavior. This premium will vary according to an automated formula in which the relative size of the public deficit and debt is taken into account (see box 2 and figure 3). 

Box 2: The size of premiums additional to the funding costs of the EMU fund

The premium will be calculated using the following formula:

R(i) = α [DEF(i) – DEF(m)] + β [DEBT(i)-DEBT(m)]

in which:

R(i) = the size of the premium additional to the funding costs of the EMU fund.

DEF(i) = the budget deficit of country i, as a percentage of GDP DEBT(i) = the national debt of country i, as a percentage of GDP DEF(m) and DEBT (m) are the maximum values for budget deficit and national debt described in the Stability and Growth Pact, i.e. 3% and 60% of GDP respectively.

Parameters α and β are coefficients determining the relative weight of national debt and the budget deficit in the formula. 

Figure 3: EMU-funds versus German funding costs
Figure 3: EMU-funds versus German funding costsSource: Reuters EcoWin

4. Expulsion from the program as an ultimate sanction

If states fail to implement the agreed policies, ultimately the decision could be taken to gradually phase them out of the program. Obviously such a decision should not be taken lightly. States which do implement agreed policies cannot be blamed for a situation where results do not meet expectations due to lower economic growth than had been foreseen, for example. Nonetheless there should be an ultimate sanction for states which do not live up to policy rules. In any case the program does have a ‘big stick’ waiting at the end, as countries which behave badly can be excluded from participation in a follow-up program, should this be decided upon.

5. Building up reserves

Through the premiums levied, the EMU fund would by definition make a profit as long as there are countries which do not meet the SGP criteria. This would be added to the agency’s reserves. Thus, buffers are built up to resolve any possible future problem cases, adding to the credibility of the exit-threat in the process. These reserves are emphatically not meant to be used for bailouts, but rather intended as a cover for the collective guarantee on Eurobonds issued. When the program ends, and if a decision is made not to set up a follow-up program, collected unused funds will be added to the capital of the European Stability Mechanism (ESM), the permanent fund currently being set up. If a follow-up program does find support, the reserves created can, if desired, be passed on to the successor Eurobond program.

Even if they have to pay a premium to the EMU fund, the weaker countries will still find this a fairer and cheaper solution than having to access the markets on their own. Note that the premium mechanism does, however, begin to discipline these countries much earlier than the financial markets have done in the past. Moreover, states can influence the premiums they are being charged by adjusting their policies in the right direction. Finally, the premiums paid to the EMU fund would be used to build up reserves, where the market’s high interest rates are only collected as a risk premiums by investors. At the same time the stronger countries will find their borrowing costs will have gone up relative to the crisis troughs, but it should borne in mind that their current interest rates are unnaturally low due to their safe haven role within the Eurozone.

Note that the buffers that have been built up should be placed at a distance from the political realm, in a situation analogous to the ECB.

6. Joint-and-several guarantees prevent contagion

If a member state finds itself in financial trouble and does not wish to adjust its policy to conform with the indications given by ‘Europe’, it may be excluded from participating not only in the follow-up program, but if necessary from the current program as well. The joint-and-several guarantees on already issued bonds, as well as the reserves that were built up to cover these, will prevent problems from spilling over into other states to a large degree. Therefore, compared to the situation without Eurobonds, those ‘transgressors’ are much less capable of wreaking havoc in the system, which will improve the EMU’s bargaining position against unwilling countries considerably. This setup thus provides for the searched-for strength of the collective, while at the same time is also adds to the time-consistency of the exit-threat.

7. A temporary regime as a lead-up to a permanent solution

The temporary regime would ideally be followed up by a new temporary or even a permanent program. However, in a permanent program it would be much harder to phase out the transgressing countries. The temporary nature of the scheme proposed here, containing as its ultimate sanction the exclusion from a future follow-up scheme, will therefore have a strong disciplinary effect and is thereby in and of itself an asset. The program will however provide policymakers with enough time to show themselves capable of good governance.

Also, the temporary nature of the program addresses the fact that it takes time to make the necessary changes to the European treaties, thus nurturing the democratic legitimacy of its potential permanent successor.

Practical and open issues

1. Calibration of the premium applied

First, the formula needed to calculate the premiums must be determined (see box 2). Determining parameters α and β will be the outcome of a political bargaining process. These should be set in advance, be uniform for and subscribed to by all the participating countries at the moment of accession. There are two key questions to consider in setting the parameters. First, the absolute size of the premiums has to be determined. This is important for the disciplinary effect and for the speed at which the buffers can be built up. Second, the relative size of the premiums has to be determined. Should premiums primarily be built up based on the size of the national debt, or on the basis of the budget deficit? Figure 4 illustrates two scenarios. The second option is preferable here, as it will allow the premiums to react more directly to changes in fiscal policy. A rising budget deficit would swiftly be punished by rising premiums, but a change in direction would be rewarded equally fast. This embeds effective incentives. As mentioned above, determining the formula is a one-off process, as opposed to the many ad hoc negotiations which have caused Europe to limp from one incident to the next in recent years.

Figure 4: Premiums in the EMU fund in two scenarios (2000-2012)
Figure 4: Premiums in the EMU fund in two scenarios (2000-2012)Source: Reuters EcoWin, Rabobank calculations

Figure 4: Premiums in the EMU fund in two scenarios (2000-2012)Source: Reuters EcoWin, Rabobank calculations

Note: This figure is a simulation of how these ratios would have progressed had Eurobonds been introduced from the start. They are based on the factual development of deficit and debt levels on a quarterly basis (related to SGP criteria). In scenario 1, more weight is given to debt ratio (α = 0.10 and β = 0.010). In scenario 2, relatively more weight is given to the developments in budget deficits (α = 0.15 and β = 0.005).

2. Guarding the term structure of sovereign debt

A possible disadvantage of the short-term Euro T-bill program is that weaker participating countries, in particular, who may find it hard to issue long-term bonds themselves, would finance their deficits and their maturing debt with short-term credit entirely. This means the average maturity of their national debt would decrease, which will increase their public finances’ sensitivity to interest rates. Therefore it is advisable to extend the maturities in a follow-up program, should the scheme be successful and a successor scheme be put in place.

As things stand, though, this feature or the proposed Euro T-bills is not much different from Draghi’s pledge to purchase bonds along the short end of the yield curve when the country has a MoU with its Eurozone partners. It’s a risk that may be addressed by obliging countries to maintain their sovereign debt maturity structure within predefined boundaries, as is currently suggested in the OMT-meets-MoU discussions.

3. Succession planning

What does its successor look like? It may be the same regime once more. Or it may be a similar regime, for instance with the country composition adapted to new circumstances, with the maximum maturities of the Eurobonds expanded, or with some of the parameters and modalities changed based on the lessons learned in the first trial period. Ultimately, it may be the case that the successor is to be a permanent Eurobond scheme, for which the temporary facility has created the time to accommodate this transition by means of the required amendments to the European Treaties.

What needs to be worked out is how this EMU fund operates alongside the ESM. It seems logical that in its temporary setting, the two act in a parallel fashion. It also seems logical that when the temporary program ends and is not continued, the built-up funds are transferred to the capital base of the ESM. In a permanent setting, however, the need for ESM alongside the EMU funds is not so clear. Perhaps in that scenario, the EMU fund would grow to ultimately replace the ESM (the resolution fund thereby crowding out the bailout fund), with the ESM’s capital given back to the contributing member states in proportion.

4. The resolution fund investment plan

An open question pertains to the optimal size of the reserves of the EMU fund. Its design in the build-up phase is such that it would grow indefinitely. At an optimal size of, say 10% or 20% of aggregate outstanding EMU sovereign debt, the premium may be level-shifted in such a way that on a net basis, no fresh additions to the fund are made. Then, the premiums could be adapted in such a way that well-behaving countries actually are rewarded by receiving a transfer from the Fund.

A related issue is where the fund is to invest its capital? It seems unhealthy in a way to invest in Euro T-bills or Eurozone sovereign bonds, since in that case countries are paying in capital ultimately to finance the debt they issue to pay in that very same capital. It does not seem politically palatable to invest the funds outside Europe either, since the sovereign debts issued to fund the fund would arguably be crowding out private European investment. Hence a diversified portfolio of Eurozone corporate bonds would seem most feasible.

What are the alternatives?

When discussing the positions for and against the use of Eurobonds, too little attention is paid to the question of what other options are available. Opponents who argue that Eurobonds would remove the pressure on policymakers to put their affairs in order make a valid point to the extent that many Eurobond proposals indeed lack any mechanism to prevent moral hazard. However, that has been addressed in this proposal. And opponents who argue that Eurobonds will not resolve the real problem, that of poor budgetary discipline in the Eurozone, are entirely correct. The main function of Eurobonds is to create an environment in which policy proposals can actually be realized. They can stabilize the markets and give the ECB some space to direct its attention back to its core function: monetary policy. However, they are by definition complementary to agreed budgetary measures and do not replace them.

But what is the way forward if we decide against introducing Eurobonds? In that case, it must be feared that the Eurozone will experience much deeper crises over the coming months and years than the current one. Implementing policy takes time and markets are no longer prepared to wait. Financial markets would still be free to speculate against the continued existence of the euro and will continue to target one supposedly weaker state after the next. Consequently, every problem, even in the smallest of member states, immediately becomes an EMU-wide problem, because it puts renewed pressure on the Eurozone. Until at some point, something has to give and one or more countries may even be forced out of the Eurozone. The ECB can keep matters under control to a certain extent through its Securities Markets Program (SMP), the LTRO and the OMT, but in doing so it is building an increasingly unbalanced portfolio, and its position as separating monetary from budgetary policy is becoming increasingly blurred, and harder to accept for the Germans. In reality, the ECB’s measures in some ways resemble the use of Eurobonds (buying weaker states’ bonds backed by guarantees from the collective, namely the central bank’s shareholders), but in an opaque way and lacking in democratic legitimacy. This should not be taken as criticism of the ECB. In contrast, its behavior underlines the weakness of the actions of Europe’s politicians.


The introduction of a four-year Euro T-Bill program as proposed here would give policymakers time to implement good policies and to consider a permanent reform of Eurozone governance. The temporary nature of the program is an important asset. Many of the proposed Eurobond programs contain more than a few elements which will clearly harm the stronger member states. In most cases, for example, they do not deal with moral hazard, or they contain as yet untested elements, begging the highly legitimate question whether they might not lead to undesirable effects when put into practice. Consider for instance the blue bond/ red bond proposal launched by the Brueghel think-tank (Delpla & Von Weizsäcker, 2011) or the idea proposed in Germany to put a so-called redemption fund in place. The disadvantages of such schemes are not just the insecurity they imply, but once in place, it will prove extremely hard to make any changes to them at all. The advantage of the temporary nature of ELEC’s Euro T-Bill program is that it will be possible to accumulate some experience with Eurobonds as an instrument, which can prove itself in this period. Any desired changes can be included in a follow-up program. No further increases to the EFSF/ESM would be needed, because in this scenario those facilities would only be open to Greece, Portugal and Ireland. Once the new fund also takes over most of the portfolio of weaker states’ government bonds accumulated by the ECB after a certain time, and places these in the Eurobond program, the central bank will once again be able to focus its energy on its core task: monetary policy with the ultimate goal of combating inflation, complemented of course by the task of guarding financial stability.

After four years, the Euro T-Bill program could, if desired, be converted into a permanent Eurobond program covering all maturities. However, the decision could also be taken to extend the program, and possibly to extend the maximum maturity of Eurobonds by a few years to three or four years. In that case the ultimate sanction, not being permitted to participate in a follow-up scheme, would still be a very credible threat on the horizon. Should the program be less successful than hoped for, and should the decision be taken not to extend it, then we may well have lost one illusion, but we would not be in a worse position than we find ourselves in today.


[1] We are indebted to the members of the ELEC working party on Eurobonds, viz., Graham Bishop, Michiel Bijlsma, Marko Bos, Niels Gilbert, Shahin Kamalodin, Rene Karsenti, Alman Metten, Franz Nauschnigg, Rene Smits and Nicholás Trillo Ezquerra. This article reflects the authors’ personal evolving views regarding the ELEC proposal. Special thanks to Shahin Kamalodin.

[2] Also see W.A. Bruinshoofd, S.A. Kamalodin and M.P. Verduijn, 2012, Euro crisis: institutional tug-of-war, Rabobank Special Report 12/14, September.

[3] Most proposals either implicitly or explicitly assume a type of agency which will issue Eurobonds. The French president François Hollande on the other hand has argued these should be issued by the ECB.

[4] So long as a full-blown ESM rescue package for Spain has not been provided, Spain would also be eligible to participate.


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SUERF2013/2, page 249 Tuesday, June 11, 2013.

Wim Boonstra
RaboResearch Global Economics & Markets Rabobank KEO
+31 6 5128 1405
Allard Bruinshoofd
Rabobank KEO
Other authors
Rabobank KEO

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