Some thoughts on Euro T-Bills
This Special by Wim Boonstra  discusses a temporary programme of short-term eurobonds (Euro T-bills), as was presented by the European league for Economic Cooperation (ELEC). A well-designed regime of conditional eurobonds can create stability for the monetary union, present policymakers with the right incentives, stabilise the European banking system and offer benefits to all participating Member States. Moreover, the ECB will be able to refocus its attention on its core task: the execution of monetary policy with the ultimate aim of maintaining price stability. Finally, Euro T-bills allow the ECB to conduct quantitative easing and will improve the transmission of monetary policy.
 Chief economist at Rabobank Nederland, Utrecht, Professor of Economic and Monetary Policy at VU University, Amsterdam, and President of the Monetary Commission of ELEC, Brussels.
The generic term ‘eurobond’ conceals many variations. Some (e.g. Mario Monti) see eurobonds above all as an instrument to stabilize the EMU. Others (e.g. François Hollande) would want to use eurobonds to boost economic growth. At the same time, some others (e.g. Angela Merkel) fear that eurobonds will undermine fiscal discipline in weaker countries and push up interest rates sharply for ‘stronger’ Member States.
However, a question that is rarely raised is whether it is possible to design a eurobond system in such a way as to boost stability within the monetary union while increasing budgetary discipline and also offering tangible benefits to the financially stronger States. After all, much depends on the way a eurobond programme is formed.
This article discusses the optimal design of a eurobond scheme. It concentrates on the temporary programme of short-term eurobonds (hereafter Euro T-bills), which was launched by the European League for Economic Cooperation (ELEC) in December 2011. The ELEC argued that a temporary regime of conditional eurobonds, if well designed, can create , present policymakers with the right incentives and offer benefits to all participating countries. This article supports this claim. Moreover, it concludes that Euro T-bills will also improve monetary transmission and offer the ECB the possibility to return to its core task, viz. price stability.
 This article concentrates on the optimal design of a eurobond schema, but it doesn’t into the background of the eurocrisis and the arguments pro and con the use of eurobonds. See Boonstra (2012) for more background in this issue.
Criteria for an ‘ideal’ eurobond scheme
Eurobonds are bonds issued, using the existing national infrastructures of government debt agencies under coordination of a new central European agency, in order to finance the participating Member States’ national debt. If well designed, eurobonds could shelter countries from strong swings in market sentiment, while at the same time improving fiscal discipline. Therefore, a relevant question to ask is: what do we want to achieve by introducing eurobonds?
A successful Eurobond scheme should:
- Bring all participating countries, both strong and weak, substantial benefits. The scheme will not be viable if this condition is not met.
- Give all participating countries access to funding under reasonable conditions.
- Avoid moral hazard but rather bring the right incentives to increase budgetary discipline.
- Strengthen financial stability by breaking the vicious feedback loop between national governments and local banking systems.
- Free the ECB from its interventions in the market to calm market nerves. The ECB can then refocus its attention on its primary goal: the execution of monetary policy with the ultimate aim of maintaining price stability.
- Improve the monetary transmission mechanism.
- Preferably be self-funding so that problems in the future can be addressed without having to resort to financial support from the stronger Member States.
Only a eurobond programme which fulfills all of the first six conditions would be acceptable to all Member States. The seventh criterium is important as well, but is more of a nice to have rather than a necessity. However, most existing proposals do not meet all or most of these criteria. Moreover, it is important to realize that eurobonds help to stabilize EMU, but do not solve its fundamental challenges. Countries still have to reduce public budget deficits and restore their competitiveness, in order to boost potential growth. The most we may expect from eurobonds is that they contribute to creating the circumstances under which such a policy of stability can be executed.
 Eurobonds are also known as Stability Bonds (EC, 2011) or EMU Bonds (Boonstra, 1991; ELEC, 2012).
Euro T-Bills: a transitional regime
The introduction of eurobonds represents a far-reaching redesign of the eurozone, which brings it closer to a genuine fiscal union. It will take time to work out the details and complete all the necessary political, legal and constitutional procedures. This is why a working party of the European League for Economic Cooperation (ELEC) has proposed to start with a temporary programme (ELEC, 2012). This programme should be able to provide all the funding the governments of the participating countries need through collectively guaranteed Euro T-bills.
A cross-guarantee scheme is preferable whereby every Member State stands behind the national debt of all the other Member States. Obviously, this is only possible if accompanied by a strict set of budgetary rules, to which participating countries would have committed, as well as effective and automatic sanctions for States that breach the terms of the agreement. If a cross-guarantee is politically not viable at this juncture, the alternative is a pro-rata guarantee by the participating countries. All countries together could, pro-rata, guarantee the total of collectively issued T-Bills. The ESM should act as an extra guarantor of the scheme.
The design of the scheme
Solvent countries only
The programme must be open to all Member States of the eurozone which are not currently receiving external financial support from other Member States or the IMF. Countries which are already in need of financial support and are not able to fund themselves in the financial markets in 2014 without support should preferably not take part as long as this situation persists. An option could be that an independent organisation such as the IMF does a debt sustainability analysis and allow all the countries into the programme that get a green light.
In addition to this first condition, the intended policies of the participating countries must be first approved by the European Commission in the European semester. Finally, it is essential that all the large states participate, including Germany.
Collectively guaranteed short-term debt
Through the programme, participating countries can cover all their funding needs (financing budget deficit and maturing debt) over the next four years (2014-2017) through collectively guaranteed Euro T-bills. These instruments will have a maximum maturity of 2 years and will be issued by a new agency, the EMU fund. Participating countries will refrain from issuing short-term bonds themselves, but would be free to issue longer-term government bonds without a collective guarantee. Accordingly, if the programme were to be discontinued after four years, all Euro T-bills would be repaid within six years (i.e. in 2019 at the latest).
Extra discipline through surcharges
The temporary character of the scheme already implies that there are strong disciplinary mechanisms present that will tackle moral hazard (see below). It is possible to bring more discipline (and financial advantages) by introducing an extra surcharge mechanism. In that case, States with a budget deficit exceeding 3% of GDP and/or public debt exceeding 60% of GDP would be liable to pay a premium on top of the funding costs of the EMU fund (the interest paid on the Euro T-bills). This premium will have to vary according to an automated formula, determined in advance, in which the relative size of the public deficit and debt is taken into account (see Boonstra (2012) for some concrete examples).
Building up reserves and/or paying a dividend
Through the premiums levied, the EMU fund would by definition make a profit, even after distracting its operational costs. One option is to add the profit to the new agency’s reserves. These reserves are not meant to be used for bailouts, but intended as a cover for the collective guarantee on Euro T-bills issued. This means the contingent liability of the Member States will gradually diminish over time as reserves are built up. Another option is that the profits are (fully or partly) distributed to the Member States that fully meet the deficit and debt criteria of the Stability and Growth Pact.
Relatively cheap funding costs, which can be influenced by good policies
Even if they have to pay a premium to the EMU fund, the weaker countries will still find this a cheaper solution than tapping the markets on their own. Note that the premium mechanism does, however, enforce fiscal discipline much earlier than was done by the financial markets prior to the crisis. Moreover, Member States can lower the premiums they pay by adjusting their policies in the right direction. Given the size of the issue of EMU T-Bills, it may expected that a substantial liquidity premium will occur that, compared with the situation without eurobonds, declining funding costs for the stronger countries as well.
Expulsion as an ultimate sanction
If Member States fail to implement the agreed policies, ultimately a decision could be taken to gradually phase them out of the programme. In any case, the programme does have a ‘big stick’, as countries which do not conform to the agreed rules can be excluded from participation in a follow-up programme, should this be decided upon. Moreover, in case of default, the existing guarantee and the reserves that were built up will prevent problems from spilling over into other States to a large degree (i.e. lower contagion risk). This will considerably improve the EMU’s bargaining position against unwilling countries and strengthen the credibility of the sanction mechanism.
Of course, such a decision should be taken lightly. Only when countries refuse to play by the rules, this option should come on the table. The decision to remove a country from the scheme, or refusing to admit it in a follow-up scheme, should be taken by a qualified majority.
Advantages and disadvantages
Advantages of this approach
- Temporary character is an advantage in itself
One important benefit is that as the short-term eurobond programme proposed here is temporary in nature, it can be introduced quickly. What’s more, it provides the opportunity of learning lessons along the way and, if necessary, refine and improve eventual follow-up schemes. In the meantime, it will allow the EMU to carefully design any future Eurobond-system and to embed it in law. It should be stressed that it will be extremely difficult to make changes to a permanent eurobond programme. For this reason alone a trial programme would be desirable.
- Countries are sheltered from changes in market sentiment
The programme’s duration would give sufficient time to Member States to get their policies in order without fearing financial markets’ reactions on a daily basis. This would provide enough time to design the right policies and implement them when appropriate.
- Credible sanctions for countries that refuse to conduct the agreed-upon policies
The temporary nature would also offer a strong and credible sanction against countries which do not adhere to the agreed rules, as they would not qualify for the eventual follow-up programme. The risk of moral hazard can be further lowered by the possibility to phase a country out of the programme and, if desired, by means of the premium levied in the internal allocation mechanism.
- Introduction of a risk-free asset
At the short end of the yield curve, Euro T-bills would be the only euro-denominated high-quality short-term paper available to investors. This would also provide the EMU with a common so-called ‘risk-free’ asset as a collateral for transactions with the central bank. This would strongly improve the working of the money market within EMU.
- Freeing the ECB from all non-monetary policy tasks
Once a eurobond (or Euro T-bill) scheme is in place, the ECB can stop its interventions in the bond markets to support public bonds of Member States. It can, again, fully concentrate on its major task: safeguarding price stability.
- Better monetary policy transmission
Nowadays, government bond yields act as the unofficial ‘floor’ as they serve as the safest asset available in a given country. This ‘floor’ can differ considerably between countries, resulting in highly diverging funding costs for local companies and banks. Eurobonds can result in a narrowing of interest rate spreads between different Member States, to the benefit of the private sector. This will strongly improve the monetary transmission mechanism.
Eurobonds would also allow the ECB the possibility to adopt, if circumstances require this, a more traditional policy of quantitative easing without having to intervene in national bond markets should circumstances demand this (e.g. in the form of the SMP programme).
- Stabilizing banking systems
The direct link between governments and their national banking systems would be severed with the introduction of Euro T-bills This constitutes a major improvement in the current situation. Note that the ECB’s operations, especially the LTRO, actually caused those ties to become a good deal tighter.
- Self-financing mechanism
The premiums paid by the participating Member States will help to create a fund that can cover the guarantee given by all countries.
The monetary union can be consolidated by the introduction of eurobonds, without more political integration than had been planned already on the basis of the agreed tighter governance of the eurozone. As shown above, it is not just the weaker countries which will benefit, there are advantages for the stronger states too. They will benefit from a more stable EMU and the above-mentioned self-funding character of the programme is also an important advantage for the countries that in the current crisis pay most of the bill. A further benefit for stronger states concerns the expected liquidity premium. This is because the market for Euro T-Bills will be the most liquid, even surpassing that of short-term German government bonds, which may result in lower interest rates (ELEC, 2012).
There are disadvantages too.
- Phasing out a country is painful
Phasing out a Member State from the programme might cause market unrest, although given the cross-guarantee on the outstanding debt, the chances of serious contagion risks are slim. Therefore, the bargaining position of unconforming States would de facto be seriously undermined by the introduction of Euro T-bills.
- Shorter average debt maturity
Another disadvantage is that the average maturity of the public debt of the weaker countries could decrease. Thus, it may be advisable to extend the maturities of the EMU T-bills in a follow-up programme.
- Calculating the risk premium is a sensitive item
Finally, if a surcharge mechanism is to be in place, the formula needed to calculate the premiums must be determined ex ante, although this should not pose as a serious problem (see Boonstra, 2012).
The proposed temporary Euro T-bill programme would give policymakers time to implement the right policies and to consider a permanent reform of eurozone governance. The temporary nature of the programme is an important asset, as it will be possible to accumulate some experience with eurobonds (i.e. learning-by-doing is key). Any desired changes can be included in a follow-up programme. Once the new fund also takes over most of the portfolio of weaker states' government bonds accumulated by the ECB and places these in the eurobond programme, 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. And the monetary transmission mechanism will improve considerably.
After four years, the Euro T-bill programme could, if desired, be converted into a new temporary, or even a permanent eurobond programme covering all bond maturities. Should the programme be less successful than hoped for, and should the decision be taken to not extend it further, then we may well have lost one illusion, but we would at least not be in a worse position than we find ourselves in today.