Originally posted 17 September 2011 at Voxeu and reproduced here with permission.
While almost everyone is agreed that the Eurozone is in crisis, there is much less agreement about how to stop it. While almost everyone is agreed that the Eurozone is in crisis, there is much less agreement about how to stop it. This article argues that policymakers should move beyond the current proposal for Eurobonds – something the authors label as “economically wrong and politically indefensible”. Instead, they call for “synthetic Eurobonds” that would insulate the financial sector – and much of the economy – from the current debt crisis.
The Eurozone is in crisis, with several governments and banks likely to lose access to market funding. The crisis, however, has (at least) two layers, a crucial point sorely missed in the current policy debate:
- There is a sovereign debt crisis; and
- there is the financial sector crisis.
While they are interconnected, each requires different perspectives and tools for their resolution.
The failure to stem the crisis is due to the single-minded focus of political leaders on containing sovereign default risk as their key objective. By contrast and on purpose, our perspective here is instead on the functioning of the financial sector and tackling the financial sector crisis.
Diagnosis: Debt crisis causing uncertainty in the financial system
It is in the normal business of banks to hold sovereign debt. But the prospects for default have risen substantially in several Eurozone countries. Accordingly, the market value of this debt has decreased considerably. This has undermined the solvency of a few banks. Probably more importantly, it has also increased general uncertainty in the financial system. The yield on two-year Greek bonds has recently exceeded 50%. These bonds are essentially assets with a very risky pay-off stream or, more bluntly, a casino gamble. If Greece defaults, bondholders may lose a large part of their money but, should default be avoided, they may see substantial gains relative to current market values.
While the majority of European banks are probably solvent at current market prices, there may be a significant number of failures if Greece or another European country does not honour its debt. As a result of this solvency risk, the trust in financial counterparties in Europe is quickly eroding.
- Banks park their reserves at the ECB rather than trading with each other.
- Depositors are withdrawing their funds; southern Europe is witnessing a slow-motion bank run.
- The ECB has turned to increasingly desperate measures of propping up market prices for these risky securities through direct market intervention, effectively buying the sovereign debt off the balance sheets of banks at inflated prices and, ultimately, at the cost of the Eurozone taxpayers.
At the same time, the ECB is pressing policymakers to avoid a Greek default at any price, as it fears negative repercussions for the European banking system, when it cannot accept Greek bonds as collateral any longer. Without a return of the European financial system to a moderately healthy state, the freeze and distrust will continue to fester and grow, affecting in turn the availability of credit to enterprises and households. This is a dangerous situation indeed.
Therapy: Synthetic Eurobonds
Much discussion and scepticism surrounds the idea of Eurobonds. They are typically thought of as sovereign bonds, underwritten jointly by all Eurozone governments. They are viewed as a vehicle to enable countries experiencing a sovereign debt crisis to deal with their situation. But they also imply that prudent governments end up guaranteeing, and may ultimately pay for, the fiscal transgressions of more profligate countries. If introduced at all, it will be a challenge to construct them so that they will have a high rating rather than the rating of the weakest members.
The goal of restoring the health of the financial sector offers a different perspective, however.
- We suggest creating a European debt mutual fund, which holds a mixture of the debt of Eurozone member (for example, in proportion to their GDP).
- This fund then issues tradable securities whose payoffs are the joint payoffs of the bonds in its portfolio.
- These securities could be called synthetic Eurobonds.
Now, if one member country defaults or reschedules its debt, this will likewise affect the payoff of these Eurobonds, but in proportion of the overall share in its portfolio. As Greek’s share will be small (it makes up about 2% of Eurozone GDP), its default will not pose a significant risk to the Eurobond.
No guarantees needed
A key advantage of these bonds is that there will be no built-in guarantees or bailouts by other countries. The pay-off of the synthetic Eurobond will simply be the combined interest rate payments of the bonds held by the fund. To be sure, the bonds are not completely risk-free, but diversification benefits will insure that a drastic reduction in payments will be unlikely. Put differently, they will be reasonably safe, and safe enough for most practical purposes. Note that the securitisation structure itself would be completely riskless – unlike some securitisation vehicles that failed during the subprime crisis – as its claims will be fully backed by marketable bonds.
We propose that the ECB then accept these Eurobonds as collateral in their open-market operations and repurchase operations. At the same time, the ECB should stop accepting high-risk bonds from individual member countries.
Synthetic bonds reduce uncertainty in the banking system…
To get these Eurobonds started, European banks would sell their current sovereign debt to the European debt mutual fund and receive synthetic Eurobonds in return.
- The selling of banks’ current holdings could take place at market prices, or, if politically desirable and taxpayer-financeable, at prices slightly above.
- The ECB should sell its own holdings to this fund.
The fund may also buy debt on the market, to achieve some proportionality.
This means that banks must realise the losses of these bonds if they are still held in their bank books. But it insulates them from the risk of a default by Greece, or other high-risk European countries. It takes the current casino bets out of the hands of the banks, replacing them by a much less risky payment stream instead. It also keeps all Eurozone sovereigns in the market for securities that can be used vis-a-vis the ECB. It thereby allows and forces banks to reduce risk on their balance sheet.1 It helps with both liquidity and solvency problems of the European banking system and, most critically, helps to distinguish between the two.2
…and allow the ECB to get out of the business of buying debt of high-risk sovereigns
The ECB – after taking the step of getting out of the debt markets for individual countries generally – should return to the prudent practice of only accepting top-graded sovereign debt, aside from these new Eurobonds. This insulates the ECB and the euro against sovereign default risk, and finally restores the European financial system to a healthy situation. The ECB would benefit as it no longer faces pressure to purchase bonds from high-risk countries. Finally, governments in the rich countries would benefit as they no longer face pressure to provide guarantees to sovereign debt in order to save the banking system.
Synthetic Eurobonds have significant advantages and are feasible
The current discussion on Eurobonds, on the other hand, has focused on joint liability of Eurozone governments for each others’ debt. Along with many other economists, we see this as a dangerous path, economically wrong and politically indefensible, as it violates the requirement of “no taxation without representation”.3 It institutionalises the bet that Greek authorities have been playing over the past years, building up a Ponzi scheme in the firm expectation that other Eurozone countries will pick up the pieces. The expectation of its proponents that this would calm market as it would get an AAA rating (consistent with the rating of the strongest euro members) has also been destroyed by S&P‘s announcement that such a bond would get the rating of the lowest-rank member, i.e. junk status.
The argument that the issue of such bonds would go hand-in-hand with fiscal convergence and a joint fiscal regime (similar to joint monetary policy) in the Eurozone reminds us of a similar discussion on the benefits of the Stability and Growth Pact that was to ensure fiscal discipline. Issuing Eurobonds with the goal of joint fiscal policy is putting the cart in front of the ox. Putting the ox in front of the cart may demonstrate, on the other hand, that the cart is too hard to move in any case.
Ours is a better, smarter solution. It is feasible, it does not require taxpayer money, and stands a good chance of safe-guarding the euro and returning the Eurozone financial system back to health and vibrancy. There may still be other good reasons for European governments to help each other survive their fiscal crises, the rescue of the financial system no longer needs to be part of that discussion, though.
Our plan can work. But time is of the essence. Political leaders must act now.
Allen, Franklin, Thorsten Beck, Elena Carletti, Philip Lane, Dirk Schoenmaker and Wolf Wagner (2011), “Cross-border banking in Europe: implications for financial stability and macroeconomic policies”, CEPR Policy Report.
Gros, Daniel (2011), “Eurobonds: Wrong Solution for Legal, Political and Economic Reasons”, VoxEU.org, 24 August.
Hau, Harald (2011), “Bank recapitalisation is the best euro rescue strategy”, VoxEU.org, 2 September.
Laux, Christian and Christian Leuz (2010), “Did Fair-Value Accounting Contribute to the Financial Crisis?”, Journal of Economic Perspectives, 24:93-118.
Manasse, Paolo (2010), “My Name is Bond, Eurobond”, VoxEU.org, 16 December.
Wyplosz, Charles (2011), “They still don’t get it”, VoxEU.org, 22 August
1 See Hau (2011) for a recent discussion on recapitalisation needs of European banks.
2 For a discussion on bank resolution and the treatment of government debt on banks’ balance sheets, see Allen et al. (2011) and Laux and Leuz (2010).
3 For a more detailed analysis, see – among many others – Manasse (2010) and Gros (2011). See Wyplosz (2011) for a more general discussion on the policy response to the European sovereign debt crisis.
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