One persistent question about the crisis in the eurozone is why it is a crisis for the euro at all. The sovereign debt of individual states is denominated in euros, but the issuer remains a national government, not the “eurozone” or the European Central Bank or the EU or anything other than Greece, Italy, Germany, and so on. There is no guarantee clause written into the sovereign bond contract putting anyone behind it other than the state that issues it. In that case, why is a default on Greek bonds any more of a threat to the euro as such than the default of some developing world state that issues sovereign debt denominated in dollars, and which might even have adopted the dollar as legal currency within its economy, a threat to the dollar?
The quick answer is that the threat is not to the euro as such, but instead to the eurozone. The eurozone is more than merely the collection of national economies that happen to denominate various things in euros or accept it as legal tender. Greece is not a euro version of some dollarized economy somewhere in the world. The eurozone countries entered a zone that included various governance obligations and which strongly suggested to markets that they could regard the zone as a whole entity. After all, this was precisely how many of the benefits of monetary union were to be achieved. In reality, as we all know now, the agreements papered over crucial questions of how monetary union could work without fiscal union, and the attendant problems of moral hazard. The markets took the euro as the eurozone, and then imputed to the zone the finances of its strongest member; official European policy encouraged them to do so, as well. And even if there is no explicit guarantee, just as with entities such as Fannie Mae, there is an implicit guarantee that turns out to be very hard to abandon.
Moreover, many of the benefits that attend the euro – the lowered transaction costs across eurozone economies, the ability to more closely and easily intertwine financial institutions and markets across borders, and so on – turn out to have significant risks in difficult environments. Some of these might have been avoided – for example, holdings of Greek sovereign bonds by German banks that were encouraged by capital rules – with prudential regulation that recognized the risks. But the problem in part is what counted as attractive features, and more exactly, the features of an upward virtuous cycle pulling Greece in the direction of German probity and governance, turn out to be either chimerical or else flat out bugs in a different environment.
One solution that has been proposed increasingly is to break up the euro. With as much decorum as possible, to be sure, but essentially having Germany and the stronger northern economies exit the euro, creating a northern euro and a southern euro. The essentially political nature of the European project presses for the euro to stay together, and to treat this as a crisis in the dialectical sense, pressing from crisis to greater political and economic union. But precisely because of the millenarian nature of the political project, it has always been willing to put out a form of words that papers over fundamental differences in the belief that words can create enough momentum to bring union in fact. A lot of that has worked so far, at least in keeping the project apparently moving forward.
The nature of these collectivities, however, is the classic institutional problem – growth happens by increments, but then failure is swift and by whole institution. I don’t think this will happen to the euro, but a break-up of the currency in all but formal name, a breakup of the zone even if not the currency as such, through much more clearly signaled north and south euros, is a real possibility. (My proposal for names – we’ll call the northern, German one the … ‘duro’.)
The emergence of two glossed over “euros,” hard and soft, seems to me the minority possibility at this point. More likely is the current proposal for centralized “eurobonds” issued by the eurozone as a whole and regulated by the ECB. The Economist has a good summary of current proposals and arguments over design. The main driver for doing this now, as the Economist points out, is that existing ring-fencing of sovereign debt risk in the eurozone is starting to look inadequate.
Whether Germany would ever agree to such a thing – and whether its courts would accept this as constitutional – is very much open to question. The German constitutional court is set to issue a ruling on September 7 on whether the bailouts already underwritten by Germany were constitutional; as I understand it (and I’m not a German law expert) eurozone sovereign bonds would raise at least some similar issues, at least without changes in the treaties as they exist now. The widely-reported August 2011 Bundesbank report is strongly resistant to anything that looks like a wider or deeper bailout of any kind.
Eurobonds might be either a restraint on future bailouts – or an enabler. As with strategic ambiguity games generally, the same term that is sold to one party as one thing is sold to another party as something else; to Germany as a restraint and to Portugal as an enabler and a way out of genuine fiscal restraint. As the Economist adds, up to now the prospect of collective eurozone debt has been viewed in Germany with horror, as its borrowing costs would then have to absorb Greece or Italy’s (a German think tank suggests the additional cost could eventually be 1.9% of German GDP). Says the Bundesbank in the report’s conclusion concerning bailout authority (graf break and emphasis mine):
The recent resolutions transfer sizeable additional risks to the countries providing assistance and their taxpayers, and go a long way towards communitising risks caused by unsound public finances and misguided macroeconomic policies in individual euro-area countries. This weakens the foundations of monetary union, which is based on the principles of national fiscal responsibility and the disciplining effect of capital markets, without noticeably increasing the influence and control over individual national fiscal policies as a quid pro quo. Overall, there is a risk that the originally agreed institutional framework of the monetary union will increasingly become eroded.
While fiscal policy will continue to be determined by democratically elected parliaments at national level, the resultant risks and burdens will increasingly be borne by the Community in general and the financially sound countries in particular, without this being offset by any concrete powers to intervene in the sovereignty of national fiscal policies. No comprehensive change in the European treaties is currently envisaged that would democratically empower a central entity to exert some control over national budgetary policies. This means there is a danger that the euro-area countries’ propensity to incur debt may increase even further, and the pressure on the euro area’s single monetary policy to adopt an accommodating stance may grow. Unless and until a fundamental change of regime occurs involving an extensive surrender of national fiscal sovereignty, it is imperative that the no bailout rule that is still enshrined in the treaties and the associated disciplining function of the capital markets be strengthened, and not fatally weakened.
Presumably eurozone bonds on this analysis are just another indirect bailout, as an economic conclusion and perhaps a legal one as well. However, a new and interesting report from the European think tank Bruegel, to which the Economist points, comes up with a potential solution to the risks of centralized eurozone bonds. I’ve just read it, and if this is your area, it’s worth a look. The Economist summarizes the underlying issue and Bruegel’s proposed solution this way:
Until now the countries that call the shots in the euro area—those with strong public finances, notably Germany—have viewed Eurobonds with horror. They have two main objections. First, the pooling of public debt in the 17 member states would raise the interest rates paid by the most creditworthy while lowering them in countries with weaker fiscal positions … Second, Eurobonds would remove the pressure on improvident governments to put their public finances in order. Would Italy, for example, have pushed through its recent austerity budget had it not been pushed by the markets?
Proponents of Eurobonds have an ingenious answer to both these objections. A policy proposal published last year by Bruegel, a think-tank, said that for each country they should be limited to 60% of GDP (the maximum ratio of debt to GDP first intended for the monetary union). Together with a liquidity premium that should arise from creating a much bigger market, in Eurobonds, than the national sovereign-debt markets, this limit would curtail the feared rise in borrowing costs. Countries would retain national responsibility for debt above the 60% threshold, which the authors dubbed “red” (as opposed to the “blue” Eurobonds). This would create an incentive for them to behave prudently, since borrowing costs on red bonds would be higher.
But the idea has two snags. First, by dividing sovereign debt into tranches, the enhanced safety of the blue bonds would come at the expense of the red ones—which could become red-hot for risk-averse investors. Vulnerable countries could find themselves in an even trickier position if investors demanded higher yields on this portion. Second, the proposal assumes that the 60% limit could be maintained. In a future debt crisis, it might not be.
It is not insignificant that the Bruegel briefing paper is titled “The Blue Bond Proposal”; it focuses almost entirely on the virtues of blue bonds that would be separated from the red bonds. I’d like to suggest, however, that the question of the red bonds is at least as interesting; the implicit assumption of The Blue Bond Proposal seems to be that, having created eurozone blue bonds that are fiscally prudent and centrally regulated with a German-like interest rate to match, the markets will figure out how to price the correlative red bonds. The report acknowledges there will be lots of red bonds. Apart from the overall political question of whether the lines between blue and red will hold in a crisis, the questions of a market in red bonds seem to me much more important than the proposal seems to contemplate.
One way to characterize the blue bond, red bond proposal, after all, is to think of the red bonds as quasi-junk bonds. The evolution of corporate junk bonds includes equity-like features, however, as well as the risk of default and then the imposition of bankruptcy, reorganization, and related institutional features. These do not correlate well with sovereign debt, because of the nature of corporations as institutions as compared to states as sovereign countries, with their institutional obligations for populations. At least in this preliminary version of the proposal, I do not see exactly how blue and red bonds interact with one another, in their covenants and mechanisms that affect institutional relations and, finally, each other. Simply establishing rules of priority, as with corporate debt in bankruptcy, does not seem adequate to the issues of sovereign debt. Indeed, one wonders whether one result would be, over time – were such a centralized eurozone issuance established – the emergence of a centralized eurozone resolution authority for sovereign debt in the zone, the equivalent of a eurozone sovereign debt bankruptcy court.
But those are just the beginning questions; the Bruegel report is notably skimpy on the functioning of red bonds; let me put the question to readers: what are the issues concerning red bonds? Is it useful or not to compare them to corporate junk bonds, both for the features they have and the features that, on account of being sovereign debt, they might lack? My political guess, for whatever it’s worth, is that something like this proposal will be tried before Germany or other northern economies give up and go for the ‘duro’; it seems too hard politically for the eurozone not to double-down on centralized issuance, whether it works or not.
As a question of market trust, the question of separate blue bonds-red bonds is the usual one of whether the markets would believe a new assertion that fiscal discipline will be maintained – starting with a 60% rule. Or whether, alternatively, just as the markets believed and still believe in the Bernanke-Greenspan put, they will believe in a German put and price risk accordingly. Would collective discipline hold? That might ultimately be a purely material economic question, when Germany runs out of funds. But for a long time before that point, it is a political question – but one that runs both directions. European elites (including many German ones), believing that they either have created the European ‘demos’ because they themselves are true believers or because elite opinion has long been the dominant political factor in Europe, will put the political project ahead of anything else.
But if, as I imagine most Germans, and most German politicians who face actual German elections, already suspect, internal fiscal probity is a characteristic of a political culture – a particular demos, unsurprisingly – and it is as nontransferable by any quick means to places like Greece, if at all, as democracy to a place like Afghanistan. It is impolitic to say so, but strikingly, the most important lesson of the past decade seems to be that culture matters. Expect this intra-European conversation – as it increasingly threatens to become an inter-European state conversation – to get ugly and heated.