IMF Working Paper No. 12/172
Summary: This paper discusses proposals for common euro area sovereign securities. Such instruments can potentially serve two functions: in the short-term, stabilize financial markets and banks and, in the medium-term, help improve the euro area economic governance framework through enhanced fiscal discipline and risk-sharing. Many questions remain on whether financial instruments can ever accomplish such goals without bold institutional and political decisions, and, whether, in the absence of such decisions, they can create new distortions. The proposals discussed are also not necessarily competing substitutes; rather, they can be complements to be sequenced along alternative paths that possibly culminate in a fully-fledged Eurobond. The specific path chosen by policymakers should allow for learning and secure the necessary evolution of institutional infrastructures and political safeguards.
The European Monetary Union was purposefully designed as a monetary union without a fiscal union. History has not been kind to such arrangements, as Bordo et al. (2011) argue and as several critics had warned before the eurozone came into being (for a review of that earlier literature, see Bornhorst, Mody, and Ohnsorge, forthcoming). The ongoing crisis appears to have validated these concerns. The absence of formal pooling of resources has required the construction of additional arrangements for inter-governmental fiscal support to respond to countries in crisis. These arrangements include the European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM). And as the crisis has evolved, the European Central Bank (the ECB) has needed to play an important role in supporting banks and, indirectly, sovereigns in need.
In this context, the common issuance of debt in the euro area has been increasingly evoked— including most recently by the European Parliament and the European Council—both as an immediate response to the financial crisis and as a structural feature of the monetary union.
This paper is a review of various proposals for common debt issuance. Clearly, common instruments are not the only or necessarily the primary way to reduce financial instability or improve economic, financial and fiscal governance in the euro area. Indeed, common debt issuance is inextricably linked to the shape and form of a future fiscal union. Because a fiscal (and banking) union is likely a longer-term project, a discussion of common instruments today can help sharpen the discussion of the choices underlying a fiscal union and possibly initiate more limited forms of risk-sharing and pooling that create a valuable learning process.
In undertaking this review, we are motivated by the following questions:
* How does the proposal change incentives of governments (debtors) and creditors? Does it offer clarity on how average and marginal costs of borrowing would be affected, and how default would be treated?
* What is the nature of the insurance that is being offered? Would the new instrument help reduce risk and improve liquidity? Who will want to hold those instruments?
* Would the (currently perverse) sovereign-bank linkages be reduced? What are effects on current financial markets (ill)functioning?
* What are the phasing-in, transitional, legal, and institutional issues?
* And, are there paths along which the different proposed instruments may be combined?
Common debt could bring reprieve from current financial instability. Specifically, the creation of a large safe asset can reduce flight to safety from one sovereign to another and weaken the links between banks and their respective sovereigns that are currently destabilizing. Common debt issuance could also be a structural stabilizing feature of the euro area by helping to create deeper and more liquid financial markets allowing the monetary union to capture the liquidity gains of a broader sovereign debt market. Importantly, these initiatives can serve to focus attention on the need for fiscal federalism including macroeconomic stabilization and risk-sharing mechanisms but also fiscal discipline.
But there clearly are risks associated with such common instruments. In terms of fiscal discipline, the pricing approaches, where countries’ own debt is lower ranked and hence pays a higher price, are intriguing. But the tranching creates new challenges, not least if the junior tranches replicate the instability that we are currently witnessing. Similarly, to the extent that funds are earmarked to repay the common debt, greater pro-cyclicality may ensue as earmarked resources are less available to deal with adverse shocks.
Ideally then, common debt should follow from a fundamental discussion of the long-term shape of a fiscal, financial and monetary union. The absence of a debate on fiscal union reflects in part historical concerns that one group of countries may become dependent on another group on a permanent basis. But short of addressing these fundamental issues completely, common debt issuance can initiate a political process towards this goal. If, for the moment, there is only appetite for limited and bounded fiscal risk-sharing, then the Eurobills can start a learning process. These could be scaled up if proven successful and evolve towards more ambitious structures. If the assessment is that a key task today is to bring debt-to-GDP ratios down before further progress can be made, then the Redemption Pact is the right first step. But this would take 20-25 years and delay the creation of a permanent mechanism to complete the monetary union.
Thus, addressing both the current debt overhang problem and insuring against loss of market access likely requires combining several proposals. And while a gradual phase-in provides some advantages, in particular as it can foster a political discussion about fiscal risk-sharing and transfers, the current financial crisis might call for more rapid introduction. Regardless, steps towards common debt issuance require an open political discussion given the importance of accountability and legitimacy dimensions associated with the embryonic creation of a fiscal union. Federations are not static political constructs and common debt issuance can both contribute to effective economic management and act as a catalyst for political change. In that sense, the proposals put forward are a constructive feature of the ongoing discussion, forcing a critical and focused rethinking of the EMU architecture.