Euro bonds are understood here as centrally-issued, jointly-guaranteed bonds for financing all of the euro area countries’ public debt. In that form, euro bonds could, under strict conditions, enhance the stability of EMU. First and foremost, a stable EMU would be unthinkable without stronger and more enforceable safeguards for sound national public finances, including the correct incentives for enlarging the structural growth capacity and countering macroeconomic imbalances. However, even if that condition has been met, unexpected large shocks in individual countries might still generate market unrest about fiscal health. Rules can never anticipate all problems in advance. This time it was the build-up of imbalances and a financial crisis, but the next time it may be a natural disaster that causes one or more euro area countries to see an unexpectedly sharp deterioration in their public finances. Doubts about a country’s fiscal health can subsequently trigger a vicious circle, with high interest rates leading to a fiscal deterioration, which in turn pushes up interest rates. In this way, every country could eventually become insolvent, even if this is not justified by the initial deterioration in itself. In comparison to countries with their own currencies, euro area countries have less policy instruments for independently breaking this vicious circle. As they do not have their own monetary policy and exchange rate, interest rate cuts and devaluations cannot offer any (temporary) relief. Because market participants know that all euro area countries are vulnerable in this respect, financial turmoil in one country can easily spread to other (problem) countries. This contagion risk is exacerbated by the far-reaching interdependencies of the financial sector in EMU.
The present choice is to combat these problems by providing liquidity support through a European emergency fund. By attaching conditions to this support, recipient countries can be compelled to carry out reforms. This is essential, because the current structure of the euro area does not provide enough other ways of forcing countries to reform. At the same time, this approach also leads to unrest. The question whether conditions for payment of the next part of the loan have been fulfilled now arises periodically. Moreover, an emergency fund offers a less fundamental solution to the danger of contagion than euro bonds. With an emergency fund, interventions only take place when the vicious circle has already started and the risk of contagion cannot be fully removed. Over time, the introduction of euro bonds hence offers a better solution to the instability of the euro area described above than the existence of an emergency fund. However, a number of strict conditions must first be fulfilled.
A proven safeguard of national fiscal discipline is of prime importance. Because of the mutual guarantees and the lack of market discipline, euro bonds in themselves reduce the incentives for healthy national fiscal policy. Moreover, the current fiscal problems show that the incentives for sound policies were already inadequate. Before euro bonds can be introduced, national fiscal discipline must be demonstrably safeguarded. The debt ratio must have at least fallen to the limit of 60% of GDP laid down in the European Treaty. This ensures that even if the budgetary situation deteriorated severely, the chance is small that the mutual guarantees would be invoked. A low level of debt also means that if the guarantees do have to be invoked, it is credible that the other countries can absorb the extra burden. This lower debt ratio can only be realised and maintained through independent enforcement of the European fiscal rules and by anchoring these rules in national legislation. An independent European authority that can increasingly intervene in the fiscal policy of countries that break the agreements is essential in this respect. Such an authority should also pay attention to the build-up of macro-economic imbalances and the structural growth capacity of euro area countries.
In order to ensure that compliance with the fiscal rules is truly enforceable, a European and national statutory ban on national debt issuance by euro area countries should come into effect at the same time as the euro bonds are introduced. The independent authority would therefore obtain full control over a country’s debt issuance, meaning that, as an ultimate sanction, funding for a country that notoriously fails to meet the rules can be curtailed. With euro bonds, this sanction can be more credibly imposed than at present, because i) countries can only access financing through the authority ii) the (re)financing of the existing debt is not at issue. Relinquishing the option of issuing national debt may seem a huge sacrifice, but in practice it will be already costly for a country that has funded all its government debt with euro bonds to independently seek extra financing, seeing as the market for such funding is highly illiquid. In addition, a country that seeks access to the market shows that it does not have its affairs in order, leading to mistrust among investors. Finally, the current crisis shows that countries lose their access to the market when things go wrong. A complete ban hence merely serves as an extra lock on the door.
However, a complication is that if a country, because of having breached agreements, is refused access to new financing, it cannot provide any support to systemically important banks should the need arise. This might undermine market confidence in the national banking sector, possibly causing funding problems for national banks. In order to credibly limit euro bond financing as an ultimate sanction, an important condition is that a European bank safety net (including a European deposit guarantee scheme) is established; this would also require European banking supervision. Note that this is already part of the Dutch government’s vision of the future of EMU.
If all these preconditions are met, a potential advantage of euro bonds is that they would lower financing costs for all euro area countries. A much larger market would be created, lowering the liquidity premium for smaller countries in particular. In addition, the combination of proven national fiscal discipline, low debt levels and mutual guarantees could make euro bonds an extremely safe investment, further pushing down interest rates. There is therefore no need for the financing costs of the current strong countries to increase, preventing a “transfer union”.
From a practical perspective it is not possible to fulfil all of these conditions in the short term. Euro bonds are therefore only useful as the capstone of EMU and not as a crisis instrument. However, a credible prospect of strict fiscal discipline with euro bonds as the capstone could signal a commitment by European government leaders to a stable EMU, and so contribute to alleviating the current turbulence. This requires an action plan, just as for the establishment of EMU, in which the necessary prerequisites are fulfilled prior to the introduction of euro bonds.