The proposal to issue E-bonds, made in the FT by Jean-Claude Juncker and Giulio Tremonti, has sparked widespread controversy. Some observers (for example, Wolfgang Münchau) have said that it contains the kernel of a solution to the European debt crisis – which, under some circumstances, it might. But the initial response from Angela Merkel has been negative, exactly as it has been in many earlier rounds of this particular debate. The E-bond idea will obviously go nowhere without the support of Germany. But they have never before faced the real possibility that there could be a break-up of the euro if the sovereign debt crisis is not overcome. Maybe it is time for them to think again.
All previous versions of the E-bond plan have fallen at the first fence because of the budgetary guarantee which Germany would implicitly offer to other member states if E-bonds are backed with a “joint and several” guarantee from all of the member states. In effect, this would mean that, in extremis, the strong economies would become liable for all of the government debt issued within the EMU bloc. Germany has always regarded this as a non-starter, for very understandable reasons.
An alternative is to offer only a “proportionate” guarantee for the E-bonds, under which each member state would simply stand behind a fraction of the bond issue, with this fraction being broadly proportionate to GDP. Under this form of guarantee, Germany would not have to bail out other countries if they defaulted. Instead, the private sector bond purchaser would stand to take the loss. This is basically the form of guarantee which is being offered on this week’s EFSF bond issues. Germany finds this form of guarantee somewhat more acceptable than the first kind, because it only stands behind a maximum obligation equal to its share in the total equity of the EFSF (plus a cash buffer of 20 per cent), no matter how many other countries eventually default.
However, Germany is not keen on expanding the quantum of bonds with this second form of “proportionate” guarantee for two reasons. First, the bond yield on such instruments will be higher than the yield on bunds, so Germany would pay more to do this type of funding than it would if it issued its own bonds. Second, this mechanism subsidises the weakest countries, which gain access to funds at rates which are much lower than they could achieve on their own, and this protects these countries from the normal market incentives to reduce their borrowing.
The Juncker-Tremonti (JT) plan attempts to get round some of these difficulties. Although I have not seen it spelled out in any detail, it seems to be based on this proposal published last May by the Bruegel think tank in Brussels. Basically, the plan would finance part of each member’s debt via E-bond issues, which would be jointly guaranteed by all members. This would be called the “blue debt”. The rest of any member’s debt (the “red debt”) would need to be financed by the member itself, without any form of EU guarantee. There would be an agreed default procedure on the red debt (which is something Germany wants to see), and countries would face rising bond spreads on this debt if they seemed likely to default. Therefore there would be market incentives encouraging good behaviour.
The significance of this plan clearly depends on the ratio of blue debt to red debt for each member state. If the blue debt covers the entire government debt of a member, then all of its debt has in effect been guaranteed by the system as a whole, which ultimately means that the strong economies have underwritten the entire eurozone. But if the ratio of blue debt is set very low, then then new mechanism would, in effect, be no different from current arrangements. This is a subject for negotiation.
In the JT plan, blue debt would be set at 40 per cent of GDP for each member, so that any debt in excess of that amount would not be affected. This would mean that all member states would still need to finance a significant portion of their debt in the normal way.
How would this arrangement solve the present crisis? There would be three areas where it could help. First, a large chunk of the existing debt of the troubled economies would be refinanced at lower interest rates, which improves the solvency of the weakest members, not just their liquidity. Second, according to JT, there would be a bond restructuring plan, under which the private sector holders of troubled debt would have an option to swap this debt for blue debt at current market values. This restructuring would reduce the debt ratios of the troubled economies, because their bonds are currently marked at par, whereas they trade in the market at much less than par. Third, JT say that, under genuine crisis conditions, all of the new debt issues of the problem economies might for a while come in the form of blue debt, which would eliminate the scope for speculation against the system.
I argued in this previous blog that the EMU zone, taken as a single bloc, has a strong enough fiscal position for it to be able to solve the current crisis fairly easily. And both Germany and France have promised to “do whatever it takes” to safeguard the euro. For example, Wolfgang Schäuble said on Sunday that:
“If even a smaller country were to drop out (of EMU), the consequences would be incalculable. I think of the Lehman bankruptcy when I say this: we must not make the same mistake twice.”
The blue bond plan is a long way from being perfect from the German point of view, because it does involve an element of bail out and moral hazard. But it might prove preferable, even for Germany, than a second Lehman bankruptcy.
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