The Dangerous Siren Song of E-Bonds in 2011
The New Year has brought the welcome development of a heavily oversubscribed issuance of €5 billion five-year bonds by the European Financial Stabilization Mechanism, which was created last year to deal with the spreading financial crisis in Europe. While it is obviously good news for European Union governments that their newly created "crisis fighting tools" of jointly guaranteed debt can sell well among investors, especially in Asia, there is now a risk that this EU-level bond market success will lead to "irrationally exuberant" calls for the large-scale issuance of regular eurobonds, or E-bonds. It is crucial for the long-term viability of the European project, however, that EU leaders resist that temptation.
As envisioned by Jean-Claude Juncker of Luxembourg, head of the European Union's finance ministers, and Finance Minister Giulio Tremonti of Italy in December, the eurobond has definite advantages making it attractive to many market participants. It would provide access for peripheral eurozone governments to low-interest financing and create a potentially deep and liquid E-bond market in Europe. Such a market could lure in large outside investors looking for a potential alternate "safe haven asset" to the US Treasury market. A deep liquid E-bond market could also provide a traditional "interest rate risk only" sovereign bond market for investors, who have been shunning peripheral "credit risk" debt markets recently.
Similarly, the process of converting some bonds of peripheral countries into E-bonds (initially proposed for bonds equaling up to 40 percent of GDP) could allow private debt holders and peripheral governments to swap Greek government debt, for example with secure E-bonds, though at a discount. Such an E-bond conversion process, accompanied by a haircut, would consequently begin a necessary restructuring of peripheral debt in much the same way Brady Bonds were used in Latin American and elsewhere starting in the late 1980s.
But despite these obvious potential market benefits, E-bonds remain a potentially destructive idea in Europe for several reasons.
First, it is not clear that they would actually deal decisively with the current problem of already unsustainable debt burdens in Greece and elsewhere in the eurozone. Converting 40 percent of a total debt burden of around 150 percent of GDP to senior E-bonds, even at a discount, would still leave Greece with a very large national and now subordinate debt burden. The resulting two-tier bond market would transform Greece into a one-third OECD country bond issuer and two-thirds emerging-market bond issuer. It seems far from likely that the total funding costs for Greece would be substantially lowered.
Given the Italian fingerprints on this proposal, it is not surprising that high debt eurozone countries like Italy, with a substantial domestic savings base to which it would sell its now reduced national debt, would reap the biggest benefits of this type of E-bond. Yet E-bonds would still leave the eurozone with the need to find a solution to its euro-introduction "legacy problem" of unsustainable debt burdens and unreformed product and labor markets in its southern periphery.
There is the further issue of politics, too often forgotten when new EU visions are unveiled. Irrespective of the financial market benefits of E-bonds, such bonds represent "taxation without representation."1 Citizens in AAA-rated eurozone countries (not only Germany, but also Luxembourg, Netherlands, Finland, Austria, and France) would be implicitly asked to pay for the fiscal decisions of peripheral lower-rated eurozone governments. Irrespective of any envisioned increase in the eurozone/European Commission's fiscal surveillance mechanisms, this obligation would be without any direct democratic influence over these fiscal decisions.
E-bonds simply lack the democratic legitimacy to be sustainable in a European Union where citizens' self-identity overwhelmingly remains at the national level as Spaniards, Belgians, or Germans. While the willingness of Europeans to be taxed by their governments evidently remains higher than in the United States, the willingness to pay taxes to Brussels or stomach potentially open-ended unconditional transfers to other countries is far lower. An E-bond introduction is the certain way to spawn "tea party transfer protests" across Europe.
E-bonds, finally, lack the intrusive and coercive conditionality that is the most important long-term feature of any IMF program, including the bailouts for Greece and Ireland. IMF program conditionality, by improving a recipient country's economic growth performance and thereby raising its debt capacity (reducing the risk of a debt restructuring and/or lowering the required haircut) makes it possible for a recipient country to begin a de facto "debt restructuring" right away.
The periphery of the eurozone still suffers in many places from overregulated labor and product markets and bloated welfare states for protected insiders. It is vital for the eurozone not to waste its crisis window of opportunity, as a certain former White House chief of staff once put it. A quick glance at the latest IMF list of imminent structural reforms in Greece [pdf] reveals that many have been on the OECD/IMF/European Commission wish list for decades. Now the forceful hand of the IMF is finally seeing that they happen. The eurozone cannot afford to lose this ultima ratio source of structural reforms.
Instead, E-bonds would be issued unconditionally at the volition of individual eurozone governments to retire existing national debt. As a long-term crisis solution mechanism, they would be similar to the Securities Market Program (SMP) of the European Central Bank (ECB), which provides helpful liquidity support to peripheral countries through outright purchases of national secondary market debt. But because the SMP is an unconditional "crisis fighting tool" and the ECB does not have the power to force the hand of elected eurozone governments,2 the potential for reforms is missing.
This unsustainable situation is clearly present in the case of Portugal, a country already "on the take"—despite its government's misleading protestations that it can do without a bailout. There, the ECB—in acting to shield Spain from any Iberian contagion—has effectively already put Portugal on such a large support program that by some estimates it amounts to the entire Portuguese medium- to long-term sovereign bond issuance in 2010.3 As a direct result of this unconditional ECB "crisis support," Portugal is the biggest reform laggard in the eurozone southern periphery since the Greek crisis began in early 2010. An early and forceful IMF hand in Portugal would have been a superior strategy.
The situation with Portugal illustrates why the new permanent European Stabilization Mechanism (ESM) should be allowed to purchase eurozone government bonds in the secondary debt markets, but only in return for the benefitting eurozone governments agreeing to implement economic reforms.
This will also enable the ECB to tell eurozone governments to "go somewhere else" for short-term liquidity support—and then to do their reform "homework" before getting financial relief from other borrowers.
Europeans, take note of the advice of Virgil: Forsan miseros meliora sequentur!
1. An issue we residents of Washington, DC, are of course intimately familiar with.
2. Only at special points in time does the ECB have the required coercive power, as in May 2010 when they initiated the Securities Market Program and in return got a pro-reform pledge and money for the European Financial Stabilization Mechanism and European Financial Stability Facility from EU member states, or in November 2010, when the ECB forced the Irish government to accept the EU-IMF bailout package.
3. See Goldman Sachs Global Viewpoint, January 5, 2011, The EMU Sovereign Crisis, One Year On.