Tuesday, April 7, 2020

Eurobonds And Other Creative Ideas

The United States of America did not become united states overnight. When the 13 colonies declared independence in 1776, the governmental unision was a difficult birth. And the population at large was definitely not united in breaking with the mother country. The unifying institution throughout the War of Independence was the army. While it hardly won any battles, it upheld a sense of common purpose and destiny throughout the 13 colonies.

Alexander Hamilton, the illustrious Founding Father, argued that the first step towards a federal union was a federal army. And the second step? Yes, Hamilton was emphatic about insisting that all debt of the 13 colonies would have to be mutualized and federal debt introduced to the markets.

The debate then was similar to the debate within the Eurozone in recent years. The frugal Northern colonies were against the profligate South. The principal protagonists were Thomas Jefferson and Alexander Hamilton. Jefferson, history's darling for having drafted the beautiful Declaration of Independence, came from the South (Virginia) and represented the landed gentry of gentlemen farmers. He was literally paranoid about any central government with centralized powers over decentral states. Hamilton, an immigrant from the Caribbean and a brilliant mind, had studied the economies of several countries, notably that of Great Britain. His conclusion was that one prerequisite for economic growth was federal debt in unision with a Central Bank. Federal debt which carried the "full faith and credit of the United States of America" and, therefore, became a safe asset. Furthermore, Hamilton was convinced that the only way to maintain the union, or to even make it an ever more perfect union, was to have mutualized federal debt which made the states dependent on one another and on the central government. Hamilton prevailed in the end (Jefferson agreed to the debt mutualization in exchange for getting the nation's new capital for the South; Washington, D.C.). And as it turned out, the federal army and the federal debt hugely contributed to making the USA an ever more perfect union.

Why this long introduction? Because there can be no doubt that a joint federal debt, i. e. a Eurobond, is a prerequisite if one hopes to ever have a more perfect union in Europe. Just like a coordinated fiscal policy with a federal treasury is another such prerequisite.

My second point is: anyone who is truly interested in ever achieving a more perfect union in Europe is doing this goal a disservice by pressuring for Eurobonds now. A Eurobond would not achieve any benefit today which cannot also be achieved by alternatives which are less divisive. A Eurobond is likely to be eventually accepted by the North but it will require time, persuasion, a change of treaties, etc. To steamroll the EU into Eurobonds with the argument that a virus requires it will eventually result in a backlash. As Gideon Rachman, the renowned British journalist, wrote in the Financial Times:

"Advocates of eurobonds stress the potentially disastrous effects on public opinion in southern Europe if ­northern Europeans fail to respond while the Italians and Spanish live through a tragedy. But northern Europe also has to consider politics and public opinion. The mutualization of debt within the EU has always been the reddest of red lines for the Germans, the Dutch, the Austrians, the Finns and others. If it is pushed through now — in an atmosphere of crisis — it could set a time-bomb under the EU."

Let us take one step back for a moment. What actually is a Eurobond? I am afraid that one might get many different answers if one asked many people today. Perhaps one should look at the American equivalent of a Eurobond (US Treasuries) to extrapolate how it might work in Europe.

A US Treasury is a bond emitted by the federal government through its Treasury and it carries "the full faith and credit of the United States of America". The cash proceeds of the bond flow into the Treasury which uses the funds to finance federal expenses. Put differently, the entity which raises the funds and assumes the debt is the same entity which controls the use of those funds (i. e. the federal government under authorization from Congress). Also, that entity has its own independent revenue base such as federal taxes.

The federal government can spend the money on anything which Congress authorizes with one very important exception: the US Constitution prevents the federal government from extending financing to individual states or from assuming responsibility for state debt. Put differently, when disaster in the form of a brutal hurricane strikes the State of Louisiana and that state needs to raise funds to pay for the damage, it can raise funds by issuing its own bonds but it cannot resort to the federal government as a lender of last resort. The federal government can provide specific purpose relief funds or grants but it cannot provide general purpose funding for the state government.

I am appalled by the absence of specific proposals as to what the supporters of Eurobonds have in mind. One gets the impression that they think of Eurobonds as a source of funding which some third party will pay back. One author, Professor Fancesco Giavazzi, described it as follows:

"Member states should jointly issue a large amount of very long maturity COVID Eurobonds backed by their joint tax capacity. Each country would issue its own bonds, but the bonds would otherwise be identical. Their common rating would be the result of all bonds being guaranteed by the joint tax capacity of the countries participating in the joint issues."

Now that, dear Professor, is plain nonsense! There is a contradiction within the first 2 sentences: first, it is argued that member states should jointly issue Eurobonds and, then, it is argued that each country would issue its own bonds with the guarantee by the joint tax capacity of all participating countries. Well, dear Professor, it is one or the other but it cannot be both!

A bond cannot be issued jointly because the proceeds of it will have to flow to an individual account. Also, the purchasers of the bonds need to know who to sue in case the bond does not get paid. One can only go after the guarantors after the issuer has defaulted. There must be an issuer and it is currently not clear at all who the Eurobond supporters propose to be the issuer.

The idea that individual countries can issue their own Eurobonds as they please is childish, at best. No third party, and certainly no Northern member of the Eurozone, would guarantee such a blank check. The American example shows very clearly that a federal bond must be issued by a federal institution which represents the full faith and credit of the federal union. That full faith and credit is not accomplished because all US states jointly and severally guarantee federal bonds. Instead, it is accomplished through the federal institution's tax capacity and through its monopoly over the currency.

There is currently no EU institution which has a federal tax capacity. The EU has some revenues like import duties, etc. but the bulk of the EU's expenses is covered by contributions of the members states. If the EU issued its own Eurobonds, no purchaser would buy them because they would not represent the full faith and credit of the EU. It would only represent the full faith and credit of the EU Commission which has very little revenues and no authority to raise taxes. Clearly, the purchasers of the bonds would require a joint and several guarantee of the member states.

A joint and several guarantee means that the creditors can call on each of the guarantors for full repayment in case the EU Commission defaults. Every guarantor would be liable for the full amount of the bond and, obviously, the creditors would go first to those guarantors who have the strongest resources to pay. In all likelihood, each of the guarantors would attempt to limit his liability by setting caps. Then it would no longer be 'true' Eurobonds but only 'limited' Eurobonds.

If the EU raises funds via Eurobonds with the joint and several guarantee of its member states, the proceeds of the bonds go into an account of the EU. Then the principal question becomes: how do those funds flow to the proper beneficiaries and in what form. If they flow from the EU to, say, Greece as a loan, there is virtually no difference for Greece whether it raises funds via its own bonds or via Eurobonds. There used to be a difference during the crisis because Greece could not sell it own bonds or, if so, only at prohibitive interest rates. Today, with the ECB's declared policy, Greece can essentially sell its own bonds at the same interest rate as a Eurobond would carry.

A Eurobond only makes sense if it leads to a vast expansion of the EU's budget and when that expanded budget is used to provide relief to those countries that need it the most. Relief means non-repayable funds, i. e. grants or subsidies or whatever. It is special purpose relief and not general purpose funding of state budgets.

The battle for Eurobonds is currently the wrong battle at the absolutely wrong time. The far better response to the challenges faced by the South as a result of Corona would be to establish a large Relief Fund which would be funded either by direct contributions of certain member states or, alternatively, through its issuance of bonds jointly and severally guaranteed by certain member states. Obviously, if, say, Greece needs the relief, it does not make sense to have Greece guarantee its own relief.

Any relief must be non-repayable. In times of zero interest rates, it is no longer possible to provide relief via a lowering of interest rates. In many aspects, that Relief Fund would be rather similar to the Marshall Plan ("European Recovery Fund"). The Marshall Plan provided non-repayable funds for projects in individual countries. But here was the trick: in each country, there was a High Commissioner of the Marshall Plan who had final authority on the application of the funds.

Dear proponents of Eurobonds: please stop dreaming that Eurobonds are an easy way to draw down debt which someone else will repay without any strings attached! And please bear in mind that if you really want to plant a time bomb under the EU, then steamroll with the pressure of Corona other countries into crossing red lines which they have promised their voters they would never cross. The results will not be pleasant for the EU.


  1. Is this your opinion as a Northerner? Here is my opinion as a Southerner:

    Dismantle the eurozone now. The Northern countries will never accept a federal government, common debt issuance, or any form of surplus recycling mechanism. They're in this for as long as it lasts, to milk every penny out of the South, to enjoy a lower exchange-rate for as long as it exists, to buy any Southern assets in fire-sales similar to the ones that the European program forced Greece to do.

    Enough is enough. Dismantle this parody of a monetary union now.

    1. Dear Southerner, regarding the devastation the Troika caused with the measures that they forced on Greece I totally agree with you.

      The rest of your statement ignores the fact that via Target II before all others Italy and Spain have received implicit funding by Germany each higher than 400 Billion €.
      At zero interest and no timeline whatsoever to repay.
      Think again please.

    2. You are a bit confused about how Target-2 works, Anonymous. The only thing that Target-2 financed is the constant flow of deposits from the South to the North. If it wasn't for Target-2, then there would have been no monetary union to begin with.

    3. Well dear southerner, to understand the machanics and meanings of Target II is quite a bit challenging. Most probably there is the necessity to do some further study on the subject. That might enhance to deliver sound statements.
      Cheers to the south.

  2. Happy Easter 2020, Klaus. Take care be well.

    Best wishes from Cologne

    Details, details, details:

    I appreciate your ability to put rather complex matters into a, language even me, the semi-commercially-educated-nitwit can understand. Basics, understand basics, that is.