Following a recent meeting with European Central Bank representatives and the publication of the European Commission Green Paper on Eurobonds Muellbauer is hopeful that the idea of conditional Eurobonds is gaining popularity.
The advantage of the conditional bond is that they can deal with the problem of ‘moral hazard’ (the idea that a country would alter its behaviour if it knows that it is insured against certain outcomes) explained Muellbauer. He described how the principle of a Eurobond would work with the following simple example: “The German Ministry of Finance could offer a two-year loan to the Italian government at 3% above what Germany pays, and promise that next year, if the Italian reform programme is showing visible signs of success, the spread could fall to 2.5% and then to 2% if progress continues. With backsliding (reverting to ineffective practices) the cost would rise. This would be highly profitable for the German taxpayer while the conditionality of the offer would keep the new Italian government committed to reform, aiding Italy’s credibility as a Eurozone member.” The Eurobond would just be the multilateral extension of this example.
Muellbauer believes that conventional Eurobonds, with the same funding costs for every country but with risk collectively underwritten, could be a recipe for disaster. “They would encourage lax fiscal policy, backsliding on reform, and moral hazard,” he said. This could allow the Eurozone to slide into even deeper crisis.
“Because we know that the Italian government has not been committed to fiscal discipline and labour market reform, it is appropriate that it should pay more when it borrows. If it borrows at same rate as Germany it encourages laxity and continuation of short term, myopic behaviour. This conditional borrowing rate gives the Italians the incentive to get their fiscal house in order and improve their competitiveness,” commented Muellbauer.
Muellbauer recommends that a sort of European IMF should be set up to manage and issue Eurobonds and, with collective agreement, define the spreads and supervise the Eurobond structure. However, as setting up a permanent Eurobond structure could take some time he recommends that a short term Euro Bill should be introduced quickly to set a temporary spread.
Recent press coverage
What the IMF should tell Europe
Financial Times November 30, 2011
Contingent short-term euro-denominated bonds to help
ZDF Heute.de December 7, 2011 (article in German)
Four Ideas to Save the Common Currency
Spiegel online December 7, 2011