FIRE for the Euro: A Superior Way to Bond Market Stabilization

Abstract

Summary Government bond markets within the euro zone may have fallen victim to a self-fulfilling crisis of confidence. Eurobonds may contribute to stabilization in the short-run but would imply destructive disincentives and incalculable risks for joint and several guarantors. Monetary interest rate equalization through the ECB government bond purchase program poses risks for central bank credibility and price stability. This contribution proposes fiscal interest rate equalization (FIRE) as an alternative. With FIRE, countries that benefit from low interest rates as a consequence of market panics would transfers some of their savings to subsidize the borrowing of crisis countries within a conditional fiscal scheme. The paper presents FIRE’s principles and discusses its advantages over alternative stabilization approaches. Furthermore, a simulation of a FIRE specification is presented which would shield Italy and Spain against interest rates above 5 percent.