Is the ‘Euro Bond’ the Answer to the Euro Sovereign Debt Crisis? What Outcome Can Investors Expect from Europe?

Abstract

This article analyzes the causes of the sovereign debt crisis in the euro zone and examines the policy alternatives confronting euro area governments. The author suggests that pooling fiscal risks, creating an EU Treasury, and issuing jointly backed euro bonds would be an optimal solution and the inevitable conclusion of the economic integration project in Europe. The author examines the advantages and disadvantages of euro bonds and concludes that issuing euro bonds would transform a market that is fragmented along national lines into a single unified European government bond (EGB) market with the same depth, breadth, and liquidity as the U.S. Treasury market. By enhancing the size and liquidity of the EGB market, global investors and wealth managers would be able to use euro bond instruments as a tool for payment or transaction needs as well as short-term precautionary and investment balances, which would increase the demand for them and lower their yields. This development would allow the euro area to extract “seigniorage” benefits similar to those that the U.S. has enjoyed in the post-World War II period, which would lower funding costs even for fiscally strong euro area countries. It would also consolidate the euro as one of the world’s two principal reserve currencies. The risk that fiscally weak area countries might take advantage of low borrowing costs to increase debt could easily and effectively be mitigated by agreeing on a formula that would establish an escalating rate in the sharing of interest costs that would be proportional to their debt–GDP ratios. Thus, moral hazard would be mitigated, and incentives would be created to reduce debt and increase income. <b>TOPICS:</b>Fixed income and structured finance, developed, financial crises and financial market history