Hans-Bernd Schäfer Bucerius law school, Hamburg Consequences of Different Eurobond Proposals Sovereign Risk and the Euro: Lessons from the Crisis - Bologna, October 26-27-28 2017

The legal structure of the European Monetary Union and why Eurobonds were not a crisis instrument

The Institutional Framework of the Euro Price stability has a categorical priority over any other policy goal The European Central Bank is a bank for banks but not a bank for the state(s) unlike most other central banks Neither the EU nor any member state can be made liable for state debts of any member state or public body.

Article 127 1. The primary objective of the European System of Central banks (hereinafter referred to as the "ESCB") shall be to Maintain price stability. Without prejudice to the objective of price stability, the ESCB shall support the general economic policies in the Union.

Art. 123 No State financing by the Central Bank Overdraft facilities or any other type of credit facility with the European Central Bank or with the central banks of the Member States in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited... .

The European central bank -cannot give a direct credit to a state -cannot buy government bonds on the primary market ----- -Can buy government bonds on the secondary market for reasons of monetary policy -Can it buy government bonds on the secondary market to help a distressed country fiscally?

Art. 125 („no bail out clause“) The Union shall not be liable for or assume the commitments of central governments,regional, local or other public authorities, other bodies governed by public law, or public undertakings of any Member State... .

Public Debts in the Eurozone 200-2012, percent of GNP Source: Eurostat

Interest Rate Spreads (over German Gov. Bonds)

Why not mutualize all public debts in the Eurozone by a swift change of the TFEU? This was one proposal of the EU-Commission in 2012

Relation between EU law and national law EU-law trumps national law including national constitutional law and it is directly applicable That is national courts must apply European law. Member States must enforce it.

The relation between EU-Law and core principles of national law

In France: French Constitutional Council (Conseil Constitutionnel) referred to rules and principles that are ‘inherent to the constitutional identity of France’ that cannot be disregarded ‘except when the constituting power consents thereto’ Thereby transforming Directive 2001/29/EC of the European Parliament and of the Council of 22 May 2001

Ireland: Any European legal changes implying a substantial transfer of sovereign powers to the EU requires a referendum. Also Ireland makes use of “protocols” stating that it will not accept a particular ruling on the content of a particular European legal norm.

Germany constitutional court defined two exceptions for Germany in the 2 Solange Decisions. Ultra Vires decisions of the European Court of Justice Identity infringement of constitutional core principles (human rights, democracy) Gave access to every citizen in questions of the Euro, if core principles of democracy are concerned

The Commission’s proposal (2012) of mutualizing all debts or proposals with a change of the TFEU would most likely be unconstitutional in Germany and would have required a change of the constitution, which explicitly allows that. The crisis management would have been delegated to voters and courts

II. Eurobonds Beyond Crisis management The blue bond-red bond proposal with Eurobonds as blue bonds European Safe Bonds (ESBies) The pro rata liability proposal with a common interest rate for borrowers The pro rata liability proposal with different interest rates for borrowers The mutualization of all debt and the blue bond-red bond proposal with Eurobonds as red bonds

reduce the debt burden of a distressed country ? Can the proposal reduce the debt burden of a distressed country ? provide more safe assets? stabilize the Euro against one way speculation against its existence? Diabolic loop

cause additional reckless lending or borrowing? lead to a mutual gain by a lower liquidity risk premium?

The Liquidity Premium Liquidity risk and liquidity risk premium Size of the liquidity risk premium in the Eurozone The trade-off between the risk premium for Eurobonds and national bonds Under reasonable parameters for the function there exists a threshold size for the Eurobond market, which makes Eurobonds a win-win constellation.

III. Prudent and risk taking lending and borrowing on a national government bond market

National Bonds with default risk Credit constraint = Sl Sh Bond Market Size Interest rate=risk free interest rate plus risk premium Risk free interest rate Government bliss point of indebtedness

Effects of a bail out (ex-post solidarity (Tirole 2015)) Third countries minimize the sum total of spillover costs and bail out transfers. The expected bail out allows reckless lending and borrowing above the debt sustainability level. The expected bail out reduces interest rates . The bail out leads to a subsidy of creditors, it privileges large and system relevant creditors

C. National Bonds with bail out Credit constraint without bailout credit constraint with bail out = Sl Sl +B Sh expected bail out Bond Market Size Interest rate=risk free interest rate plus risk premium Risk free interest rate

III. The blue and red bond proposal (Delpla and von Weizsäcker)

D. The Delpla/Weizsäcker proposal Credit constraint = Sl Sh Bond Market Size Interest rate=risk free interest rate plus risk premium Risk free interest rate

The Delpla/Weizsäcker proposal Credit constraint = Sl Sh Bond Market Size Interest rate=risk free interest rate plus risk premium Risk free interest rate Blue bonds Red Bonds

Lending under the blue bond and red bond proposal Blue bonds are restricted to the debt service capacity of any country in in bad economic situation The proposal reduces interest rates for blue bonds

increases interest rates for red bonds cannot reduce the debt burden of a distressed country Imposes little additional risk on any guarantor and does not lead to open or hidden transfers provides no additional incentives for risky borrowing Reduces the liquidity premium, if the blue bond market is big enough Provides more safe assets in the Eurozone Might be time inconsistent

Legal Requirements European law, Change of Art. 125 TFEU, big change with referendum in some countries (Kaemmerer 2016) National Constitutional Law, could be unconstitutional, would require a constitutional change (Amtenbrink 2016) International law: The pari passu rule, but probably no violation of it (Waibel 2016)

The blue bond/red bond proposal would not reduce the debt burden of a distressed country It would lead to a mutual gain of all countries IF The time inconsistency problem could be solved Proposals: Direct Access of a European debt agency to parts of the tax income Bills instead of bonds

IV: The European Safe Bonds Concept (ESBiES) Markus Brunnermeier (Princeton) Esbies have similar properties as Eurobonds But without guaranties and joint liability. Safe assets Reduction of the liquidity premium Diabolic loop is dampened No additional moral hazard

Legal reqirements of the ESBies proposal No change of TFEU necessary No changes of National Constitutions necessary Establishment of a European debt agency necessary

V. Pro rata bonds without joint liability and a single interest rate for all debtors Proposal of the European Commission 2012

Pro rata bonds (Proposal by the European Commission) -Lead to a steady transfer from the stronger to the weaker country. -The problem of ex-ante solidarity: strong covariance of economic indicators -No safe assets -Mutual gain through the liquidity premium National bonds country A Eurobonds intrrest ratek Interest rate: high National bonds country B interest rate: middle Interest rate: low

Why pro rata bonds might be toxic and might lead to a race to the bottom Interest rate of pro rata bond=average of national bond rates If pro rata bonds co-exist with national bonds a state can -increase national debtsincrease riskincrease national interest rateincrease interest rate of pro rata bondsshift some of the costs to other states. This might lead other states to do the same to avoid this burden.

Transfers from the stronger to the weaker countries Economic Consequences: Transfers from the stronger to the weaker countries Increases moral hazard No safe assets Mutual gains through reduced liquidity premium possible Probably no stabilizing effect against diabolic loop

Legal Requirements It is debated whether they violate The TFEU, Art. 125 They might violate national constitutional law in those countries, from where there is a transfer payment. As this transfer payment is only implicitly part of the budget.

Pro rata bonds exist already European development bank European Stability Mechanism (ESM) Credits to Greece before the establishment of the ESM

VI. Pro rata bonds Eurobonds “light” pro rata bonds with internally differentiated interest rates A European debt agency issues Eurobonds at an average interest rate. Each country is liable for its share of the debts. Each country pays its national interest rate. The decreased liquidity premium leads to a profit of the debt agency. Member states can distribute this profit as they like. Pure Pareto improvement (win-win) No spillover effects No additional moral hazard No stabilization effect No safe assets Few legal hurdles

VI. Mutualization of all public debts or Eurobonds as red bonds (EU-Commission), The proposal of the German Council of economic experts, The 5 Presidents’ Report -Lowers interest rates for distressed countries considerably. -increases interest rates of other countries. -Carries huge moral hazard problems.

Proposals to avoid moral hazard: Transfer of debt management of all member countries to a Eurozone body. (Council of ministers, Parliament, Minister of Finance) This would imply a degree of centralization unknown even in federalist countries

VIII. The red bond blue bond proposal with all debts over 60% of GNP as blue and mutualized bonds. (Weder di Mauro)

Introduce blue bond/red bond concept Change the treaty (TFEU) IX. Preferred Proposal Introduce blue bond/red bond concept Change the treaty (TFEU) Change national constitutions Make member state insolvency easy Reduce bailout necessities by requiring more equity capital for financial institutions

X. The most likely outcome The 5 presidents report (2015) Commission Central bank European Council European Parliament Euro Group Speech of President Macron in September 2017

A separate parliament for the Eurozone. A budget for the parliament to finance projects in the Eurozone. Own taxes and/or Eurobonds to finance it. A “European Finance Minister”