EUROBONDS: A CRUCIAL STEP TOWARDS POLITICAL UNION AND AN ENGINE FOR GROWTH Paul De Grauwe University of Leuven and CEPS

Introduction Euro zone isthrown in a deep and existential crisis. This crisis has led to an increasing consensus that political union is necessary to preserve euro zone At the same time, there appears to be little willingness in Europe today to take drastic steps towards a political union. Thus, if the euro is to be preserved, a strategy of small steps towards more political integration will be necessary.

I will argue that a common Eurobond issue is an important first step towards political union that can pacify financial markets and bring back financial stability in the euro zone. In addition, the joint issue of Eurobonds can also be used to provide a boost to economic growth in the euro zone.

I will also draw the attention to a number of objections that have been raised against the issue of joint Eurobonds. These objections have to be taken seriously. They have to be dealt within the design of the Eurobonds.

The need of Eurobonds: political The crisis has degenerated into an existential crisis of the euro zone. Investors now ask themselves the question of whether the euro zone, as we know it today, will survive. This lack of trust in the future of the euro zone leads to endemic instability. It has the effect of transforming bad news about one particular country into bad news for other countries, and for the system as a whole.

This vicious circle must be halted. This can only happen if the member countries are willing to design a mechanism that will convince the market about the seriousness of their commitments towards the euro zone. Solemn declarations by leaders of government will not be sufficient. They are seen as “cheap talk”.

A common Eurobond is such a mechanism. By jointly issuing Eurobonds the participating countries become jointly liable for the debt they have issued together. This is a very visible and constraining commitment that will convince the market that member countries are serious about the future of the euro.

In addition, market participants will see it as a first step on the road to political union. This will “pacify” the financial markets because it takes away the existential fears that destabilize them today. As a result, it will contribute towards restoring stability in the euro zone.

Financial need for Eurobonds By creating a large bond market in the euro zone that can compete with the dollar bond market, it also creates a market with a lot of liquidity. This will make it attractive for outside investors (e.g. from Asia) in search of diversification. This also increases attractiveness for AAA- countries in eurozone

Eurobonds as engine for growth Budgetary austerity in the euro zone now forces many governments to cut back on public investment projects. One of the most robust results from the theory and the empirics of economic growth is that public investments (infrastructure and education) are a significant variable in boosting economic growth. Public investment boosts overall productivity in economy

Unfortunately, this strong positive relation between public investment and economic growth has not prevented many European governments from cutting public investment first and more dramatically than any other spending item. Contrast with the US is stark

Source: European Commission, AMECO databank

The decline in public investment in the euro zone must be halted and reversed. The joint issue of Eurobonds can be a factor in this reversal. One way to achieve this would be to require countries participating in the joint Eurobond to increase public investment as a percent of their GDP. Another way would consist in directly issuing Eurobonds to finance European infrastructure (Verhofstadt(2009)). Both approaches would help to raise public investment thereby increasing productivity and economic growth in the euro zone.

Objections to Eurobonds The proposal of issuing common Eurobonds has met stiff resistance in a number of countries. This resistance is understandable. A common Eurobond creates a number of serious problems that have to be addressed

Moral hazard Common Eurobond issue contains an implicit insurance for the participating countries. Since countries are collectively responsible for the joint debt issue, an incentive is created for countries to rely on this implicit insurance and to issue too much debt. This creates a lot of resistance in the other countries that behave responsibly. This moral hazard risk should be resolved.

Low attractiveness for AAA-countries What are the benefits for AAA-countries? By joining a common bond mechanism that will include countries enjoying less favourable credit ratings, countries like German and the Netherlands may actually have to pay a higher interest rate on their debt.

The design of common Eurobonds Should take care of these objections This can be achieved by working both on the quantities and the pricing of the Eurobonds A combination of – Blue and red bonds (Bruegel): participation in common eurobond limited to given % of GDP (blue bond; senior); the rest is red bond (junior). – Differential interest rates (De Grauwe and Moesen): countries pay an interest rate related to fiscal position

Such a design minimizes moral hazard risk Makes it attractive for AAA-countries (they face low average and marginal borrowing cost) and for lower rated countries (they face relatively low average borrowing costs but high marginal costs). This design gives the right incentives to low rated countries