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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.

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Eurobonds a crucial step towards political union and an engine for growth l.jpg

Eurobonds:a crucial step towards political union and an engine for growth

Paul De Grauwe

University of Leuven and CEPS


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Introduction

  • Euro zoneisthrownin 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.


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  • 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.


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  • 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.


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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.


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  • 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”.


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  • 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.


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  • 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.


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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


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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


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  • 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


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Source: European Commission, AMECO databank


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  • 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.


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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


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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.


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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.


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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


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  • 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


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