How to Reduce Joint Liability in the Eurozone

Since the announcement of the European Central Bank’s Outright Monetary Transaction Programme (OMT), lending rates for Eurozone countries in high levels of debt have sunk to a level that cannot be justified by these countries’ economic balance sheets. Although reducing interest rates may help to lessen the burden on many EU countries, removing any kind of discipline from the capital markets has considerable risks.

Taking this step rewards countries that have amassed excessive levels of debt while punishing those trying to improve their economic performance and maintain sustainable public finances. The move also has the potential to stoke political conflict in the Eurozone as countries like Germany grow concerned that they are being forced to shoulder the costs of other nations’ lax fiscal policies. The capital markets are no longer evaluating individual members of the Eurozone, either positively or negatively, based on their fiscal policy.

What can we do then to avoid making the same old mistakes in Europe? Together with Friedrich Heinemann, I have come up with an idea for a new form of “junior” government bonds which we call “accountability bonds”. The introduction of these bonds should recreate a situation in which it is possible for the markets to assess individual states in light of their financial and economic policy decisions. “Accountability bonds” differ from standard bonds in a number of key ways.

Firstly, they cannot be bought by the ECB as part of its bond-purchase programme. Secondly, “accountability bonds” can no longer be serviced once the issuing country has entered the European Stability Mechanism (ESM) programme or its debt-to-GDP ratio exceeds a set limit, perhaps 120 per cent of the GDP. Countries could be granted limited exemptions from this rule if their current debt levels are already higher than this.

Every region in the Eurozone would be required, under certain conditions, to issue a certain percentage of its debt in the form of junior bonds. This amount could be dependent on how well the country in question complies with the fiscal rules of the Stability and Growth Pact (SGP). Countries with a debt-to-GDP ratio below 60 per cent and a budgetary deficit of less than three per cent would be completely exempt from having to issue junior bonds. Member States with a debt-to-GDP ratio of over 60 per cent would be expected to reduce the amount of debt over this threshold by 1/20 a year, as laid out in the SGP.

If a country exceeds the deficit limits agreed under the SGP, they are obligated to issue a portion of the excessive debt in the form of junior bonds. This would mean that nations would lose at least a certain amount of the implicit financial support for their excessive debts that is granted by the current implicit communitisation of debt in the Eurozone. Investors in accountability bonds would demand considerable risk premiums for their involvement. This system would therefore expand upon the reformed SGP by introducing automatic market-based sanctions, with excessive deficits leading to immediate interest rate premiums.

Thanks to the policy of the ECB, the extent of communitised debt in the Eurozone has quadrupled. The concept of “accountability bonds” hopes to reduce the level of joint liability and to create appropriate incentives for sustainable fiscal policy without destabilising the government bond markets as a whole.

A longer version of this article (in German) initially appeared on the website of the European news portal EurActiv and can be accessed here.