by Simon Tilford

The institutional weaknesses of the eurozone have been laid bare. The attempt to run a common monetary policy without a common treasury has failed. Investors do not know what they are buying when they purchase an Italian bond – is it backstopped by Germany or not? The best credit must stand behind the rest, or bear runs, such as those that have derailed Greece, Ireland and Portugal and which threaten to do the same to Italy and Spain, are inevitable. Debt mutualisation alone will not save the euro, but without it the eurozone is unlikely to survive intact.

The eurozone’s July 21st summit was a small step forward. Leaders agreed to lower interest rates on loans made by the European Financial Stability Fund (EFSF) and they recognised that Greece’s debt burden is unsustainable. But this fell far short of what is needed to arrest the deepening crisis in the currency union. Borrowing costs remain unsustainably high for many eurozone economies, and not just those in the periphery. For example, the economic growth potential of Spain and Italy has fallen to as little as 1 per cent, but their borrowing costs exceed 6 per cent. By contrast, German sovereign yields have fallen sharply, lowering the public and private sectors’ borrowing costs. This is a recipe for further economic divergence and insolvency, not the urgently required convergence.

To prevent this, the eurozone has to have a ‘risk-free’ interest rate. The struggling economies need lower borrowing costs, or they will suffocate economically (and political support for eurozone membership will evaporate). Only the mutualisation of debt issuance will generate the low (risk-free) interest rate needed to enable them to put their public finances on a sound footing and lay the basis for a return to economic growth.

All eurozone countries should therefore finance debt by issuing bonds which would be jointly guaranteed by all member-states. The obvious problem with eurobonds is moral hazard: how to prevent fiscally irresponsible countries free-riding on the credit-worthiness of other member-states. This is the understandable fear of countries such as Germany and the Netherlands.

A possible solution to the problem of moral hazard would be for member-states to issue debt as eurobonds up to a certain level – for example, 60 per cent of GDP – but be individually responsible for any debt above it. This would give countries with high levels of public debt an incentive to consolidate their public finances. Had the eurozone introduced such a system from the outset, it could well have worked. But it is too late for that now. For a number of economies, the additional borrowing would simply be too expensive. A better solution would be for a new, independent fiscal body to establish borrowing targets for each member-state and for a European debt agency to issue eurobonds (up to a certain level) on behalf of the member-states.

How would these rules be designed? A dogmatic target of budgetary balance four years hence irrespective of a country’s position in the economic cycle would achieve little: targets are meaningless if they are impossible to implement. These fiscal rules would have to be set with reference to the cyclically-adjusted fiscal position for each member-state. The OECD already produces estimates for these. Member-states will have to be permitted to run deficits when their cyclical positions demand it. Inappropriately pro-cyclical fiscal policies and ruinous interest rates would depress economic activity and with it the investment needed to boost productivity.

Careful thought would need to be given to the composition of the new fiscal body. A board of 17 people, one from each eurozone economy, would be unwieldy, and unlikely to win the support of the eurozone’s principal creditor countries. At the same time, a board dominated by the creditor countries would be unlikely to win the backing of the debtor countries. A board of nine economists, from the big eurozone economies, the European Commission, the ECB and the OECD might form a good basis.

The eurozone, of course, has a poor record of enforcing fiscal rules. To ensure that there is no repeat of this failure, there would have to be strong penalties for non-compliance. If a country deviated from its fiscal targets, it would not be allowed to borrow the additional funds at the risk-free rate. Instead, it would have to borrow under its own rating, which in the case of the fiscally weaker countries would be more expensive. To provide additional incentives to abide by the borrowing rules, the ECB could refuse to accept debt issued under national ratings as collateral. Alternatively, a new EU financial regulator could handicap own country bonds by requiring banks holding them to set aside more capital.

Fiscal rules of the type envisaged (and a new body to enforce them) would not necessarily require a treaty change. But various creditor countries rightly fear that the adoption of eurobonds will push up their borrowing costs and constitute a transfer union. Opponents of eurobonds may eventually come around to seeing them as the least bad option. The risk is that by the time they do, it could be too late to save the euro from a partial break-up: what could work if adopted promptly could be ineffective in six months’ time.

Opponents need to be persuaded as soon as possible that this is the least costly option for them. Eurobonds would certainly be a cheaper option for core countries than the underwriting of loans to struggling member-states, which essentially involves throwing good money after bad: they will book large losses on these EFSF loans. These losses will only increase if, as seems possible, some of the countries currently in receipt of EFSF loans end up having to leave the eurozone and default on their debt.

Simon Tilford is chief economist at the Centre for European Reform.