Sat, May 29, 2010 - Page 9 News List

Breaking up European debt would enhance financial discipline

By Jacques Delpla and Jakob von Weizsacker

Financial markets almost succeeded in breaking up the eurozone, so the idea of harnessing the power of the market and of financial engineering to guarantee the euro’s long-term viability might seem paradoxical. But this is precisely what our proposal to split eurozone sovereign debt into senior and junior tranches aims to achieve.

The senior tranches would comprise debt totaling up to 60 percent of the GDP of each participating country. These countries would then pool this debt and issue a joint and several guarantee. The resulting “Blue Bond” (named after the color of the European flag) would be an extremely safe and highly liquid asset, comparable in volume to US T-bills, thereby helping the euro’s rise as an international reserve currency and ensuring low refinancing costs for the bulk of eurozone debt.

By contrast, any debt beyond 60 percent of GDP would have to be issued as junior “Red Bonds” under purely national responsibility. These Red Bonds would make borrowing beyond 60 percent of GDP more expensive, thereby enhancing fiscal discipline and reinforcing the targets set by the Stability and Growth Pact.

Moreover, Red Bonds could be conveniently ring-fenced so that they do not destabilize the banking system, thereby ensuring that the no-bailout clause that applies to them becomes a credible proposition. For example, the European Central Bank should exclude Red Bonds from its repo facility while a standardized collective-action clause to facilitate debt rescheduling should be made mandatory for Red Bonds.

If implemented successfully, our proposal would lower the costs of servicing debt while strengthening the incentives for individual countries to pursue fiscally responsible policies. This is what distinguishes our proposal from suggestions that all eurozone debt be pooled in euro bonds in a spirit of solidarity.

But successful implementation of this plan requires a rock-solid governance structure that markets and taxpayers in the most stability-oriented eurozone countries can trust. In particular, the danger of “mission creep” — the temptation to expand the 60 percent of GDP debt ceiling for Blue debt — needs to be addressed.

That is why we believe that the annual allocation of Blue Bond emissions should be delegated to an Independent Stability Council. The council would offer a take-it-or-leave-it proposal to the participating countries on the allocation of Blue Bonds for the coming year. Each national parliament would then adopt the proposal, given participating countries’ role in providing the guarantees implied by that allocation.

Within this mechanism, countries that pursued reckless fiscal policies could be gradually excluded from the system by lowering their Blue Bond allocation. Countries unhappy with the system’s evolution could gradually exit it simply by rejecting their annual Blue Bond allocation for a sufficient number of years in a row — thereby no longer issuing Blue Bonds or guaranteeing the fresh Blue Bonds of others. The Independent Stability Council, not wishing to lose the Blue Bond club’s most stability-oriented members, would have a strong incentive to ensure that these countries’ interests are properly taken into account.

In economic substance, the Blue Bond scheme is compatible with the no-bailout clause in Article 125 of the EU Treaty, because the debt guarantee would apply only to senior debt amounting at most to 60 percent of GDP, the level that the Maastricht Treaty deems sustainable for any EU member state. Therefore, the guarantee would not apply to debt crises caused by excessive borrowing to finance unsustainable fiscal policies. To the extent that a higher debt ratio is allowed only in exceptional situations (Article 100 of the Treaty), such as natural disasters (where a bailout would be allowed), a legal conflict should not arise.

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