Macroeconomic and policy implications of eurobonds

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Highlights

  • In a monetary union, sovereign debt is issued with full or limited joint liability.

  • A fiscal expansion has higher output effects with full joint liability (Eurobonds).

  • But cross-border spillovers are negative, except with limited joint liability.

  • This is due to a trade channel and a financial channel.

  • Our results support proposals of limited joint liability.

Abstract

This article explores the controversial subject of Eurobonds, by analyzing their economic consequences in an asymmetric monetary union like the Eurozone, where countries differ in size and policy preferences. We thus build a two-country monetary union DSGE model to compare three scenarios of government debt issuance: i) countries issue their own sovereign bonds (the baseline scenario is given the label “National bonds”); ii) countries issue common sovereign bonds without any limitations on the amount they can borrow (this scenario is labelled “Eurobonds”); and iii) there is a cap on the issuance of Eurobonds by each country so that the joint liability is limited (we call this scenario “Limited Eurobonds”). Assuming that a country decides to increase public spending and cares little about debt stabilization, we find that the spending multiplier would be the highest with Eurobonds and the lowest with Limited Eurobonds. The spillover effects on output in the rest of the union would be negative with Eurobonds but positive with Limited Eurobonds. The positive trade channel of the spillover effects is reinforced while the negative financial channel is reduced in the latter scenario. From the perspective of the monetary union as a whole, Limited Eurobonds could bring about higher overall output and produce larger benefits for aggregate household welfare depending upon country size. Altogether, our findings support the case for limited joint liability, especially when the public spending shock originates from a country which is smaller than the rest of the union, but not too small.

Introduction

During the global financial crisis and the subsequent sovereign debt crisis in the Eurozone, some countries were faced with a surge in sovereign bond yields and lost access to financial markets.

The impact of these crises on government bond markets has been extensively studied.1 In particular, Sibbertsen et al. (2014) provide evidence of a structural break in 2008 in yield spreads of government bonds issued by member states of the European Monetary Union (EMU). Ludwig (2014) detects some regime shifts with divergent sovereign bond yields in 2010 for Ireland, Greece and Portugal. Gruppe and Lange (2014) identify a break in the convergence between German and Spanish government bond yields, which could be interpreted as a shift in market perception of sovereign credit risk in Spain. In the case of Greece, Katsimi and Moutos (2010) point out the relation between government debt and current account deficits and explain that a growing share of Greece’s public debt is held by non-residents, which makes the country vulnerable to changes in foreign investors’ perception of risk. Gómez-Puig and Sosvilla-Rivero (2013) investigate contagion effects and find that the causal relationships between sovereign debt yields in peripheral EMU countries increased significantly during the sovereign debt crisis. Gruppe et al. (2017) emphasize the role of redenomination risk in the divergence between national government bond yields during the sovereign debt crisis. This risk is related to the possibility that a country leaves the EMU and introduces a depreciating national currency. Such a country has to face increased risk premia and government bond yields due to both types of risk, sovereign credit risk and redenomination risk. Hence, it is of prime importance to think about options to cope with risks of EMU exit.

Moreover, borrowing costs increased much not only for the public sector but also for the private sector of distressed countries. A deep recession ensued with dire financial and economic consequences for the EMU countries that were most affected by the sovereign debt crisis. Neri and Ropele (2015) provide evidence of the marked deterioration in the cost and availability of credit for the private sector in these countries, which had significant negative effects on economic activity. Moro (2014) discusses some developments in financial markets, among which the mispricing of sovereign risk by capital markets and the severe funding problems for businesses and households following the tensions in sovereign debt markets and banking sectors. The problem of mispricing is well-documented in the case of Greece, in particular by Gibson et al. (2014). In the case of Italy, Albertazzi et al. (2014) find that tensions on the sovereign debt market affected the cost of credit for businesses and households. For Ireland, Whelan (2014) explains that despite a strong fiscal position and a low level of government debt before the global financial crisis, sovereign bond yields rose in 2010 because the government had guaranteed the liabilities of Irish banks. By contrast, in Portugal, the increase in sovereign credit risk affected the capacity of banks to get access to liquidity in the eurozone interbank market (Sérgio and de Sousa, 2016).

In the end, financial assistance was provided to distressed countries (Greece, Ireland, Portugal, Cyprus and Spain) to avoid sovereign default, increased contagion effects and ultimately a collapse of the EMU. Financial support took various forms, among which conditional loans by the European Stability Mechanism (ESM) and bond purchases through Outright Monetary Transactions (OMT) by the European Central Bank (ECB).

Member states of the European Union (EU) disagreed about appropriate policy responses, and in particular about the interpretation of EU law. The Treaty of Lisbon (former Treaty of Maastricht) forbids joint liability of sovereign borrowers, that is a member state cannot take on the liabilities of another member state (Article 125 of the Treaty on the Functioning of the EU - TFEU). A strict enforcement of this “no bail-out” clause was not endorsed by all member states. It is in this context that proposals for the creation of sovereign Eurobonds started to emerge.2 Since 2010, the idea of pooling sovereign debt instruments has been met with enthusiasm in some member states (e.g. France, Italy) and skepticism in some others (e.g. Germany, Netherlands). The latter mostly fear that the existence of Eurobonds would impair commitment to fiscal discipline and are reluctant to assume the debt of spendthrift governments.

The severe economic crisis caused by the coronavirus pandemic has brought back the idea of Eurobonds to the fore. Indeed, in March 2020, leaders from nine EU countries asked for the creation of a common debt instrument to finance national policies required to contain the virus and mitigate the economic consequences.3 Eurobonds (or “coronabonds”) would complement the broad set of actions taken by the ECB and the European Commission in response to the Covid-19 crisis. Leaders from other EU countries did not endorse the proposal. Disagreements between member states over the idea of Eurobonds have certainly not disappeared. In late July, the EU summit clearly showed deep divisions between member states on the features of the recovery fund (750 billion euros), with a strong opposition from some member states (Netherlands, Austria, Sweden and Denmark in particular). EU leaders ultimately agreed to authorize the European Commission to borrow funds on the capital markets and use them for loans (€ 360 billion) and grants (€ 390 billion). The Commission will sell bonds on behalf of the EU and use own resources of the EU budget for repayment. These new powers are to be limited in size, duration and scope. While the deal does not represent sovereign debt mutualization, it can be considered as a first step towards Eurobonds, albeit small. It also reveals that sharing the debt burden is a matter of much concern for countries with strong fiscal positions.

In this paper, we are interested in studying the implications of Eurobonds in terms of fiscal policy.4 What would happen if a member state, say Greece, began to increase government spending and issue Eurobonds? Would fiscal policy in this country be more effective? What would be the consequences for other member states, among them Germany? Would cross-border spillover effects on output really be negative?

There is certainly political disagreement between member states in the matter of Eurobonds. Yet, academic research has provided some strong arguments in support of joint liability in sovereign borrowing (Basu and Stiglitz, 2015; Tirole, 2015; Baglioni and Cherubini, 2016; Basu, 2016; Favero and Missale, 2016), albeit with some reservations (Beetsma and Mavromatis, 2014; Esteves and Tunçer, 2016; Hatchondo et al., 2017).5 So, what is it all about?

A sovereign Eurobond is a debt instrument that would be issued and backed by all eurozone countries. It would enable member states to borrow funds. It can be seen as a form of debt mutualization inasmuch as member states would collectively guarantee repayments. The nationality of the sovereign issuer would not be known. Hence, interest rates on Eurobonds would be the same whatever the sovereign issuer. The risk premium, in principle, would depend on the average level of sovereign debt in the Eurozone and on the perception of financial market participants upon the credibility of the joint guarantee of repayment.

The main advantage of Eurobonds would be the existence of a large and liquid market for sovereign bonds. The most indebted member states would benefit from a decrease in borrowing costs because they would no longer issue debt with a country-specific risk premium. In addition, as long as changing risk perceptions among financial market participants play a significant role in sovereign spreads, the creation of Eurobonds could protect heavily indebted member states against contagion effects during financial turmoil, and this would benefit fiscally responsible member states as well (Favero and Missale, 2012). It could also prevent debt dynamics from getting into (or staying in) an unsustainable path (Tielens et al., 2014). This outcome holds if moral hazard does not prevail though.

Moral hazard is a critical issue. Sovereign Eurobonds could raise some incentive problems in terms of fiscal discipline because higher public deficits would no longer be bound to be sanctioned by higher borrowing costs.6 Furthermore, if some governments were to become profligate, this could be costly for the least indebted member states (and particularly for those which enjoy a triple A credit rating). The latter would face a higher public borrowing cost if the average eurozone sovereign risk premium were higher than theirs. They could even incur welfare losses in some cases of policy coordination and cooperation between fiscal and monetary authorities (Engwerda et al., 2019).

Some solutions to the problem of moral hazard have been put forward in the literature about joint liability in the context of sovereign debt. A third party could impose costs if a sovereign borrower reneges on its commitments (Basu and Stiglitz, 2015), but sanctions should be feasible (Tirole, 2015). A debt management agency could issue insurance bonds with country-specific risk premia that would be based on national economic fundamentals (Muellbauer, 2013). Eurobonds could be used to finance projects that benefit all member states (Favero and Missale, 2016) or they should cover only a fraction of government debt (Baglioni and Cherubini, 2016).

In this respect, Delpla and von Weizsäcker (2010) made a “Blue Bond proposal” to pool only a share of public debts. Each member state would be allowed to issue Eurobonds (“blue bonds”), but up to a limit corresponding to 60 percent of its GDP (the Maastricht criterion). Blue bonds could be issued with low interest rates, because all member states would collectively guarantee the repayment. Furthermore, they would be senior debt, that would protect creditors from defaults by giving them a preferred status in sovereign debt repayments.7 Any member state that would need to borrow more than 60 percent of its GDP would have to issue its own bonds (“red bonds”). The latter would be junior debt that would be honored only after the senior debt has entirely been serviced. Red bonds would not be guaranteed by other member states, and as a result, they would likely be issued with higher interest rates. Furthermore, they would not be eligible for the refinancing operations of the ECB.

There are, however, downsides. Esteves and Tunçer (2016) studied five experiences that they consider as being early forms of debt mutualization in the pre-1914 period. The first case ended up with a default of Greece, and the loan was ultimately paid by the guarantors (Britain, France, Russia). The other cases were implemented with some international financial control and/or some write-downs of existing debt. Moreover, Hatchondo et al. (2017) show that if non-defaultable debt (Eurobonds) and defaultable debt (national bonds) coexist, the decrease in the interest rate spread is short-lived, because the government still has to issue defaultable debt. In other respects, Beetsma and Mavromatis (2014) demonstrate that the guarantee of repayment by other countries should not be 100 % and should be sufficiently low to incite a government not to put into more debt than if it had no guarantee at all. However, Badarau et al. (2016) argue that if the joint guarantee of repayment is not full, the institutional framework of Eurobonds might lack credibility, and, as a consequence, macroeconomic outcomes might not be favorable.

Last but not least, there are some legal questions about the introduction of Eurobonds that must be tackled. Article 122 TFEU allows for financial assistance when “a member state is in difficulties or is seriously threatened with severe difficulties caused by natural disasters or exceptional occurrences beyond its control”. Eurobonds are a form of financial assistance. Do they necessitate legal reforms? Matziorinis (2012) argues that a revision of the EU Treaty or the adoption of a new EU Treaty is required to obtain the full support of member states for some institutional changes such as: a unified public accounts system, a Treasury board to supervise public borrowing, more binding rules in the Stability and Growth Pact, and a debt agency to manage the issuance of common sovereign bonds. This could be difficult to do because a revision of the Treaty must rely on a unanimous decision. An alternative could be an agreement reached by a subset of member states through “enhanced cooperation”. But this procedure to establish deeper integration must involve a minimum of nine member states.

In fact, Claessens et al. (2012) note that the need for legal reforms depends on the specific features of the proposals. For instance, Delpla and von Weizsäcker (2010) consider that their Blue Bond proposal is compatible with the EU Treaty because EU countries would not pool the entirety of their public debt under jointly guaranteed debt. In addition, an Independent Stability Council would be in charge of the annual allocation of Blue Bonds, and this allocation would be voted on by the national parliaments of all participating countries.

In this paper, we consider two main proposals for Eurobonds – full and partial joint liability – and analyze their macroeconomic implications in an asymmetric monetary union. We build a dynamic stochastic general equilibrium (DSGE) model to describe a monetary union composed of two countries with different size and different fiscal policy preferences. We study the effects of a positive country-specific public spending shock to investigate what would happen if one government were no longer fiscally responsible in a monetary union with sovereign risk pooling. To do so, we compare three scenarios of government debt issuance. In the baseline scenario with national bonds only, each country issues its own sovereign bonds with country-specific risk premia. There is no risk pooling, and the risk premium paid by each government to borrow funds in the bond market depends on the level of its sovereign debt. In the scenario with Eurobonds, by contrast, there is full risk pooling and both countries share a common risk premium which depends positively on the level of total debt at the union level. In the third scenario, there is a cap on the issuance of Eurobonds up to 60 percent of GDP in each country. Beyond this limit, countries must issue national bonds with their own individual risk premia. This last scenario corresponds to the proposal of Delpla and von Weizsäcker (2010). There is only partial pooling so that joint liability is limited. This scenario is labelled “Limited Eurobonds”. It is important to note that in this scenario, Eurobonds are assumed to be risk-free debt instruments because of their special features (“blue bonds”): issuance cap, seniority and eligibility for the refinancing operations of the central bank.

Assuming that a country decides to increase public spending and cares little about debt stabilization, we find that its spending multiplier would be the highest with Eurobonds and the lowest with Limited Eurobonds. The spillover effects on output in the rest of the union would be negative with Eurobonds but positive with Limited Eurobonds. In this respect, our findings support the proposal of Delpla and von Weizsäcker (2010) for limited joint liability.

In the literature, Badarau et al. (2016) also provide similar results in a DSGE model of a monetary union, but they do not consider differences in country size between member countries. Yet, this feature is at the heart of the recent debate about Eurobonds in the Eurozone. Here, we propose a generalization of their model by introducing an adjustable size parameter. This extension allows for a more realistic analysis of Eurobonds and a better consideration of structural heterogeneity in the Eurozone. Three novelties are to be noted.

First, we introduce imported goods in government consumption. This assumption is based on the observation that, according to EU law, public procurements must be open to competition between businesses of all member states. Admittedly, this assumption makes the cross-border spillover effects of an increase in government consumption more likely to be positive (see Blanchard et al., 2016). However, to keep the model analytically tractable, we refrain from incorporating usual assumptions in the model, which would make spillover effects positive, such as habit persistence or liquidity-constrained households (as in Naraidoo et al., 2017). We do not describe explicitly the role of financial intermediaries either. It follows that our model does not account for the impact of sovereign risk on the cost of borrowing for firms (see Corsetti et al., 2013; Badarau et al., 2014), but it allows for an impact of sovereign risk on the expected return of household portfolios. So instead, we put special emphasis on the definition of government budget constraints and debt issuance in the three scenarios under consideration.

Second, we consider that changes in governments’ behavior may occur because of changes in the regime of debt financing. A government may not care about debt stabilization as much as it used to if the cost of borrowing is no longer dependent on the level of its own debt alone. In particular, the response of public spending to government debt in the fiscal policy rule, which in principle is needed to stabilize debt, is assumed to be lower in the spendthrift country once Eurobonds are implemented.

Third, we check the sensitivity of our results to heterogeneity across countries with regard not only to policy preferences but also to country size. In particular, we look at cases where public spending is procyclical in the spendthrift country and counter-cyclical in the rest of the union. We also explore the case where this country is a small country and explain the implications in terms of spending multiplier and spillover effects. Additionally, we examine various monetary policy rules.

In the end, we carry out a welfare analysis to compare outcomes under the three scenarios of government debt issuance in which countries differ in size.

The paper is organized as follows. Section 2 presents the model by paying special attention to the determinants of government debt issuance and sovereign risk premia in each scenario. Section 3 outlines the calibration of the model. Section 4 explains the results of the simulations of a country-specific public spending shock under the three scenarios. Section 5 provides the sensitivity analysis. Section 6 concludes.

Section snippets

The model

The theoretical framework is a dynamic stochastic general equilibrium (DSGE) model of a two-country monetary union (MU). We extend the model proposed by Badarau et al. (2016) by adding a few features of the Eurozone: imported goods in government consumption; structural differences between countries in size, in government behavior and in policy preferences (fiscal policy rules). In this paper, we explain the influence of these features on the sign and extent of domestic and cross-spillover

Calibration

We solve the non-linear stochastic model and run simulations using Dynare program (Adjemian et al., 2014).

The benchmark calibration of the model is displayed in Appendix B. For standard parameters, which are related to the behavior of households and firms (preferences and technology), we choose plausible values by drawing on the literature about DSGE models and estimates for the Eurozone (e.g. Smets and Wouters, 2003; Christiano et al., 2005; Coenen et al., 2008; Jondeau and Sahuc, 2008;

Results

The model is run to simulate a positive public spending shock in the home country under different scenarios of government debt issuance: National bonds (baseline scenario), Eurobonds, and Limited Eurobonds. The size of the shock is 1 percent deviation from steady state and its persistence is high (the autoregressive term ρz is set at 0.80). We examine the effects of the shock on the home country and its spillover effects on the foreign country which stands for the Rest of Union (RoU). Fig. 1

Sensitivity analysis

In this section, we check robustness to various policy rules and country size.

Conclusion

Proposals for pooling sovereign risk through the creation of Eurobonds have not led eurozone member states to move in that direction so far. The main point of contention stems from a lack of trust. Healthy member states, such as Germany, Austria, Finland or the Netherlands, fear that heavily indebted member states, such as Greece or Italy, would not abide by the EU rules of fiscal discipline anymore if they benefited from full joint liability. Actually, the proposal for limited joint liability

CRediT authorship contribution statement

Cristina Badarau: Conceptualization, Methodology, Software, Validation, Investigation, Writing - review & editing, Visualization. Florence Huart: Conceptualization, Methodology, Investigation, Writing - original draft, Writing - review & editing. Ibrahima Sangaré: Conceptualization, Methodology, Software, Formal analysis.

Declaration of Competing Interest

None.

Acknowledgements

We thank the editors, the anonymous referees, Kevin Moran and participants at the 19th INFER Annual Conference, the 47th MMF Annual Conference and the 4th UECE Conference on Economic and Financial Adjustments in Europe for their valuable comments. Furthermore, this project has benefited from a grant “Bonus for the Quality of Research” awarded by University Lille 1.

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  • This article should not be reported as representing the views of the BCL or the Eurosystem. The views expressed are those of the authors and may not be shared by other research staff or policymakers in the BCL or the Eurosystem.

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