Whether a country is solvent depends on the interest rate it is charged. There are two possible equilibriums. In the good equilibrium, investors believe the country will pay its debt and demand a low interest rate, which makes the solvency self-fulfilling. In the bad equilibrium, however, investor suspicion drives up interest rates, which in turn makes default (or a bailout) unavoidable due to the high cost of servicing the debt. The periphery of Europe is now stuck in the bad equilibrium.
On the other hand, Germany’s ability to finance its debt has actually benefited from the crisis (Dullien and Schieritz 2012). Since it is perceived as a safe haven, investors have bid its interest rates to record lows, significantly improving the country’s fiscal position. However, even Germany would not remain solvent for long if it had to pay Spanish interest rates.
Jointly issued Eurobonds have been proposed as a solution to the crisis. But Germany is understandably wary of guaranteeing the entire stock of debt of other Eurozone countries.
Mutualise the coupons, not the principal
We propose a simpler alternative that does not have this drawback but will still move the periphery from the bad to the good equilibrium. Countries would continue to issue bonds separately, at whatever interest rates are demanded by investors, as compensation for their perceived risk of default. We would compute the average of all the coupon rates weighted by the amounts issued by each country. Then, countries that paid a coupon rate lower than this weighted average would transfer the difference to countries that issued at a higher rate. We term this the Euro-coupon solution.
- All EZ countries would effectively be issuing new debt at the same interest rate.
In this way, we would get out of the self-fulfilling bad equilibrium since a country’s high interest rate would no longer increase its likelihood of default.
However, there would still be the possibility of default by countries with unsustainable debt levels, even at the pooled interest rate.
Crucially, this risk would be fully borne by investors, not by the other countries in the union.
Illustration of the costs
As a simple illustration, imagine that all the countries in the Eurozone issued the amounts expected this year at the current respective 10-year yields.
- Germany would issue at a coupon rate of 1.8% and Spain at 5.2%.
- The weighted average of the coupon rates off all countries would be 3.5%.
Under our Euro-coupon scheme,
- Germany would then transfer the difference between 3.5% and 1.8% times the amount issued to the central pool; and
- Spain would receive the difference between 5.2% and 3.5% times the amount issued from the central pool.
This corresponds roughly to transfers of €5 billion from Germany, which issues 24% of all the debt in the Eurozone, and €3 billion to Spain, which has a share of 19% of total debt.
Is it politically feasible?
These are considerable amounts. But two points are worth noting.
- The amounts are an order of magnitude smaller than a bailout of the principal. The big interest gaps arise from existence of, or fear of, the bad equilibrium; if the scheme ruled out the bad equilibrium, the gap would be much smaller.
The 3.5% in our example might actually be closer to what German interest rates would be if there were no crisis – in which case there would be no capital flight to the German safe haven. For example in 2005, before the crisis, both Germany and Spain had the same 10-year interest rate of 3.0%.
- Crucially, with an interest rate of 3.5% there would be no question of Spain going broke, so markets might find 3.5% a reasonable rate of return.
Correspondingly, investors would not be scared of a self-fulfilling default and would actually demand a lower coupon rate of Spanish bonds, thereby reducing the weighted average and the size of the transfers.
The very acceptance of the Euro-coupon scheme would immediately lead to lower interest rate spreads and fewer doubts about the solvency of countries with relatively modest transfers.
Of course this scheme does not solve the moral hazard problem of over-issuance of debt. Countries would be tempted to run up debt since they don’t have to bear the full cost of their profligacy. This means:
- We would still need policies like the recent Fiscal Compact to limit budget deficits or the total amount of debt.
- Unlike Eurobonds, under the Euro-coupon plan, market-set interest rates for each country would still be observable – a useful signal for policymakers.
In this way, the Euro-coupon scheme provides a large incentive to EZ members to monitor each other’s debts, since all are affected by any member’s higher interest rates.
Finally, countries would need to coordinate their bond issuance to sell bonds with the same maturities in the same proportion at the same time. So the Treasury function would have to be centralised to some extent.
The Euro-coupon scheme could represent a decisive step towards restoring confidence in the Eurozone. Once investors realise that no country would again be dragged into a negative spiral of higher deficits driven by higher interest costs, the spreads between the different countries would narrow, making the solidarity implied in the scheme less onerous.
Regarding feasibility, remember that in the Euro-coupon scheme Germany does not guarantee the capital or even the coupons of the Spanish bonds. It only commits to transfer the difference between its actual financing costs and the theoretical common costs (weighted average) of the currency union. While this would seem impossible in normal times, it may actually be Germany’s cheapest way of putting an end to the crisis. After all, the alternative may be hundreds of billions more in public loans to failing southern nations.
Euro-coupons achieve much the same benefits as Eurobonds with only a fraction of the political difficulty.
Dullien, Sebastian and Mark Schieritz (2012), “German savers should applaud the growing TARGET balances”, VoxEU.org, 7 May