In democracy, political forces often tend to push the volume of public debt beyond socially desirable levels. This time, the amount of accumulating public debt appears to be unprecedented in peace time (Buiter and Rahbari 2010). This is most obvious in the Eurozone with its soaring public debt levels and the sovereign debt crisis. But fiscal troubles also extend to other EU member states, to Japan, and to the US.
One approach is to strengthen the so-called Maastricht criteria for allowable budget deficit and debt levels (see the views of Manasse 2010, Wyplosz 2010, De Grauwe 2010, Buti and Larch 2010, and Delpla and Weizsäcker 2010). While this may help increase discipline, it tends to fail if important countries do not fulfil the criteria. In such circumstances, the countries violating those criteria may form a majority that supports the suspension of penalties.1 Moreover, tax and spending are in the hands of national parliaments. Ultimately, fiscal responsibility will only prevail if national governments and parliaments have higher incentives to control and limit deficits and public debt.
In this column, I propose a new financial instrument, and present a method to improve fiscal discipline - by making market discipline more effective. The method can be applied in the Eurozone, as well as in any democratic country. This instrument is called "government bonds with vote shares" or simply "vote-share bonds".
The vote-share bond proposal
In a nutshell, the proposal is as follows:
- Each government bond is tied to the share of the votes that its underlying budget deficit adoption has received in parliament.2
- A government bond that has a higher vote-share than another is senior. This creates a ladder of relative seniority for which the vote-share is the organising principle. At the top of the ladder are the bonds with the highest vote-share.
- Any government funds available for servicing and repaying government debt will always be turned first to the top of the ladder to satisfy the claims of the bond-holders with the highest seniority. The other bond-holders are served sequentially by moving down the ladder.
Main ideas behind vote-share bonds
There are six core ideas motivating the proposal of vote-share government bonds.
- First, a government bond-holder with a lower vote share would suffer a higher loss in the case of default, thus demanding higher risk premiums and hence higher interest rates. Accordingly, it is up to parliament to determine the marginal costs of current borrowing by voting.
- Second, minorities opposing further public indebtedness can make it more costly for the ruling government majority to issue debt. A minority cannot prevent the issuance of new government debt, but by opposing it, it can give it junior status, thereby inducing high risk premiums.3 Enhanced fiscal discipline would tend to decrease the average cost of borrowing.
- Third, fiscal discipline is likely to be improved further. Buyers of bonds face the risk of downgrading in relative seniority status, as the parliament might approve new debt with higher vote shares in future periods, thus making current bonds less senior. Suppose, for example, that in a country with a moderate stock of existing debt, new debt is issued with a vote share of 55%. Although default risk may be low at the moment, the buyers of newly-issued bonds must be concerned about the risk that new debt with higher vote shares might be emitted in the future, causing larger losses in the case of default on bonds with the 55% vote share.
- Fourth, government bonds with vote shares allow for less disruptive defaults, both for the defaulting country and for other countries. Essentially, government bonds with vote shares allow a country to default on the most junior bonds, allowing for partial and orderly default.4 This will reduce the likelihood of ensuing systemic crises, as the contamination of other countries or banking systems is limited.
- Fifth, vote-share government bonds align the strength of the political support for particular government activities with the pledge to repay debt. This is desirable in its own right, as voting for debt-financed government expenditures is connected to the willingness to repay. Accordingly, it may have a favourable effect on deliberation in democracy by linking debt-financing with repayment promises when political debates about new government expenditures take place.
- Sixth, vote-share bonds would enable governments and parliaments to stabilise negative macroeconomic shocks, e.g. by allowing automatic stabilisers to work. In times of crisis, they can issue debt with high vote shares – and thus with high seniority – at comparably low interest rates.
There are numerous further issues and reflections that deserve scrutiny. But even at this early stage, it is apparent that vote-share bonds are a new tool that liberal democracy would do well to explore.
Conclusion
Overall, fiscal discipline is likely to be enhanced by vote-share government bonds, and we could expect lower overall debt levels, while flexibility in stabilising negative macroeconomic shocks would be retained.
References
Auerbach, A (2008), “Federal Budget Rules: The US Experience”, NBER Working Paper 14288.
Barro, RJ (1979), "On the Determination of the Public Debt", Journal of Political Economy 87:940-971.
Beetsma, R, M Giuliodori and P Wierts (2009), “Budgeting Versus Implementing Fiscal Policy in the EU”, CEPR Discussion Paper 7285.
Buiter, W and E Rahbari (2010), “Greece and the Fiscal Crisis in the Eurozone”, CEPR Policy Insight 51.
Buti, M and M Larch (2010), “The Commission proposals for stronger EU economic governance: A comprehensive response to the lessons of the great recession”, VoxEU.org, 14 October.
De Grauwe, P (2010), “Why a tougher Stability and Growth Pact is a bad idea”, VoxEU.org, 4 October.
Delpla, J and J von Weizsäcker (2010), “The Blue Bond Proposal”, brueghelpolicybrief, 2010/3.
Gersbach, H (2009a), "Democratic Mechanisms", Journal of the European Economic Association 7(6):1436-1469.
Gersbach, H (2009b), “Minority Voting and Public Project Provision”, Economics - The Open-access, Open-assessment E-journal, 2(35).
Gersbach, H (2010), “Government Debt Threshold Contracts”, CEPR Discussion Paper 8001.
Manasse, P (2010), “Stability and Growth Pact: Counterproductive proposals”, VoxEU.org, 7 October.
Sovereign Insolvency Group – International Law Association (2010), The State of Sovereign Insolvency, The Hague Conference.
Wyplosz, C (2010), “Eurozone reform: Not yet fiscal discipline, but a good start”, VoxEU.org, 4 October.
1 One might use sophisticated voting rules to make it harder for countries violating the Maastricht criteria to escape the penalties. For instance, only those countries currently fulfilling the criteria would be allowed to vote on a particular decision. Another possibility is minority voting. Countries in a majority supporting the suspension of penalties in a particular period are not allowed to vote in the next period (see Gersbach 2009). Other possibilities to foster fiscal discipline are outlined in Gersbach (2010).
2 This can occur during regular budget approval sessions or in parliamentary sessions on extraordinary rises in government expenditures financed by debt. One could also prescribe a vote on each new volume of debt issuance.
3 In extreme cases, it is conceivable that minorities might make it impossible to issue new government debt when default risk is already high and debt servicing cannot be credibly promised for new very junior debt.
4 In the Eurozone, an orderly insolvency procedure for member states has yet to be established, as otherwise bailouts tend to take place. For a thorough legal account of policy options in organising sovereign insolvency, see the Sovereign Insolvency Study Group of the International Law Association (2010).
