Eurobonds: a Path Towards Common Prosperity or a One-Way Transfer Union?

Abstract

Since the conception of the euro, it has often been suggested that the eurozone start a programme of jointly issuing government debt. There are many arguments for these so-called Eurobonds, and temporary issuance of them has already taken place in response to the economic impact of the recent COVID-19 pandemic. However, a permanent Eurobond programme remains a controversial topic within the EU.
Advocates claim that a Eurobond programme can facilitate economic growth and stability for the entire eurozone. It could offer much-needed fiscal space to some of the eurozone’s most heavily indebted southern economies, by decreasing borrowing costs. It is assumed that the extra growth facilitated in these countries will spill over to the rest (mostly the less indebted north) of the eurozone, through increased cross-country trade and investment. Criticism mostly originates from the more financially sound eurozone member states, which fear a situation of moral hazard that leads to uncontrolled spending, and a possible deterioration of their own creditworthiness.
This research attempts to explore the economic effects of the introduction of Eurobonds on the eurozone economies. For this effort, two distinct types of Eurobonds are identified and analysed: unlimited Eurobonds and Blue Bond Eurobonds, with the former allowing unlimited issuance of mutualised debt, and the latter restricting this to 60% of a country’s GDP.
The economic sub systems that are crucial for explaining the dynamics relevant to this study show a high degree of complexity and uncertainty; whether it is the dynamics of debt management (including stocks, flows, delays and feedback mechanisms), the different ways of determining bond yields (these are structural uncertainties), or the magnitude of economic elasticities/sensitivities (these are parametric uncertainties). These system characteristics stress the need for a simulation modelling approach. Because the interactions between the system’s components and the relative importance of certain elements are of interest, and because the results should be insightful to non-technical policy-makers, a transparent, ‘white-box’ model can provide the most meaningful results. For these reasons, a system dynamics model has been developed for this study.
Specifically, an exploratory system dynamics modelling and analysis approach is used, due to the inherent structural and parametric uncertainties related to the system that have to be accounted for. Through exploratory experimentation with this model, the effectiveness of both Eurobond policies has been assessed based on how they affect eurozone and country-specific GDP, interest rates, and debt levels. All experimental results are robust for the different structural and parametric uncertainties identified in the system; multiple methods of determining bond yields taken have been into account, just as a large number of configurations of the parametric uncertainties.
As for the economic growth facilitated by both Eurobond policies, the country-level results are mostly insignificant (i.e., not more than 0.50% additional GDP growth after 10 years). Only slight increases in GDP are observed for both policies, with the benefits not evenly distributed amongst member states. Southern, more heavily indebted economies have more to gain, due to the larger relative decrease in their borrowing costs, assuming that the additional funding is spent productively. Furthermore, the anticipated positive economic spill-over effects caused by increased cross-country trade and investment (and not attributed decreases in interest rates) are shown to be insignificant as well.
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However, the results of the analysis do indicate that both unlimited and Blue Bond Eurobonds have the potential to offer significant benefits to the eurozone’s economic stability, by reducing borrowing costs for all participating countries. As anticipated, it is again mostly the heavily indebted southern economies that benefit from this. Unlimited Eurobonds offer slightly more benefits to these countries, when compared to Blue Bond Eurobonds. However, the latter is the preferred option for the less indebted north, since it restricts debt issuance and subsequently prevents Eurobond yields from surpassing their current borrowing costs; something will eventually be the case with unlimited Eurobonds.
Based on this study’s results, a recommendation is made to start the implementation of (a variant of) the Blue Bond Eurobond policy. It has the potential to significantly increase the eurozone’s public debt sustainability, while also offering minor (mostly insignificant) growth benefits to the heavily indebted southern member states, without deteriorating the creditworthiness and the fiscal position of the other, northern member states. Furthermore, the existing market pressure for prudent fiscal behaviour is maintained in the Blue Bond Eurobond proposal, mitigating the risks of moral hazard feared by critics of debt mutualisation.
Additionally, it is necessary to set up an adequate legal and political framework that incentivises fiscal discipline and does not allow for free-riding behaviour. A transfer of fiscal sovereignty to the EU level is to be a requirement for participation in the Eurobond programme. This is necessary to build confidence in the system, both for the eurozone member states, as for the capital markets and the general public. It is further deemed sensible to include a legal clause in the Eurobond programme that allows for the suspension of individual member states’ participation. The (budgetary) conditions for such a clause to be invoked, and the potential (financial) penalties associated with this remain to be decided upon by the eurozone member states and the EU’s (to-be erected) fiscal and monetary institutions.
Keywords: Eurobonds, Bond yield determination, Debt sustainability, Macroeconomic analysis, Policy analysis, Exploratory Modelling and Analysis