Eurobonds: Not a question of ‘whether’ but one of ‘who will issue them’ and ‘who will back them’

by Yanis Varoufakis and Stuart Holland

Ever since the Crisis erupted, Europe’s leaders have reacted to the suggestion that eurobonds are sine qua non with a familiar repertoire of responses. First came denial of the need for eurobonds, coupled with a snub for those who proposed them. More recently, we witnessed depression at the realisation that all other means have failed to stem the Crisis. Now, as the powers-that-be realise that the idea of eurobonds is winning ground (even within their hitherto loyal commentariate), they adopt subterfuge: they are creating a straw eurobond so as to knock it down. Will this tactic delay the final stage (of acceptance) so much that it will be too late to save the eurozone (as Wolfgang Munchhau fears)? It may well come to that. In a bid to prevent such a calamity, we are hereby clarifying precisely the kind of eurobond that can help the eurozone overcome the Crisis.

The current EFSF-issued eurobonds

Unbeknownst to most, eurobonds already exist. The bonds issued by the European Financial Stability Fund (EFSF) to fund the Irish and Portuguese bailouts are precisely that: eurobonds. The reason why they are not referred to as eurobonds is that each one of them consists of slices of debt each backed by one member-state (each slice having a size that is proportional to the corresponding member-state’s national income). In this sense, the EFSF bonds are structured in a manner that maintains, as much as possible, the facade of bilateral loans: each creditor member-state has guaranteed a slice of a loan for a particular debtor member-state.

Elsewhere, we have explained why this bond structure is toxic, why the facade of the bilateral loans is but a facade[1] and, lastly, how embedded in this bond structure is the dynamic of the chain reaction which threatens the eurozone with a major implosion. Because of this negative dynamic, some have (erroneously) suggested that the EFSF bonds need to become ‘proper’ eurobonds by eliminating the different slices within each bond; by moving to another arrangement whereby all member states guarantee jointly the whole bond.

The wrong eurobonds

Opponents of eurobonds scream blue murder at the idea of jointly backed EFSF-issued eurobonds, remonstrating that such an arrangement would lead to interest rates that are too high for the surplus countries and not low enough for the deficit ones. We submit that they are quite right to scream blue murder at this suggestion. Such eurobonds would be unhelpful and potentially as poisonous as the current heterogeneous CDO-like EFSF-bonds.

Only the other day Moritz Kraemer, managing director of EMEA sovereign ratings, had this to say (according to Reuter’s): If the eurozone is to band together and issue common debt, with each member-state guaranteeing its own bit, then the resulting eurobond would resemble a chain whose creditworthiness would be the same as that of its weakest link. Here are his precise words: “If the euro bond is structured like this and we have public criteria out there then the answer is very simple. If we have a euro bond where Germany guarantees 27 percent, France 20 and Greece 2 percent then the rating of the euro bond would be CC, which is the rating of Greece.”

Mr Kraemer is spot on. If this is how our new eurobonds are to be structured, we deserve all the trouble that we shall get  into. Of course, there is no reason why they ought to be structured that way. Consider, for instance, a small amendment: For example, the new EFSF eurobonds may be both jointly issued and severally backed. This means that each member-state is responsible for all the debt; not just for its ‘bit’. To give a simple parallel, consider a group of five students that rent a flat. If the rental agreement says that each student will be responsible only for her share of the rent, then the landlord truly has reason to fear that the probability that the rent will be fully paid each month is a function of the creditworthiness of the most impecunious of the five renters. But, if the rental agreement specifies that each of the five students is to be held responsible for any shortfall in the monthly rental payments, then things are quite different and the landlord can sleep more easily at night. In this case, the landlord’s rental income security will edge closer to some weighted average of the five students’ capacity to pay (as opposed to being equal to the financial capacity of the poorest of the five students).

In short, if the EFSF is to offer jointly issued and backed eurobonds, the result will be a disaster and the new bonds will be reduced to junk bonds even before they hit the markets. If, on the other hand, they are jointly issued and severally backed, then the interest rates will be closer to that of the AAA-rated member-states albeit not close enough. Thus, if this is the type of eurobond we can have, it is a bad idea to push for them. Alas, both types of eurobond discussed in this section are different versions of the straw eurobond that Mrs Merkel and opponents of a rational resolution to the euro crisis are parading around only to knock it back triumphantly.

The right eurobond: ECB-issued and backed

Readers of this blog, especially those familiar with our Modest Proposal for Overcoming the Euro Crisis, will not be surprised by our suggestion (which we have been making for some time now) that eurobonds must be issued and backed by the ECB. Period. They must not be backed by member-states. They should not be issued by the EFSF. They ought to involve no organisation other than the ECB which will, in a revenue-neutral manner, use the funds it borrows through the issue of its own eurobonds in order to service the Maastricht-compliant debt of all eurozone members who wish to participate in this overall debt reduction scheme. Under this scheme, first put forward by our Modest Proposal, the interest rates that the ECB will be able to fetch at the money markets will be at or even below that of Germany’s bunds and, to boot, will have no impact on the interest rates at which Germany and the surplus countries will be able to issue new debt.

Since we have explained fully this proposal a year or so ago, as part of our Modest Proposal, we shall not repeat our arguments here. Readers may read our justification of the claims made above arguments HERE and HERE and HEREWhat we shall, however, do below is (a) answer some practical questions put to us by a reader (regarding the transfer of the Maastricht-compliant debt to the ECB, by means of the ECB-issued eurobond) and (b) comment on a recent proposal by Tom Palley (featured in a Financial Times Op-Ed).

Two questions on our Modest Proposal’s eurobond mechanism (see our Policy 1)

Here we try to answer two excellent questions put to us by reader Migeruet  regarding the mechanics of the transfer of the Maastricht-compliant debt to the ECB. Readers not familiar with the Modest Proposal and related arguments are advised to read up on them before proceeding.

Question 1: Given that when a bond is transferred to the ECB, as part of the transfer of the Maastricht-compliant debt to the ECB, it remains an asset of the original bondholder, and that there may be other financial intermediaries involved (such as a bond broker holding and servicing the bond for a non-financial-institution investor), what prevents the bond from being traded in the secondary market? And, if the bond is no longer tradeable in the secondary market, does it not become an illiquid asset which causes a number of problems?

Our response: The asset remains that of the original bondholder but, according to our Modest Proposal, is now is in an untraded ECB debit account – unlike the Breugel proposal for a European debt agency. The point of it becoming an illiquid asset is to address and avoid the central problem of market volatility which threatens defaults and risk for both governments and bondholders. This thereby protects bondholders from a financial meltdown against which they cannot individually protect themselves. There is mutual advantage as the bond transfer to the ECB (that is financed by means of ECB-issued eurobonds) would make the original bondholder more secure.

Question 2: How does the debit account of, say, the Italian Treasury with the ECB, to which the ECB would debit the bond service payments giving Italy time to pay back, not constitute an “overdraft facility” or at least be construed as a “credit facility” in violation of Article 123 of the Treaty on the Functioning of the European Union?

Our Response: The ECB would not be offering either an overdraft facility or net credit on the debit account. This is easy to understand once one grasps the difference between a debit and a credit card. Just like an individual cannot overdraw on a debit card, under our Modest Proposal member-states cannot overdraw on their debit account with the ECB. Note also the relevance of the distinction between stocks and flows. We are not proposing overdraft facilities with the European Central Bank (for this would be a ‘flow’) but a transfer of debt to it (a ‘stock’).  Nor are we proposing “the purchase directly… by the European Central Bank or national central banks of debt instruments”. Our Modest Proposal merely recommends a debt conversion without any debt purchase. This policy was not anticipated by the Maastricht or other Treaties but, by the same token, it is not constrained by Article 123 of the Lisbon Treaty.

Thomas Palley’s Proposal

Thomas Palley has put forward (see here) an interesting alternative to our Modest Proposal. Here is a summary of what he proposes:

  1. The eurozone establishes a European Public Finance Authority (EPFA) to  be governed by member-countries, with votes allocated on a per capita basis. The EPFA would then issue eurobonds jointly and severally guaranteed by member-states who would cover the EPFA’s interest on a per capita basis. In other words, the total interest would be serviced by each member-state in proportion to its population size – not is creditworthiness.
  2. The ECB buys the EPFA’s bonds and then trades them through standard open-market operations. The money raised by the EPFA is then used to buy existing member-state debt, again on a per capita basis. The idea here is that low debt countries (Palley gives the example of Luxembourg) will receive their share of EPFA funds as cash and they could buy EPFA bonds to cover their contribution to the EPFA’s interest obligations.
  3. The EPFA issues new eurobonds each year on behalf of member-states in deficit. How much funding will each deficit member-state get? This, Palley argues, can be decided democratically by EPFA’s governing council in accordance to the EPFA’s statute. “Member-states that manage to go into surplus could use the new funds to retire debt or create a sovereign wealth fund.”

On the positive side of Palley’s proposal, it highlights the importance of enabling the ECB to manage bond interest rates by means other than the current utterly unfunded (and thus controversial) bond purchasing scheme. Additionally, his proposal shows that it is possible to unite the eurozone financially without creating a fiscal union (since, under this scheme, there will be no unfunded financial transfers from/to any member-state).

On the negative side, however, Palley’s proposal fails the test of Ockham’s Razor: It is our view that Policy 1 of our Modest Proposal offers a much simpler, less politically controversial, more efficient solution: Enable the ECB to issue its own bonds not in order to buy member-state bonds but to finance the servicing of these bonds up to the Maastricht-compliant level (of 60% of GDP).[2]

More precisely, our first criticism of Thomas Palley’s interesting and helpful proposal is that the creation of the EPFA undoubtedly requires Treaty Changes which will never come about before the euro has collapsed. Additionally, the very notion of making the ECB pay for these EPFA-issued bonds at rates considerably higher than the yields of German bonds (for reasons already explained above), in order to buy back the debt of the deficit countries, will prove not only politically unpalatable but also financially ineffective (courtesy of the interest rates of the EFPA’s bonds being significantly above Germany’s bunds). Lastly, if these EPFA bonds receive only a moderate credit rating (as they surely will), how and by which means can the ECB be instructed to purchase them (please note the difference between being given the right to purchase them and being instructed to buy them)?

Which brings us to Ockham’s Razor, the principle that, when faced with competing hypotheses or alternatives, one ought to favour the candidate which comes with the fewest new assumptions. Our Modest Proposal demands one main assumption: That the ECB’s reputation will be enhanced (or at least remain intact) in the money markets if it stops its unfunded bond purchases and, instead, issues eurobonds whose intertemporal servicing it passes on to member-states (through suitable debit accounts). In contrast, Thomas Palley’s proposal requires three new assumptions: (1) That the EFPA (and in particular its democratic governance structure) can be instituted before the euro crisis brings the euro down; (2) That the ECB can be forced to buy the EFPA’s eurobonds (whose credit rating will be perpetually insecure for reasons that Mrs Merkel will be only too happy to point out).


To conclude, there seems to us only one way in which the euro debt crisis can be resolved: The ECB must issue its own eurobonds in order to fund the servicing of the Maastricht compliant debt while, at the same time, it debits the member-states for the full intertemporal cost of this conversion loan (to be paid in the fullness of time and at interest rates slightly higher than the rock bottom yields of the ECB’s eurobonds).

[1] The reason this is a facade is that as one  member-state after another moves from the group of creditor to the group of debtor member-states, the bilateral loan structure breaks down badly.

[2] It is clear to us that Thomas Palley has not considered the possibility of the ECB issuing bonds not in order to buy back bonds but, rather, in order to service bonds (up to the Maastricht-compliant level). We say this because in his FT Op-Ed he presents his scheme as an alternative to: (a) one in which the eurobonds are jointly and severally issued by something like the EFSF (a policy we have already rejected as a non-starter above) and (b) to another in which the ECB issues eurobonds in order to buy the bonds of member-states. The Modest Proposal, in sharp contrast, has been suggesting for a year now that the ECB-issued eurobonds should NOT be used in order to buy back debt and, instead, to service it. The difference is  gigantic. Had

25 thoughts on “Eurobonds: Not a question of ‘whether’ but one of ‘who will issue them’ and ‘who will back them’

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  6. Congratulations to both for your work, and a special thanks to Dr Varoufakis who has been the only source of clarity for the laypeople in Greece, who are desperately trying to figure out what is going on and what could be the alternatives to what the Greek government is asked to do…
    I have two questions:
    1) since debt corresponding only to 60% of a state’s GDP will be taken over by the ECB, then
    a) what happens to the rest of the debt of each country, is it written off?
    b) who decides which bondholders “get in” and who are “left out”?
    2) How easy is it to predict the repercussions of this proposal (if adopted of course) in the real economies of each state and to the Euro currency rate against other major currencies? What should we expect, in broad terms?

    Many thanks

    • (1) [a] No, it remains the liability of the member-state. However, the suggested transfer will calm markets down considerably and the interest rates that member-states will pay to refinance the remaining debt will be much lower. Greece will still have a problem, But once the eurozone-wide debt crisis is contained, a restructure of Greece’s remaining debt will be manageable. [b] No one. Each bondholder will be free to register with the ECB a proportion of their bond holdings equal to the ratio of the relevant country’s Maastricht-compliant to overall debt. E.g. All Italian bond holdings will be registered/transferred to the ECB at a rate of 50% to reflect the fact that Italy’s debt is twice that of the Maastricht level.
      (2) Predictions are always notoriously difficult. Nevertheless it is my cconsidered opinion that once the debt crisis is arrested, the banks are recapitalised and large EIB investments are unleashed, the real economies will pick up enthusiastically.

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  8. Yanis, thank you for answering my questions.

    Regarding the first issue, that bonds would become untradeable after the tranche transfer to the ECB, it seems to me that this is a fundamental restructuring (change of contractual conditions) of the debt. Bonds are tradeable because they are ‘bearer securities’ that are paid to the holder. They would be replaced with ‘registered securities’ where the payments would be made to the bondholders that comes forward at the time of the tranche transfer. I cannot see how the tranche transfer doesn’t constitute a default or restructuring from the point of view of the bondholders, which doesn’t mean I think it’s a bad idea. Unlike other restructurings, this would appear to improve, not deteriorate, the value of the restructured bond. This is because the bond would go from being priced according to the issuer’s (say, Italy, per your example) ability to pay to being priced according to the ECB’s ability to pay. In other words, the ‘risk premium’ would be greatly reduced. Also, on the balance sheets of the bondholders, the bonds would go from mark-to-market accounting to hold-to-maturity accounting, so not only would the balance sheet of the bondholders be repaired but their asset-value volatility would be reduced. The only problem would be the loss of the fetishistic feature of liquidity, on which Keynes famously said

    The spectacle of modern investment markets has sometimes moved me towards the conclusion that to make the purchase of an investment permanent and indissoluble, like marriage, except by reason of death or other grave cause, might be a useful remedy for our contemporary evils. For this would force the investor to direct his mind to the long-term prospects and to those only. But a little consideration of this expedient brings us up against a dilemma, and shows us how the liquidity of investment markets often facilitates, though it sometimes impedes, the course of new investment. For the fact that each individual investor flatters himself that his commitment is ‘liquid’ (though this cannot be true of all investors collectively) callms his nerves and makes him much more willing to run a risk. If individual purchases of investments were rendered illiquid, this might seriously impede new investment, so long as alternative ways in which to hold his savings are available to the individual. This is the dilemma. So long as it is open to the individual to employ his wealth in hoarding or lending money, the alternative of purchasing actual capital assets cannot be rendered sufficiently attractive (especially to the man who does not manage the capital assets and know very little about them), except by organising markets wherein these assets can be easily realised for money.

    Illiquid assets are much less valuable to ‘investors’ than liquid assets, even if the book values are larger. Another way to state this is that rendering the bonds illiquid makes the term structure of the ‘investors’ assets more rigid. So the ECB might end up having to accept these bonds at the discount window anyway.

    In relation with this tranche transfer you have argued here that the ECB would be perceived as highly solvent by the market:

    The ECB itself. Note that the eurobond issue, as described above (Policy 1 of our modest Proposal) is revenue neutral: In the long term, it will be costing the ECB nothing. Zilch. You may, of course, ask how the ECB (and the markets) can be so sure that Italy and the rest will honour their long term debts to the ECB (the equivalent of how Jack and Jill will make their payments to the bank after their parents have taken out a new loan on their behalf). Simple: The ECB has a great deal of clout over member states, courtesy of the complete dependence of the member states’ banks on the ECB for liquidity. Moreover, the member state debt to the ECB could be given super-seniority status, just like that of the IMF’s. Lastly, the market will be factoring in the ECB’s capacity to monetise its debts, if it comes to that. The ECB will never have to do this, under our proposal. But knowing that it can adds a powerful boost to the ECB’s credit-worthiness.

    You also argue that the tranche transfer does not constitute a fiscal transfer. I think this brings us to the issue of central bank solvency and capitalization, as well as the limits of the ECB’s ‘monetization’ ability, on which I have seen nothing more readable than Willem Buiter’s Can central banks go broke?. There he points out that the ECB is actually a tiny bank. In addition, the ECB is capitalised by the EU (not Eurozone) member states in proportion to their GDP because the ECB is owned by the 27 National Central Banks of the EU, even though only 17 NCBs are in the Eurosystem. At the end of 2010 the ECB asked the EU member states to double its capital from 5 to 10 billion euros. The Maastricht-compliant 60% of GDP would amount to about €6 trillion for the whole of the Eurozone, so unless we’re comfortable with a central bank with a leverage ratio of 600, the tranche transfer would require massive recapitalization. And then I would envisage not only loud complaints about fiscal union through the back door. It’s quite possible that ‘the market’ would not give the ECB the solvency rating you envisage in the Modest Proposal.

    Together with the second issue, the semantic distinction between a debit account and a credit facility, I would expect legal challenges to the whole approach, at the very least before the German Constitutional Court. After all, the German President recently made big waves with his public statement that in his opinion the ECB is violating the spirit if not the letter of the Maastricht Treaty with its secondary market bond purchases. If the tranche transfer were to pass, it would elicit even stronger complaints of violation of the spirit if not the letter of the treaties. You are of course aware of this as, in the declaration signed by Amato, Verhofstadt and others, you replaced the ECB with the EFSF:

    Readers familiar with the Modest Proposal will have noticed a difference between this suggestion and the Modest Proposal: Whereas in the latter we recommend that the ECB handles the tranche transfer and issues the Eurobonds, in this Declaration, in an attempt not to ruffle the feathers of those who do not want to be seen to be challenging the independence/current role of the ECB, we offer as alternatives to the ECB either the EFSF or the EIB group (which includes the EIB and the European Investment Fund). The point here is to the principle of the tranche transfer. Once that is established, we can debate whether perhaps it is better to give that role to the ECB. In the context of the present Declaration we judged that this was appropriate to allude to different existing institutions as the agency that is assigned the central role of managing the tranche transfer so as to drum up the widest possible level of support.

    Yours is a valiant proposal, but I am afraid the chances of it becoming policy are nil.

  9. Harvard professor Feldstein: Euro `Experiment’ Is a Proven Failure:

    I just hope they use another lab next time!

    Harvard ranks #2 in QS World University Rankings 2011/12. The best dutch universty ranked #63… Only 2 Eurozone countries rank within the top 50. Does giving up your own currency result in bad universities?

  10. Thank you Yanis and Stuart for the clarification and associated debate, a very essential exercise. But while you have now cleared away the last of the undergrowth surrounding the matter of debt – that still leaves the real elephant in the room; the underlying reason why we have arrived in this dilemma, The Western economies are not creating anything like sufficient numbers of private sector small businesses to employ the general populations.

    The Modest Proposal has great merit; as far as it goes. But the elephant is the lack of investment of equity capital into new job creation. One without addressing the other will not provide a long term solution to the underlying reason why we got into these difficulties in the first place.

    There is no mechanism in place to enable investment of local savings, as free enterprise based equity capital, back into the local communities.

    As you now both know, I have presented a proposal to use a vanishing bond as a source of such equity capital to create those new businesses and thus the missing jobs. The basic principle being there is a desperate need to make a swift transfer of prosperity out of the existing FIRE economy and back into the grass roots of those local communities.

    How will Euro Bonds serve to emulate that vanishing bond/equity capital input?

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  14. Have you heard the joke of extreme pain?
    Using your tongue to slide down on a razor covered with alcohol.

    I guess that is Merkel’s razor.

    Thank you once more Yanis Varoufakis and Stuart Holland for this post.

    • Why do you still worry about Merkel? Her CDU/CSU/FDP coalition lost another election. The next one with the same result is due in a few days….

      There are already rumours that she will stept down. If she is gone noone else will support the old style Europhile Mr. Schäuble.

      The EURO and the plans for the EUDSSR are toast.

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