EMU should be strengthened by central funding of public deficits

By Wim Boonstra

Although the euro, which is approaching its 11th birthday, is close to its all-time high on the markets, the currency is not without its problems.

Early last year the euro temporarily lost ground against the US dollar because of a flight to safety, despite big problems in the US financial industry. Within the eurozone, interest rate differentials on public bonds of the various national sovereign issuers suddenly increased strongly. Although spreads have eased since early this year, the recent increase in Greek bond yields illustrates that the underlying problem is far from over.

In theory, differences in public bond yields within economic and monetary union have two causes. One is the difference in liquidity between the German Bund market and the other bond markets. The larger the market, the better its liquidity and the better the tradability of its bonds.

The second cause of the rate differentials is the perceived credit risk on public bonds. However, after the start of EMU, the markets have more or less neglected the fact that Greek or Italian public bonds are of poorer quality than their German, French or Dutch counterparts. Only in the current financial crisis have markets become more aware of this. So the worse state of Greek public finances is suddenly reflected in the increasing spread between Greek and German public bonds. These sudden swings in sentiment within EMU are a big source of instability and concern.

Both facts illustrate that EMU is still incomplete. Its financial markets are to a large extent integrated and it has a well-functioning central bank. Currency risk within the eurozone has disappeared. And the euro has sheltered its member countries from many of the negative side-effects of the current financial crisis.

However, although counting all national markets together, the public bond market of the EMU is much larger than the market for US Treasuries, individually they are much smaller. This explains why the euro will always be at a disadvantage to the US dollar because of the lower degree of liquidity of its markets. Even worse, the fragmentation of the public bond market within EMU gives financial markets a crowbar to speculate against the euro’s very survival.

The best answer to these problems is the creation of a pan-European federal government with a central budget, but this option lacks political support. The next best answer is the common funding of national deficits via a central agency. If the countries in EMU agree that from now on they will fund all their public deficits through a central agency, the national bond markets would be replaced by a huge, liquid public Eurobond market, that would overshadow the US Treasury market. It would solve both problems described above, as it would also become impossible to speculate against Greek or Italian public bonds, as they would disappear from the markets.

Of course, central funding of public deficits runs the danger of undermining fiscal discipline within Europe, which makes it hard to sell to the Germans or Dutch. This can be solved by adding a spread to the cost of funds of the central agency, which would cause the funding costs of individual governments to reflect the health of their public finances. The lower the deficit and public debt ratios, then the lower the cost of financing of public deficits, and vice-versa.

This approach does not undermine the no-bail-out clause of the Maastricht Treaty. It also barely influences the degree of autonomy on fiscal policy of the participating countries. However, just as today a country can run into problems servicing its public debt, this could also happen when a country is participating in central funding. The combination of the spread mechanism, effective sanctions and adding further conditions to borrowing long before a country really runs into problems will prevent them materialising. And the central agency, being the cheapest and most reliable source of funding, will be in a very strong negotiating position vis-à-vis the participating countries.

If AAA-rated countries such as Germany, France and the Netherlands would agree on central funding of their public deficits, they could start tomorrow. The advantages of the strongly increased degree of liquidity would materialise immediately through lower interest rates, which would certainly attract newcomers that will see the spreads on their bonds, compared with the new Eurobonds, increase. The first movers would then be in a position to dictate the rules of the spread mechanism on the latecomers, which can agree or not. This start is not very different from the way the exchange rate mechanism of the European Monetary System was introduced in 1979. Sometimes, it needs a bold step to move forward.

Wim Boonstra is chief economist of Rabobank Nederland and president of the Monetary Panel of the European League for Economic Cooperation.

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The macroeconomic costs and benefits of Economic and Monetary Union VoxEU

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