Europe requires European bonds

Christophe Chamley

Is it time for Eurobonds? This column argues that Eurobonds have always been the right solution. Every successful union throughout history has needed to create a proper financial instrument of sovereign debt – and the Eurozone is no different.

The ongoing Eurozone crisis has at least four dimensions:

Divergent labour costs between countries

Reluctance to embrace fiscal sharing,

Seemingly high levels of some sovereign debts, and

Self-fulfilling high interest rates on some sovereign bonds that may lead to default.

Eurobonds have been proposed as a tool to address the last issue. Although these have been discussed for more than two years, during which the crisis has worsened, no progress has been made, perhaps because the idea seems too new, and because of the ambiguity of political positions. Yet the creation of a new instrument of public debt is not a new problem in history, and past experiences provide clear lessons.

There is no example in history of the rise of a political power without the simultaneous creation of its proper financial instrument of sovereign debt. The creation of a new financial instrument rests only on one basis, its credibility. For each of the past creations, that credibility was based on a central principle: the alignment between bondholders and both the tax revenues used to service the debt and the funding of the new debt. In other words, specified taxes were levied on which the service of the debt had first claim.

This principle was at work in the Italian cities of the Middle Age, in the 16th century Castile of Philip II, in the Dutch republic of the late 16th and 17th centuries, in England after the Glorious Revolution, and in the foundation of the US. In 18th-century France, the limited use of that enforcement mechanism may have contributed to the fiscal problem of the Ancien Régime that led to the French Revolution. All these countries had to start anew to establish mechanisms for a new financial instrument of the public debt. The same challenge faces European countries today.

The alignment between bondholders and the controllers of the tax revenues explains why the public debt emerged in the Italian cities in the 13th century (Florence, Genoa, Milan, and Venice), where the oligarchy held city-bonds and controlled the enforcement of the taxes that serviced the bonds. In 1262, the senate in Venice created the ligatio pecuniae paying 5% that was funded by revenues from specified sales taxes. The payment of interest had first claim on the revenues of these taxes, prior to any ’extraordinary’ expenses. Some of the surplus of revenues went to a ‘Sinking Fund’ for the amortisation of the debt (Tracy 1985, p11). Indeed, Genoa went through a transition in the 14th century that could be a model for Eurobonds1.

A century earlier, cities in the north of France (Douai and Calais), and in Flanders issued similar bonds (Tracy 1985). When nation states introduced their public debt, they began by issuing loans through cities in order to achieve credibility through the alignment between sovereign bondholders and controllers of taxes.

Castile under Philip II, in the second half of the 16th century, presents the first case in history of a large public debt. It rose to the modern and, at that time, unprecedented level of 60% of GDP. The debt was national and the central government had no administration to collect the taxes that serviced the debt. These collections were delegated to 18 cities of the realm and their surrounding regions. Each city paid a yearly lump-sum to the central government and the government-issued bonds that were serviced at the city level. That service had first claim on the tax revenues: the cities would deduct from the lump-sum the amount of the debt service. That system ensured the credibility of the debt because the local oligarchy that controlled the tax revenues either owned the bonds or was closely connected to the holders of these long-term bonds that served as retirement income (Álvarez-Nogal and Chamley 2011). The debt was secure, its real interest rate gradually decreased from 8% to 5% during the 16th century.

In 18th century England, the national parliament that gained power after the Glorious Revolution controlled both expenditures and the collection of revenues. However, the parliamentary balance between bondholders in cities and taxpayers in the countryside could change (Stasavage 2003) and the service of the bonds out of general revenues lacked transparency. Interest rates began to fall only when the debt was funded through earmarked taxes: each new bond issue that would be approved in Parliament required the introduction of an earmarked tax (eg an excise on specific items) that would finance its long-term service. During a war, a new bond issue was made in each year. Each new issue had the same financial terms (maturity, redeemability) as the previous one in order to create a financial market as wide as possible for the same bond. That consolidation facilitated the reduction of the interest rate in 1749 without disruption in the financial market. It was formalised a few years later by the famous consols that have been the backbone of the English public debt ever since (Chamley 2011).

In the same century, France had no comparable system to service the debt and had to pay a higher interest. The least costly debt and credible instrument was the life annuity because a default would have entailed a strong penalty through its durable impact on the retirement benefits of the people. (When the abbé Terray conducted a partial default in 1770, he did not touch the standard life-annuities). However, life-annuities were very expensive compared to the standard funded debt and that is one of the reasons France eventually cracked in its race against England.

In 1790, under the impulsion of Hamilton, the new US federal government bought at par, without haircut, all the debts that the states had accumulated up to various levels during the War of Independence, and introduced new taxes (tariff and excise) to service the new US bonds (McKinnon 2011). In the US today, the retirement benefits of Social Security are paid out of an earmarked tax. The Bush administration tried to abolish that earmarking and to include the tax into the general revenues, but the outcry forced its retreat.

Financial markets are now far more sophisticated. Much of today’s complexity is incomparable with the past. But one thing that hasn’t changed is the importance of the credibility of the debt. And on that measure, Europe’s leaders have something to learn from their predecessors in centuries passed.

Eurobonds could be created with an ad hoc institution, the Euro-Fund. Because of the multiple governments, that fund would have some features of financial intermediation, but would not be a bank. It would be an independent institution, with minimal staffing and policy role. In the current situation of the states' debts, its first initiative could be the purchase of 50% of the public debt of participating countries. It would finance these purchases by issuing Eurobonds. The participating countries would be committed, by treaty, to devote a specific tax for payments to the Euro-Fund. That tax would have first claim to the revenues of a country, prior to any expense of any sort, as in 1262 Venice. Each country would keep a separate balance at the Euro-Fund and be charged the same rate on that balance. A surplus or deficit of the tax revenues would entail a variation of the debt of the country at the Euro-Fund. The liability of a country at the Euro-Fund would have a maximum of 60% of its GDP. A country's public debt above that level would be financed like any sovereign bond. A country could keep a margin of safety below the ceiling for any emergency refinancing of its remaining sovereign debt and to prevent speculative attacks on its interest rate.

The funding would ensure the credibility of the Eurobonds. It would satisfy the political or constitutional concerns about transfers between the current states. At the same time, it would represent a true European project. The ad hoc tax would make each citizen more conscious about the implications of the public debt and the participation to the European project. Financial institutions could hold in their portfolio a safe asset that would have a large market. Right now, speculative attacks on interest rates can be successful because they select targets in fragmented markets. Interest rates in Italy are high because Italy would default if interest rates are high. They rise in Spain, France, and even Germany because a default of Italy would have a major impact on their financial institutions. Eurobonds may not entirely eliminate contagion, but they would greatly reduce its possibility. In the current situation, banks hold in their portfolios bonds of their national state, or use these national bonds as unstable collaterals to get euros. Hence, they are more vulnerable to the public finances of their country and the state is more vulnerable because of the need to bailout the banks if they fail. With Eurobonds, banks would be less affected by the instability of the public finance of their country.

Most countries in Europe now have a sovereign debt above 60% of their GDP and would keep a sovereign debt that would be priced by itself in the market. The interest rate on these sovereign bonds would obviously be higher than on Eurobonds and would depend on a country's commitment to fiscal stability. But because these rates would apply to a smaller fraction of a country's debt, any increase of the fiscal surplus would have a larger proportional effect on the service of that debt and therefore on its interest rate, thus enhancing the marginal incentive of governments towards fiscal stability. Furthermore, should a default occur, its side effects would be reduced because it would be expected to affect only a smaller fraction of a national debt.

References

Álvarez-Nogal, C and C Chamley (2011), "Debt policy in Spain: Philip II, the Cortes and Genoese bankers", mimeo, Paris School of Economics.

Chamley, C (2011), "Interest Reductions in the Politico-Financial Nexus of 18th Century England'', Journal of Economic History, 71:555-589.

Mc Kinnon, R (2011), "Oh, for an Alexander Hamilton to save Europe!", Financial Times, December 18.

Pezzolo, L (2007), "Government debt and state in Italy", mimeo, University of Venice, Ca Foscari.

Tracy, JD (1985). A Financial Revolution in the Habsburg Netherlands, Berkeley: University of California Press.

Stasavage, D (2003), Public Debt and the Birth of the Democratic State: France and Great Britain, 1688-1789, New York: Cambridge University Press.