The point here is what is underlying the issues of common government securities, i.e. interest rates and collaterals. In this series of articles, we will explain what Eurobonds are, why there are so many concerns around them and if they could be developed someday soon. In particular, we will go through European peculiarities and analyse all viable options to face extreme circumstances as it is for COVID-19.
Why everybody messed up with debt
European history is made of visionary, well thought purposes. After WWII, six countries gave birth to the ECSC – European Community of Coal and Steel, aiming to pull off every possible source of conflict between countries. Very soon, they committed to a common market, the EEC – European Economic Community, 1957. Every day since, state after state joined the group to get to the 27 EU members by today. Among these countries, there is a free circulation of goods, services, people and capital and, of course, 19 EU members have a common currency as well.
In 1971 , the US abandoned the Bretton Woods system, based on fixed exchange rates, and currencies started being very volatile around the world. As a result, the European leaders recognised the power of a monetary union and created the ERM I – European Exchange Rate Mechanism, basically every currency in the area was pegged to a new one resulting from the weighted average of those. Then, in 1988, they gave Jacques Delors, President of the European Commission at the time, the task of writing down steps needed to create the EMU – European Monetary Union. The Delors Report highlighted the need for interest rates convergence, a commoneconomic policy among countries, fiscal rules and the ECB – European Central Bank.
Besides historic details, we are still trying to achieve the 3rd phase of this project, i.e. 7 of the 27 countries have not yet matched convergence criteria to obtain the euro.
The result was latter countries facing a very low cost of debt (the one levelled in the community), compared to the previous they had, and a very little power of European authorities to enforce the promises for convergence. Thus, governments started the deficit era, piling long term debt for short term fiscal requirements of the Stability Pact. Making things worse, those measures represented political moves to gain consensus.
Consequently, they generally were short term social policies that have usually lasted for 3 to 5 years. Indeed, especially in Italy, politicians used to discredit pasted decisions and to claim new ones. As one can understand, this lack of continuity has never given the chance to any move to break even.
Let’s now try to step back and analyse the concept of convergence. The eurozone is made of 19 different economies, with 19 diverse growth rates and levels of production technologies as well. We could also say, without any loss of meaning, that all the rules set by both the Fiscal Compact and the Stability Pact rely on the GDP and, in particular, on its growth rate. In conclusion, politicians should focus on the economic convergence rather than the fiscal convergence, as the one depends on the other. This means enhancing and levelling productivity above the board.
To sum up, countries have financed short term fiscal policy with deficit, rather than reform education and production systems. As this, debts piled and the ability of paying them back stayed the same.
As the reader will know, this is something very similar to what for a firm is called risk of default, just applied to sovereigns.The lower governments’ ability of paying interests, the higher the risk and so interest rates.
Given a basic knowledge of bonds, the higher interests, the lower the price, which is also the amount the issuer manage to gather at the beginning. In other words, states were earning little compared to future obligations. Furthermore, risk is strongly correlated with volatility: interest rates were so volatile that an investor was able to make a ton of money in a day, buying bonds for pennies on the dollar an re-selling in better times.
National banks were at that point compelled by governments to buy growing portion of sovereigns, as they were the only qualified investor still available, as all others were just willing to speculate or not buying at all. It resulted in banks holding huge portion of risky and volatile government bonds.
Governments were also responsible for rescuing banks, as, at the time, it didn’t exist the ESM, European Stability Mechanism. Being governments’ past debts unpaid, their risk of default grew, but also the one of banks, since their asset were made of risky bonds, i.e. sovereign default would have brought banks to collapse and so a greater risk was hidden in the sovereign that should have been increased to rescue them.
This vicious circle culminated in the so called ‘sovereign crisis’ of 2010. On this occasion the ESM – European Stability Mechanism saw the light. It was conceived to rescue states lending money under severe constraints. These was a structural reform of the debt to achieve solvency to the ESM itself. The aim was to create a 3rd entity to overcome the impossibility for ECB and states of helping other countries directly – art. 123 TFUE.
The ESM was initially financed pro quota by governments with 80 billion, now it raises capital through open market operations, it buys and sells securities.
Since 2010 interest rates on different sovereigns started diverging and they have kept doing so. The word ‘spread’ became popular and the fight upon ‘Eurobonds’ started, but we will come to it in the next article.