Volume 12, Issue 3 - Special Issue: Eurobonds beyond Crisis Management, Guest Editors: Thomas Eger, University of Hamburg; Hans-Bernd Schäfer, Bucerius Law School (Hamburg); Dominique Demougin, University of Liverpool

Eurobonds, i.e. the mutualization of (some) of the Eurozone member states debts, remain a promising tool not as a remedy for the ongoing debt crisis but for a number of other, more long-term reasons. This introduction to the present special issue of the Review of Law and Economics lays the ground for the subsequent in-depth analyses by providing a framework comprised of, on the one hand, the most prominent proposals for Eurobonds and, on the other hand, the legal and economic criteria against which the suitability of these proposals may be judged.

Analyzing the source of the Eurozone sovereign debt crisis, the paper argues the need for greater risk sharing and joint liability across sovereigns. This will require amending some of the legal provisions that underlie the European Union and the creation of the Euro. Once this is done it will be possible to consider the creation of Eurobonds and other liability arrangements, which can promote investment and job creation. A simple theoretical model is presented to bolster the argument.

The structural model of sovereign credit risk introduced in an earlier paper by the authors is applied here to measure the impact of introducing Eurobonds. Tranching (i. e. splitting the public debt into a senior and a junior tranche) is coupled with a cross-guarantee among eurozone countries and with a cash transfer. We show that Eurobonds can reduce the overall cost of servicing the public debt for some (high debt) countries in the euro area without increasing the cost for other countries. Moreover, they are likely to give governments an incentive to curb their deficits, due to the higher marginal cost of debt.

We analyze various Eurobond proposals and show that they have different effects on moral hazard, interest rates, international transfer payments and the necessity for European fiscal centralization. On closer inspection, these consequences are more diverse than the discussion on Eurobonds so far suggests. For instance, Eurobonds might increase rather than decrease marginal interest rates in weaker countries. Some proposals lead to international transfer payments while others do not. Some require changes to the Treaty on the Functioning of the European Union, others require changes to national constitutions, and others yet require both. Some proposals, while not necessitating such legal change, may still have mutual advantages for the issuing states.

We find strong evidence of country interdependence in the pricing of default risk, which suggests that a crisis can easily propagate from countries with weak fiscal fundamentals to other fiscally sounder member States. Interest rate interdependence differs between countries with high interest rates – high yielders – and countries with low interest rates – low yielders –. The former countries are linked through global spreads; i. e. they are exposed to the interest rate spreads (over Germany) of other troubled countries to a degree which increases with fiscal proximity. Low yielders with sounder fiscal fundamentals are partially immune from the high interest rates of fiscally weak member States but are still exposed to the risk of a euro break-up that is priced in Quanto CDS. This “euro risk” factor is a main driver of the interest rate spreads of low yielders until August 2012. More importantly, our case study of Italy shows that the impact of the global spread variable is dominated by changes in market sentiment, a sign that the Italian 2011–2012 crisis had the characteristics of a debt run more than a crisis of fundamentals. This evidence suggests that Eurobonds would be justified as an instrument for crisis prevention in the absence of a “lender of last resort”. With the announcement of OMTs, the ECB seems to have taken such role upon itself, mainly as a response to the risk of a euro break-up. We show that OMTs led to a significant fall in the impact effect of the global spread variable in the Italian case. The ECB’s ability to buy member States’ bonds reduces the risk of a self-fulfilling debt run but also deprives Eurobonds of their role in crisis prevention. Proposals to introduce Eurobonds to finance investment projects and expenditures related to the security and refugee crisis appear more realistic.

This contribution examines to what extent and under what conditions the various proposals for Eurobonds may be considered to be in accordance with European law (especially Art. 125 TFEU) and the national (constitutional) law of the Member States. It finds that their admissibility primarily depends on the degree to which these proposals would be able to curb debtor moral hazard, which in turn depends on the liability regime chosen: joint and several or pro rata liability. We conclude that most types of Eurobonds would require a Treaty amendment, whose political feasibility is questionable.

Departing from a political economy analysis of the benefits of common debt issuance by the Eurozone member states, we examine to what extent the various proposals for Eurobonds may be considered admissible under EU law and exemplary national (constitutional) laws, including those of Germany, Estonia, France, Ireland and Poland, from which one can deduce general national constitutional requirements applicable in all Eurozone member states. The medium and long-term potential gains from increased Eurozone stability and improved fiscal discipline must be traded off against the considerable legal and political obstacles of implementing any of these proposals. Yet key to the success of any common debt issuance is the effective dealing with the legacy debt of the Eurozone member states.

In light of proposals for Eurobonds, this article explores central legal features of the Eurobond proposals. Section 2 focuses on the development of the law governing sovereign bonds and assesses the potential, but limited role of international law for Eurobonds. Section 3 considers the equal treatment of bondholders, looking at the two potential sources of non-discrimination obligations for sovereign bonds and their relevance to Eurobonds. Section 4 turns to two crucial design features of Eurobonds which existing proposals mostly address only in passing: (i) which legal entity issues Eurobonds; and (ii) what form of debt mutualization Eurobonds involve.

This paper reviews the economic and historical literature on debt mutualization in Europe with reference to pre-1914 guaranteed bonds and the current Eurobonds debate. We argue that, notwithstanding the differences in scale and nature, debt mutualization solutions similar to Eurobonds were tried before, and the closest historical examples to the present debate are the pre-1914 guaranteed bonds. We highlight three key characteristics of debt mutualization, which are apparent both in the current debate and in history: moral hazard, debt dilution and conditionality. We show that the fears about short-run dilution and moral hazard were not unknown to pre-1914 market participants. These problems were partly addressed by mechanisms of conditionality such as international financial control. The historical evidence suggests that the dilution of outstanding obligations may be overplayed in the current debate. On the contrary, creditors’ moral hazard (ignored in current debt mutualization proposals) was as problematic as the usual debtor’s moral hazard –especially when the groups of countries guaranteeing the bonds and the creditor nations did not overlap entirely.