A system of 'European Safe Bonds' run by a continent-wide debt agency could save the eurozone without the need for fiscal union argue two leading analysts from the London School of Economics and Political Science.
Professors Luis Garicano and Dimitri Vayanos are among a group of academics from the Euro-nomics group who have today set out their proposal for the bonds which would be stable enough to survive even a debt default by one or more European countries.
The group's open letter is published in today's Wall Street Journal and in El Pais in Spain.
In it, the group suggests, the crisis in the eurozone reflects flaws in the design of monetary union, rather than in the principle itself. They say: "Many believe that that Europe needs large fiscal transfers and euro bonds to end the crisis. But a cleverly designed bond, couple with key reforms in bank regulation and monetary policy, could ensure the euro zone's survival without a fiscal union."
Their proposal is for a European Safe Bond (or ESBie for short) which would provide a secure haven for investors and which would be accepted as collateral by the European Central Bank, improving liquidity.
A new debt agency would buy the sovereign bonds of member nations and assign them a strict weight according to the GDP of the country from which they originated.
The agency would then offer two types of security based on the collection of sovereign bonds, The first, the ESBie, would have a prior claim on the return from bonds in the portfolio – perhaps the first 70 per cent – and would be an ultra-safe investment.
The second security would be backed with the remaining proportion of returns from the bonds and would be much riskier because it would absorb the losses from the portfolio. Therefore it would offer higher than average returns to compensate for the risk and would be attractive to private investors such as hedge funds.
By adopting the new system of safe bonds, the authors believe, the eurozone would escape the current trap where all sovereign bonds are treated as equally riskless which leads to poorly-diversified banks holding too much sovereign debt and riskier bonds. In the present crisis, doubts about the solvency of sovereign countries leads to fears about banks' solvency. In turn, countries feel compelled to rescue their banks with public funds which raises fear of national default.
The authors conclude: "European Safe Bonds are not euro bonds. They do not require one country's taxes to pay for another country's spending., nor do they require change to the European treaties. They are designed to be safe, not to maximise the issuer's profits, and they are simple and transparent so they cannot be manipulated to trick buyers.
"ESBies alone will not solve all of Europe's current problems. Sound financial markets require constant vigilance. But ESBies would provide a way out from the regulatory gaps at the origin of the crisis, and they lay the foundation for a stronger euro zone in the long run."
The Euro-nomics group is composed of eight leading economists, including Professor Garicano and Professor Vayanos of LSE. The others are Markus Brunnermeier of Princeton University, Philip R Lane of Trinity College, Dublin, Marco Pagano (University of Naples Federico II), Ricardo Reis (Columbia) Tano Santos (Columbia) and Stijn van Nieuwerburgh (New York University Stern School of Business)
Full text of the letter and more details at the Euro-nomics site