sábado, maio 15, 2010

Blue bond, red bond and the European Debt Crisis

At yesterday's Bank of Portugal conference in Lisbon, Jacques Delpla and Jean Tirole of the Centre d'Analyse Economique, in Paris,  presented an interesting, if radical,  proposal for the creation of an European "blue bond", cross-guaranteed by each of the Eurozone countries, to replace the Government debt up to the levels of 60% of GDP.  Government debt in excess of 60% of GDP, the "red bond", would be subordinated to the "blue bond" and would not benefit from any support from the other member countries, and would be expected to trade at significantly higher yields from the corresponding senior "blue bond". 

This proposal would provide joint and several support for the "sustainable sovereign debt" of 60% of GDP, and exclude and highlight the excessive unsustainable debt, thus using the market to descriminate in terms of risk-return and to help enforce financial discipline and avoid moral hazard.   The mis-pricing evident in the yield compression seen in early part of 2008 will be replaced by the co-existence of both lower yields for the sustainable blue debt and significantly higher junk-level yields for the excessive red debt

However, the "60% blue debt" proposal is only the second of a 3-point solution, which also requires all EuroZone countries to adopt a binding fiscal budget rule similar to that which was inscribed in the German constitution in 2009, to balance the federal budget by 2016 and the Lander budgets by 2020.  The third point  calls for the creation of a strong and European Independent  Fiscal Regulator to quantify, prioritize, and monitor  budget and non-budget spending, public debt and compliance with balanced budget criteria and provide transparency.  This regulation is to be more people-based than the rules-based Maastricht criteria which proved so easy to evade.

Thus the proposal calls for a  "budget discipline device" and relies on market discipline as much as on rules-based regulation to enforce it.
1.  Binding fiscal/budget rule adopted in all the EuroZone countries
2.  Blue Debt up to 60 % of GDP to benefit from cross-guarantees of all the EuroZone countries (about €6trillion);  Excess Red Debt above 60% of GDP subordinated, to trade on its own poor merits
3.  Reinforce European regulatory framework with an Indedpendent Fiscal Budget Regulator and Stability Committee 

With these measures, countries  would have to put an end to the current explosive combination of  "left-wing" generous public spending with "right wing" low taxation, which has proved unsustainable and has led to the current series of crises.

The on-going crisis seems to have evolved from the subprime mortgage crisis in 2007-8, to the banking crisis of 2009, and now to the Euro currency crisis of 2010.  But, in effect, it is a generalized "debt crisis" provoked by the Homeric "sirens' call" of easy credit and excessive leverage, be it  in families, in some corporations, in banks, and in Governments. 

In the ageing countries, facing the twin budget time bombs of pensions and health spending, a  lot of the excessive Government liabilities are hidden yet, in the future pension and health spending "entitlements", effective Government debt  icebergs.  By implication, all this off-budget debt, including that of deficit-ridden public sector companies and PPPs, would fall outside of the 60% limint and  would become higher yielding "red debt". 

Clearly, Europe will require not only a "federal debt solution" such as this "Euro blue bond",  but also  greater fiscal federalism to mobilize the automatic spending stabilizers in support of the single currency.

Mariana Abrantes de Sousa, PORTUGAL

See Paying for Pensioners, your budget or mine, download Bruegel Blue Bond policy brief