The stark crisis the euro area is currently undergoing originates from the intertwinement of: (1) unsustainable public debt levels in a number of countries; (2) weak banking sectors in the wake of the global recession, housing bubble bursts (and the resulting asset depreciations) and funding shortages (interbank market defiance, deposit flight); and (3) lack of competiveness and growth in the periphery. These three dimensions are mutually reinforcing: poor growth prospects cement market pessimism on debt paths, whereas fiscal consolidation undermines growth prospects; the public finance situation is made more precarious by costly bank recapitalizations (which governments cannot finance without more debt), while banks’ balance sheets are worsened by public bond depreciations.

The crisis has turned dramatic because these issues are addressed on a country-by-country basis rather than at the European level:

· The fiscal situation is viewed as unsustainable in some peripheral countries because European solidarity is bounded – a requirement of the German constitutional Court and materialized by capped rescue funds. At the aggregate level, the European Commission expects a budget deficit of 3.2% for the euro area in 2012. This figure does not look so bad given the growth forecast (-0.3%), but it is irrelevant in absence of solidarity between Member States.  

· Banks weakness partly originates from insufficient asset diversification. Banking assets are vulnerable to (local) real estate crashes, sovereign risk (also national as banks tend to own mostly public debt from their own country) and eventually to recession threats. Consequently, banks face a solvency problem (the quality of their assets deteriorates) and a liquidity one (as assets are more difficult to refinance). On the liability side, national deposit insurance schemes are unable to reassure depositors when the government is running out of cash and cannot raise more debt. Deposit flight results from this situation.

· Competitiveness and growth issues remain acute because Europe has no coherent growth strategy. On the one hand, it promotes economic integration, which leads to the concentration of activities in a small number of populated and well-connected regions while refusing to organize interregional monetary transfers on a large scale. On the other hand, the aggregate fiscal policy in the Eurozone results from decentralized decisions constrained by the stability pact. The approach is in no way to set an aggregated fiscal balance which would then be allocated according to the needs of national economies and externalities between Member States.

In addressing this crisis, we need to choose between less Europe (including the end of the euro) and more Europe. Many proposals have been made to solve the crisis through the introduction of Eurobonds, the creation of a banking union or the acceptance of a transfer union. All these proposals face significant hurdles.

· Political hurdles: under the democratic principle of “no taxation without representation”, a European solidarity would need to involve joint decision on national policies. For example, European partners should be given the right to veto a Member State’s budget when it is considered inappropriate. Such a possibility entails some form of political integration.

· Legal hurdles: the German constitution forbids the Bundestag to make undefined and potentially substantial budgetary commitments; national constitutions give national parliaments the power to decide on fiscal issues; the EU treaty forbids the bailout of a government. Eurobonds, a banking union and a transfer union would require changes not only in the treaty but also in national constitutions.

· A lack of trust: the crisis started when Greece admitted it falsified its accounts; it went on because of the inability of the Greek government to implement several elements of the adjustment plan, but also because other Member States failed to comply to their budgetary commitments; it eventually continued through the chaotic response by the Spanish government to its banking crisis. In this context, any federal solution encounters a profound lack of trust between Member States. Pooling resources could even reinforce deviant behaviors – a central argument to opponents of Eurobonds (see Gros, 2011).

These three major barriers lead many analysts to discard solutions like Eurobonds or a banking union which could only be implemented as a result of a long political process [1]. Northern Europeans can clearly not be asked to jointly guarantee debts they did not issue and upon which they have no discretion. However, status quo on these issues might well lead to a breakup of the euro area. This was acknowledged last year by the German Council of Economic Experts which proposed the creation of a “redemption fund” for sovereign debts [2]. The idea would be to progressively pool the part of debt deemed “excessive” (in excess compared to the 60% of GDP standard). The repayment of these debts would be secured by earmarking national tax revenues and through the collateralization of some public assets (a share of central banks reserves). Debt issued by the fund on behalf of national governments would then be granted a “joint and several” guarantee jointly and severally, i.e. in case of a default by one country, the other ones would substitute to serve the debt. Such a mechanism could be accepted by the Constitutional Court of Karlsruhe because it is “finite” (the amounts would be known in advance) and “temporary” (the fund would progressively disappear along with repayments). If it works, this mechanism could help restore confidence between Member-States, therefore easing the establishment of fully-fledged federal solutions. However, in addition to design issues (debt threshold, repayment rate…), creating a redemption fund faces two fundamental difficulties:

· Securing a portion of the debt makes the rest of it riskier. It would not solve the core problem of some governments, which is their inability to reimburse. [3]

· This redemption fund would not solve banks and governments short-term funding difficulties.

Another proposal, also from Germany [4], is to create not Eurobonds but synthetic bonds, tantamount to baskets of national government bonds. A newly established fund would buy on the market Member States’ public debt in proportion of their weight in the economy of the euro area (or in the capital of the ECB). It would then sell a synthetic bond consisting in a basket of these various national bonds. Acting as a mere intermediary, the fund would require no public funding. If a national government was to default on its debt, losses would be passed on to the synthetic bond. Hence there would be no mutualization of the risk, but the synthetic bond would by construction bear less risk than a Greek of Spanish bond. This low risk would ensure its eligibility to ECB refinancing, which could furthermore promote its development through favorable treatment in refinancing operations. Such a synthetic bond would indeed benefit the ECB by allowing greater sovereign risk diversification in banks’ balance sheets.       

Such a politically and institutionally low-demanding solution (compared to fully-fledged federalism) could be implemented quickly. It would however not solve the fundamental problem of debt overhang in some countries: if synthetic bonds are based on an allocation rule close to the weight of national GDPs (rather than national debts) in the Eurozone economy, then there would be too much Irish bonds and not enough German ones. Numerous peripheral countries’ bonds would remain “orphan” and would risk market rejection.

One solution would then be to combine synthetic bonds with a redemption fund together with debt restructuring. The idea would be to eliminate existing national government bonds from the market. Below 60% of GDP, domestic bonds would be bundled into synthetic bonds;[5] beyond this threshold, they would be transferred to a redemption fund. Only two types of bonds would then be traded on the market: synthetic securities (without joint and several guarantee) and fund bonds (without any mutual guaranteed), both being eligible for ECB refinancing. Member states would be banned from issuing debt outside of two vehicles[6] and the ECB would no longer accept government bonds as collateral. This ban would favorably replace the Stability Pact ex-post surveillance that has proved rather ineffective. Such an interdiction however entails introducing flexibility mechanisms on the debt reduction pace when market conditions improve or deteriorate. One could also imagine that the European Stability Mechanism could be used to temporarily finance, under strict conditionality, a government facing a country-specific shock.

One drawback arising from the removal of national sovereign bonds from the market would be the disappearance of related market interest rates. The country-specific spreads would therefore be set by a rule, keeping moral hazard in mind. The rate would take the market rate of the synthetic bond as a reference but could add (or subtract) spreads depending on government debt ratio. It would help maintain sound interest-rate differentials while avoiding spread overshooting during confidence crises.

Combining synthetic bonds with a redemption fund would still not the problem of debt overhang in some countries. However, a haircut could be applied when the debt is transferred into the redemption fund. Such a discount would be justified by the lower risk associated with the new bonds. Bank losses would be limited by the fact that a significant portion of banks’ securities are recorded at market value, sovereign risk already being discounted for troubled countries. At the end of the process, sovereign risk should be better diversified among European banks, strengthening the banking system resilience to a sovereign default: the explosive sovereign-banking risk loop would be cut. Moral hazard would be mitigated by the 60%-of-GDP limit set by the synthetic bond scheme, the impossibility - besides severe crisis times - to increase the amount of debt included in the redemption fund, the conditions attached to this fund, the interest-rate spreads and the explicit ban on national government debt issuance. As a result, the ECB could become less reluctant to buy a bond that could foreshadow a future Eurobond.

Distrust among Member States must be considered as a part of the problem. It seems therefore futile to seek to impose on Germany immediate and complete mutualization of sovereign debts. Without going as far as joint and several liability, the solution outlined herein could help solving short-term problems while giving the euro area a probationary period to rebuild trust, before a fully-fledged federal solution can be designed.
 

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