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Julian D. A. Wiseman
Abstract: Still no explanation of how, starting from here, a “Common European Bond” can work.
Publication history: only at www.jdawiseman.com/papers/finmkts/20101213_credible_default.html. Usual disclaimer and copyright terms apply.
Contents: Introduction; Credible Default; Immediate Default; Blue Debt Management; Conclusion.
Gavyn Davies, in an Op-Ed in the FT entitled How the E-bond plan would work, suggests that the plans for Common European Bond might be based on a The Blue Bond Proposal (6th May 2010), by Jacques Delpla and Jakob von Weizsäcker of Bruegel, a Brussels thinktank.
The proposal is that there be issuance of mutually-guaranteed ‘blue’ bonds that can be used to finance debt, for each country up to 60% of GDP. Beyond that funding would have to be in the form of single-country national ‘red’ bonds, for which there would have to be “the credible prospect of an orderly default”. It is argued that financing debt of 60% of GDP in mutually-guaranteed bonds should lower countries’ average cost of funds, the prospect of a default on the red debt should increase the marginal cost.
That is partly reasonable, but only partly, and anyway is unreachable starting from here.
Italy’s Dipartimento del Tesoro says that Italian “Outstanding Government Bonds as of 30/11/2010” total €1,552bn, and Italian annual GDP is about €1,216bn. So if 60% of GDP could be financed through mutually-guaranteed ‘blue’ bonds, today, that would reduce the outstanding ‘red’ bonds by ≈€730bn to ≈€823bn.
And, according to The Blue Bond Proposal, there is to be “the credible prospect of an orderly default on the red debt”. Recall that it was thought too dangerous for Greece to default on ≈€300bn of debt. So then we are asked to believe that there will be a credible default mechanism for 2¾ times as much?
Reader: do you believe that a threatened €800bn+ ‘red’ default by Italy would be met with an indifferent shrug of the shoulders? Or by investors rushing for the exit, and panic meetings in Brussels in which Germany is begged and cajoled to save the day?
To get there some mutually-guaranteed bonds must be issued. Senior eurozone politicians must then explain, jointly and perhaps severally, that remaining red bonds are de facto subordinated. That is the whole point: default is to be easier, and nastier for investors.
Imagine that a private-sector bank were to announce to its senior bondholders that, “sorry people, it wasn’t working for us, the senior debt you bought is now subordinated”. Rating agencies would, rightly, consider that to be a repudiation, and so an immediate default. The same would apply to Italy. Subordinating Italy’s current debt, or any part of it, might well be treated—indeed should be treated—as a default.
At a minimum this plan needs legal input from all jurisdictions important to finance: eurozone, non-eurozone EU, and non-EU.
Debt issuance is mostly a technocratic rather than political task (though the author has long argued that it is not always done well: see comment on auctions, selling call options, and the optimal size of long-dated bonds). But despite its technocratic features, the issuance of debt is a promise made on behalf of future taxpayers. Hence, at least in the UK, it has rightly been thought that this requires a political imprimatur.
European politicians agreeing the joint issuance of debt have some decisions.
The usual European way would be to appoint a committee of lots of people from many countries. Each person on the committee would promise to ignore instructions from their governments and act for the good of Europe as a whole. These promises would be ignored, votes being cast as instructed by the home government.
Good luck with being thought by investors to be credible.
It still hasn’t been explained how, starting from here, a “Common European Bond” can work.
|— Julian D. A. Wiseman|
13th December 2010
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