The curse of excessive and chronic public indebtedness in some eurozone nations has highlighted the possibility of debt mutualization as a solution to an increasingly untenable problem. Evaluating a model, the authors consider different forms of mutualization in multiple scenarios.
The current situation of fiscally sound eurozone nations invoking the use of emergency funds to guarantee the debt of the region’s more spendthrift members cannot hold in the long run. Because the eurozone does not have the ability to print money to finance its members’ public debt, pundits and policymakers in the region have clamored for some version of a collective guarantee in the form of a eurobond. The authors consider the issues surrounding the feasibility and desirability of such a solution, modeling various country and repayment options.
How Is This Research Useful to Practitioners?
Eurobonds have been suggested as a potential fix for the problem of how to finance uneven public indebtedness in the eurozone. Opponents view this approach as a moral hazard because it gives those nations with weak budgetary discipline a partial free pass.
Many proposed solutions fail to consider a model approach. The authors contend that doing so allows for a more focused analysis of the merits and demerits of debt mutualization. Their analysis considers different types of debt mutualization and the impact of such arrangements on member nations’ budgets and social welfare. Their discussion begins with a brief overview of numerous debt mutualization arrangements that academics and policymakers have proposed.
To consider how such an arrangement would work, the authors offer a simplified model of two countries—one being a more fiscally sound “core” country and the other being a more indebted “periphery” country. From there, they consider the respective outcomes of no debt mutualization and a debt repayment guarantee. They offer welfare criteria and illustrate the benefits and drawbacks of both a limited and an unlimited repayment guarantee for the well-being of the economic and political union. Such a guarantee could be invoked when the core nation underwrites the periphery’s excess borrowing beyond a proposed limited guarantee. Structural reform as a condition for a guarantee could serve as an inducement for less fiscally restrained members to put in place additional fiscal reforms.
Policy analysts and regulators would find this analysis thought provoking because it attempts to simulate conditions under which a solution could be proposed while considering the inherent risks. Similarly, fixed-income analysts and portfolio managers could find these insights useful in evaluating risk exposures in portfolio construction.
How Did the Authors Conduct This Research?
Using a quantitative formulaic approach, the authors model various (non)payment scenarios. They begin with the creation of a fictitious two-country currency union. Core is the fiscally prudent one, whereas periphery is given to excessive indebtedness. The model considers member nations’ political (dys)functionality and its effects on their finances over two time periods. This scenario acts as a backdrop from which to consider limited and unlimited guarantees by core of periphery’s excess debt and the effects of both on social welfare in the union. The authors introduce the element of economic reform into the model as a condition for the further provision of some form of guarantee, finding that doing so induces periphery to introduce additional reform. In any event, some form of guarantee appears prudent because it helps to lessen the transmission of periphery’s defaults and consequent economic distress into the core nation, thereby enhancing welfare overall.
Do eurobonds represent the collective will of the eurozone member nations to finance their public debt or is the problem considerably more nuanced? The authors argue the latter, given the types and complexity of the quantitative models that they propose. The presentation splits a currency zone into two nations of differing budgetary discipline and considers various types of mutualization and their effects on the political and economic welfare of the fiscal union. Expanding the model further, the authors propose structural reform that would seek to lessen the uneven debt repayment scenario through governments’ introduction of reform measures. The analysis is rigorous and better suited to those with high-level mathematics training. But the conclusions and recommendations appear to be succinct. It would be interesting to see the application of this analysis to other currency unions.