The economics of eurobonds

Proposals for eurobonds abound: Delpla and Von Weizsacker, Hellwig and Phillipon, Brunnermeier and others , German council, Boonstra. Most aim to shield countries from sovereign debt crises. Indeed, a common observation is that Europe as a whole has a lower debt to GDP ratio than the United States or Japan. At a more abstract level, eurobonds are one answer to the following question: how can eurozone countries create some form of mutual insurance while stopping short of full-fledged political integration of federative states like Germany or the US. But what do we know about the economics of eurobonds? Eurobond proposals need to deal with four issues: moral hazard, externalities, contagion and credibility.

Moral hazard

A central issue in designing optimal insurance schemes is how to address moral hazard. Eurobonds insure against events that raise interest rates. In particular, they insure against both liquidity risk and solvency risk. Most economists believe that solvency risk is at least to some extent driven by economic policy. Thus, insured countries can make a costly effort to reduce the risks they are insured against by reducing debt (e.g. by cutting spending), increasing growth (e.g. by labor market reforms or reducing entry barriers in product markets), or increasing resilience to shocks (e.g. by strict banking regulation or limiting private sector debt). When such effort is unobservable or noncontractible, this raises the issue of moral hazard.


In the presence of externalities, it may be difficult to agree upon the optimal amount of insurance. Suppose problems in one country have significant negative consequences for another country, but vice versa the impact is much less. In that situation, the two countries will want different levels of insurance. The optimal level of insurance will lie somewhere in between the two levels. To get the countries to agree might be difficult if transfers are not possible.


Suppose two countries have mutually insured themselves. This implies that shocks that raise one countries’ interest rate will now also raise the other countries’ interest rate as well. It is in principle possible that a shock that would pull only one country down now pulls both countries debt levels into unsustainable territory. The figure below illustrates this in a simple setting. Suppose countries without mutual insurance go bankrupt if the shock exceeds some level A. On the right hand side the region where both countries survive is smaller than on the left-hand side. These are benefits of insurance. The area where both countries fail together, however, is larger on the left-hand side. These are costs of mutual insurance.


Finally, insurance should be credible. When a country could withdraw from the insurance scheme if that were desirable for the country in question, this would undermine the effectiveness of the scheme. It may happen that while insurance is optimal for a country ex ante when it is not known who will be hit by the shock, ex post once shocks have occurred it may not be optimal for a country to pay up.


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