We provide evidence that the movements in yield differentials between euro zone government bonds explained by changes in international risk factors -as measured by banking and corporate risk premiums in the United States -are more pronounced for bonds issued by Italy and Spain. Liquidity factors play a smaller role, so policies meant to increase financial market efficiency do not appear sufficient to deliver a 'seamless' bond market in the euro area. The risk of default is a small but important component of yield differentials movements, which signal market perceptions of fiscal vulnerability, impose market discipline on national fiscal policies, and may be reduced only by further convergence in debt ratios.

The collection is aimed at promoting circulation and dissemination of Working Papers produced within Italy"s Ministry of Economy and Finance (MEF) or presented by external economists on the occasion of seminars organised by MEF with the aim of stimulating comments and suggestions. The contents of such documents merely reflect the views of their respective authors and do not imply any engagement or responsibility on the side of the Department of the Treasury and the Ministry of Economy and Finance.

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The only way to share common liabilities in the Eurozone is to achieve full fiscal and political union, i.e. unity of liability and control. In the pursuit of that goal, there is a need to smooth the transition, avoid unnecessary strains to macroeconomic and financial stability and lighten the burden of stabilisation policies from national sovereigns and the European Central Bank, while preserving market discipline and avoiding moral hazard. Both fiscal and monetary policy face constraints linked to the high legacy debt in some countries and the zero-lower-bound, respectively, and thus introducing Eurozone 'safe assets' and fiscal capacity at the centre would strengthen the transmission of monetary and fiscal policies. The paper introduces a standard Mundell-Fleming framework adapted to the features of a closed monetary union, with a two-country setting comprising a 'core' and a 'periphery' country, to evaluate the response of policy and the economy in case of symmetric and asymmetric demand and supply shocks in the current situation and following the introduction of safe bonds and fiscal capacity. Under the specified assumptions, it concludes that a safe asset and fiscal capacity, better if in combination, would remove the doom loop between banks and sovereigns, reduce the loss in output for both economies and improve the stabilisation properties of fiscal policy for both countries, and thus is welfare enhancing.

The paper shows that the introduction a Eurobond together with fiscal capacity at the centre would produce macro-stabilisation benefits both for the core and periphery of the Eurozone and would also achieve a rebalancing of the policy mix away from monetary towards fiscal stimulus. To demonstrate these benefits, we trace the shock-responses in a stylised model of the economy of the Eurozone with a core and a peripher to see how it would behave under alternative conditions. Alongside standard demand and supply shocks, we include financial risk-premium shocks by explicitly modelling bond yields, bank lending and public debt dynamics. We replace national bonds with Eurobonds on banks and ECB s balance sheets, and we introduce fiscal capacit at the centre with the power to adjust the aggregate fiscal stance. We conclude that had a Eurobond/fiscal capacity existed at the onset of the Great Financial Crisis, the recession would have been much more muted, and with much less need for unconventional monetary policy. Comments on an earlier version of this paper received at a seminar organised by ACES on 21 st January 2020 are gratefully acknowledged. The authors take full responsibility for all remaining errors and omissions.

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Our working paper series is designed to promote the circulation and dissemination of working papers drawn up within the Department of the Treasury (DT) of the Italian Ministry of Economy and Finance (MEF) or presented by external economists on the occasion of seminars organised by MEF on topics of institutional interest for DT, and is aimed at encouraging readers to submit comments and suggestions. The views expressed in the working papers are those of the authors and do not necessarily reflect those of MEF and DT.