Europe, public debts, and safe assets: the scope for a European Debt Agency

Abstract

The Covid-19 crisis has radically changed the game for world and EU-economies, and urged for a reappraisal of the guidelines for a healthy management of public expenditure. This requires a deep rethinking of the role of public debt in modern capitalistic economies and of efficient, equitable and politically viable ways of financing it. This paper outlines the main operating framework of a Debt Agency tasked with the management of the Eurozone sovereign debts and the creation of a truly European safe asset. The framework leverages on the potential irredeemable nature of sovereign debts in order to build a common bond. By structurally filtering liquidity risk, the Debt Agency can price the Member States’ funding costs by referring only to their credit risk, as defined by EU agreed rules. The common bond issued by the Debt Agency thus avoids mutualisation by design; hence, it can be directly bought by the ECB. Due to its structural intertemporal sustainability, the Debt Agency’s framework delineated in this paper can serve as a benchmark for institutional and political decisions. In this perspective, a counterfactual exercise has been conducted in order to evaluate the future potential impact of the Debt Agency as well as the past distortions in market pricing of Member States’ fundamental risk due to market mispricing of the liquidity risk.

Squaring the Circle: How to Guarantee Fiscal Space and Debt Sustainability with a European Debt Agency

“…We will argue below that, to ensure its political acceptability (especially in core EMU countries), an EDA would need (a) to avoid any form, explicit as well as implicit, of debt mutualisation; (b) to provide markets with a safe asset, thus relieving core EMU countries from excessive demand and from the curse of negative rates; (c) to help the normalization of monetary policy, allowing the ECB to focus on its mandate without the fear of creating instability on sovereign debt markets. We will show in this working paper that these are precisely the characteristics of the EDA as proposed by Amato et al (2021).…”

“…Proof, albeit indirect, of the EDA's efficiency as a debt management tool is provided by the counterfactual exercise whose details can be found in Amato et al (2021)). Here we show the results of a refined exercise, which gives an estimate of what might have happened to debt servicing rates had the EDA been in operation between 2002 and 2015: Take the cases of Germany and Italy (Figure 2): in spite of the intrinsic limitations of this type of exercise, the counterfactual that we present here suggests two things: i) in the presence of the EDA the market turmoil between 2012 and 2015 would not have occurred; and consequently, ii) the explosion of spreads was plausibly not linked to a deterioration in fundamentals, but to distortions in expectations that not only may not absorb shocks but, under certain conditions, actually amplify them.…”

“…For instance, following specific political decisions, it could build segregated (mutualised and non-mutualised) sub-portfolios. By way of example, "the Debt Agency could apply a mutualisation scheme to national expenses carried out in the framework of European infrastructure cooperation programmes (such as new NGEU-like programmes), while nonmutualisation would continue to be applied to debt expansions linked to strictly national fiscal policies" (Amato et al (2021)).…”

“…A quick glance at how the markets have until now 'warmly welcomed' Commission debt issuances is extremely instructive: the potential demand for European safe assets is very high, and these common bonds are already considered European safe assets. "Therefore, there are good economic and institutional reasons to methodically approach the question of the possible rollover of the common debt, and to provide innovative operational solutions" (Amato et al 2021).…”

“…In the eurozone this trade-off has so far prevented an agreement on the creation of Eurobonds: market-based solutions (Eurobonds based on pooling and tranching, without any form of public guarantee, like the ESBies) are exposed to overshooting risks on junior tranches; centralised solutions, based on a common issuer with adequate capital endowment are expensive in terms of loss absorbing capital and do not structurally avoid mutualisation, which could in principle lead to free riding and moral hazard.A federal Treasury would be an obvious, though today politically quite an unrealistic, solution to the trade-off. In its absence, however, it is possible to think of a 'European synthetic Treasury', with the task of issuing Eurobonds and subsequently providing financing to the Member States while maintaining a differentiated financial treatment according to the credit risk of each of them Amato et al (2021). provide all the details on the working of such a European Debt Agency (EDA), which would be compatible with the existing treaties.A European Debt Agency had already been proposed byDiev and Daniel (2011), who nevertheless had in mind a lending facility similar to what would eventually become the ESM, hence quite different in nature from the Amato et al proposal.…”