The coronavirus pandemic and subsequent lockdown measures have hit many economic sectors and brought about the need for strong fiscal stimulus. The governments of nine EU countries have already called for a common debt instrument to finance such stimulus. Common bonds, also called euro or corona bonds, should have long maturities and be a one-off measure. Because the bonds will be backed by all member states, they should have a high credit rating and low interest costs.
The idea of common bonds is not new and was discussed by the European Commission already in 2011. However, common bonds are highly controversial, owing to the moral hazard problem they may create. As these bonds would be a substitute for national bonds at a different interest rate, it is feared that countries most likely to benefit from the interest differential will borrow too much after their implementation. Because common bonds do not yet exist, there is no empirical evidence to either support or disprove the moral hazard argument. However, the 2011 proposal of the European Commission has triggered theoretical research on the topic.
Beetsma and Mavromatis (2014) analyze common bond designs in a theoretical model of a union with core and peripheral countries. Beetsma and Mavromatis are interested in the moral hazard of debt mutualization: how does the introduction of common bonds affect the borrowing decision of the peripheral country. They identify a form of common bonds which lowers the debt of the peripheral country. This is the so-called common bond with a limited guarantee. Under this instrument, the core country provides a guarantee for a certain maximum amount of debt by the periphery. If, however, the periphery’s debt exceeds this maximum amount, the joint liability vanishes completely, and the system returns to the situation without common bonds. The union welfare increases if, additionally, the guarantee is conditional on structural reforms. By analogy, corona bonds could be welfare-increasing if designed conditional on corona-related spending.
Kalamov and Staal (2016) also analyze the moral hazard of common bonds in a union with heterogeneous countries. In addition to studying the effects on public debt, this article analyzes how common bonds affect the conditions under which a bailout occurs. Kalamov and Staal consider common bonds with a guarantee up to a certain debt threshold. In contrast to the debt instrument considered by Beetsma and Mavromatis (2014), the guarantee of debt below the threshold does not vanish once the peripheral country’s public debt surpasses a certain level. Thus, the joint liability is only rejected for debt exceeding the agreed-upon threshold. This type of common bond does indeed increase the peripheral country’s borrowing. However, the costs of servicing the public debt decline. Owing to the lower debt costs for the peripheral country, it has less to gain by inducing a bailout. Therefore, the occurrence of a bailout becomes less likely, despite the periphery’s higher public debt level. The reason is that bailouts are triggered by high debt servicing costs, not by high levels of debt per se.
These articles show that the fear of moral hazard associated with common bonds may not be justified. A carefully crafted one-off common debt instrument with some form of conditionality and/or limited guarantee may give the fiscal space to all member states to appropriately respond to the pandemic, by keeping the costs of financing the corona-related spending at low levels.
Zarko Kalamov (TU Berlin)