Investors around the world are quickly losing faith that policymakers will find a credible solution to end Europes most serious crisis since the euros inception more than a decade ago.
As stock markets plunge and fear ratchets higher, some are clinging to an intriguing concept: euro bonds. In an effort to bring Europe towards fiscal, not just monetary union, bonds would be jointly sold by the euro areas 17 nations -- likely at far lower interest rates than those offered to troubled countries like Greece.
While the idea of euro bonds is staunchly opposed by the current German government, some believe these securities could help heal Europe, but only if they are linked to painful and politically unpopular steps to wean nations off their addiction to debt and get their economies growing faster.
I think Europe has to move towards fiscal union. A European bond would be one expression of greater fiscal union, said Marc Chandler, global head of currency strategy at Brown Brothers Harriman. Europe has to be brought there kicking and screaming, he said.
When examining the merits of euro bonds, its important to remember that while the 17 members of the euro zone all use the same currency, they have different fiscal policies and diverse economies that grow at varying speeds. That fiscal and economic divergence explains why some countries have much higher debt loads than others.
Do Blue/Red Bonds Hold the Key?
Slow-growing countries can't rely on the European Central Bank for easy policies that might create inflation in faster growing countries like Germany. That means some countries end up tightening fiscal policy while others are loosening it.
It is extremely difficult for monetary policy to be right when governments are marching in opposite directions, said Adolfo Laurenti, senior economist at Mesirow Financial.
While Germanys debt-to-GDP stands at a reasonable 83.2% and its unemployment rate is about 7%, Greece is carrying debt of 142.8% of GDP and its unemployment rate leaped to 16.6% in May.
In theory, euro bonds would allow countries that are drowning in debt to tap the capital markets and borrow at more reasonable terms. Thats because the debt would be jointly and severally guaranteed by all of the member nations, including the ones with deep pockets like Germany, the Netherlands and France.
One idea gaining traction in recent days is a blue bond/red bond concept. The blue bonds would have relatively low interest rates because they would be jointly guaranteed by all 17 countries and only cover up to 60% of a nations debt. (The euros founding treaty deems 60% debt-to-GDP as a sustainable level).
The red bonds would cover everything above that level and be issued by national governments. These loans would obviously have higher rates, a sort of penalty for spending excessively.
However, euro bonds wouldnt really fix the three basic ills Europe is suffering from: too much debt, excessive spending and too little growth.
By itself, this is not the solution, said Laurenti. Euro-zone bonds do not let countries grow faster, do not reduce the debt and do not lower spending."
Fiscal Reform Required
Thats why many believe euro bonds would only be a credible solution if they are married with structural reform, a euphemism for overhauling the entire way euro-zone national governments operate.
The structural reforms are financially, economically and politically extremely expensive, said Laurenti.
They include balanced budgets, reducing overall debt and essentially handing over control of public finances to the stronger countries: Germany, France and the Netherlands.
At a joint summit earlier this week, German Chancellor Angela Merkel and French President Nicolas Sarkozy signaled their desire to achieve greater fiscal consolidation. They called for a new euro-zone economic council, constitutional amendments to force fiscal constraint and balanced budgets, enforcement power to punish countries that break the rules (see: Greece) and a single euro-wide tax rate.
Until you fix that, all youre doing is creating an open ended liability for the rest of the euro zone, said Douglas Holtz-Eakin, the former director of the Congressional Budget Office. Why would they sign on to that?
The only problem is voters in both camps tend to abhor the notions of fiscal reform and euro bonds.
Many Germans are sick of bailing out their weaker neighbors, especially because Germany has avoided the drunken spending that is crushing Greece.
"Some people are calling for the creation of European bonds ... which they present as a panacea," French Prime Minister Francois Fillon wrote in an op-ed article on Friday. "But they forget to say that would raise the price of French debt and could even call its credit rating into question."
However, Fillon acknowledged the idea could be palatable if there is a process of integration, for which he noted there is no political consensus at the moment.
German citizens realize they would have to pay for euro-zone bonds through higher taxes and a loss of creditworthiness. One report estimated Germany would face extra costs of $67.6 billion a year through higher interest rates.
There is no doubt at the end it will be a transfer of wealth from Germany into Greece and Italy and Portugal, said Laurenti.
At the same time, citizens of debt-ridden countries dont want to hand the keys to their economies over to their richer neighbors. This will be difficult to overcome, especially given Europes deep rivalries and distrust.
Lessons from America
Despite these political barriers, the European Commission on Friday opened the door to euro bonds.
These euro securities would aim to strengthen fiscal discipline and increase stability in the euro area through markets, Olli Rehn, the EU Economic and Monetary Affairs Commissioner, said in a statement.
Its clear that euro bonds will only work if Europes economy speeds up from its current slothful place. Stronger growth will translate to more robust revenues and help the struggling countries pay back their loans.
If income doesnt pick up in the future, those euro-zone bonds will suffer the same credibility and anxiety that the bonds do now, said Jack Goldstone, a senior fellow at George Mason University.
As Europe weighs the pros and cons of euro bonds, Rickard Sylla, a financial historian at NYU, suggests policymakers take a page out of Alexander Hamiltons playbook. Then the U.S. Treasury secretary, Hamilton spearheaded the effort in 1790 to assume the debts of the U.S. states, which at the time had their own currencies and drastically different fiscal policies.
The 13 U.S. states had $25 million in debt combined, compared with $54 million owed by the federal government.
Hamilton saw a lot of problems in having 13 or 14 different fiscal policies in one country, said Sylla.
Despite fierce political opposition from Thomas Jefferson and James Madison, Hamilton ultimately prevailed and the model stuck.