European common debt is the way to topple the dollar

Greetings. You will have noticed a drumroll of stories in all parts of the FT recently about investors looking for alternatives to the US dollar, ranging from money managers to central banks. It makes for a moment of truth for the EU, which has long harboured ambitions for the euro to take the dollar’s crown.

Policymakers know this. In an opinion article for the FT, European Central Bank president Christine Lagarde declares that this is “Europe’s ‘global euro’ moment”. But will European leaders grasp the huge strategic opportunity that has landed in their laps? If they don’t, others — especially China — are ready to boost alternatives to both the dollar and the euro.

Next week’s European Council summit will discuss the euro’s international role. So today, I address the steps the leaders need to take to make the most of this moment of truth and, in particular, the perennial question of commonly issued debt. If not now, when?

Lagarde writes:

For the euro to reach its full potential, Europe must strengthen three foundational pillars: geopolitical credibility, economic resilience, and legal and institutional integrity.

I will mostly address the second point below, but the first and the third are evidently important. Geopolitical credibility hinges, as Lagarde points out, on the EU’s relevance in trading networks (where it is already a global player) and military alliances (where it is . . . not quite that). On law and institutions, the point here is that the EU’s perhaps maddening legalism and democratic decision-making mean that once a commitment is made, it can be relied on — and reliability is a scarce and valuable commodity in a Trumpian world.

But let’s focus on the economics. On “economic resilience”, Lagarde likewise mentions three ingredients:

. . . economic strength is the backbone of any international currency. Successful issuers typically offer a trio of key features: strong growth, to attract investment; deep and liquid capital markets, to support large transactions; and an ample supply of safe assets. But Europe faces structural challenges. Its growth remains persistently low, its capital markets are still fragmented and . . . the supply of high-quality safe assets is lagging behind.

She continues with the standard laundry list of policies emphasised in the recent reports of Enrico Letta and Mario Draghi, such as completing the single market, lightening regulation and unifying capital markets. But she pulls her punches on several crucial policy questions.

While she mentions the ECB’s euro swap lines for select other central banks, she fails to suggest that these could be expanded to more countries or included as part of the package the EU could offer trade partners interested in closer relations. And she doesn’t mention the digital euro, despite this being the ECB’s prepared defence against stablecoins. As Barry Eichengreen explains in the New York Times, the “Genius Act” now going through Congress could wreak havoc with the dollar monetary system by promoting stablecoins as a means of exchange (dollar-pegged crypto assets) and thereby making some forms of money risky. (Do read my colleague Philip Stafford’s Big Read on the march of the stablecoins.)

Most importantly, Lagarde only offers lukewarm advocacy for the provision of euro-denominated safe assets, which would have to take the form of EU-level debt backed in common by its member states, or “Eurobonds”. A full-throated call for EU leaders to issue more joint debt this is not, nor a commitment from the ECB to treat buying such debt as a reasonable policy instrument (which would make it even more attractive to investors). All she has to say on the topic is that “joint financing of public goods, like defence, could create more safe assets” (my italics).

A safe asset cannot, however, be a fortunate side effect of other, perhaps elusive, policy efforts. It must be seen as a goal in itself. In a new proposal for how Eurobonds could be designed, Olivier Blanchard and Ángel Ubide set out what is at stake:

Autonomy has many dimensions. The most obvious today is military autonomy, building a solid European defence system. A less obvious one, but equally important, is achieving financial autonomy, creating a European financial ecosystem that can compete with that of the United States. And a necessary condition for such a system to function is to have at its base a deep and liquid Eurobond market.

Now is the time to build it . . . Creating a deep and liquid market of Eurobonds would provide investors with the alternative safe asset they are looking for. Failure to do it now would be missing an historical opportunity to reduce the cost of funding European public debt and, by extension, European private capital.

There is an important recognition here that common borrowing offers much more than a source of funding (possibly a bit cheaper than that of most national governments). As Blanchard and Ubide point out, a sizeable Eurobond market, by encouraging a reallocation by global investors, would also increase the attractiveness of private investments in Europe because of the bedrock of a unified benchmark asset and a substitution into higher yield. It is the most likely way the EU and the Eurozone will reduce their current account surpluses — in other words, begin to put their own savings to work at home rather than to finance growth in other economies.

Until the pandemic, Eurobonds were anathema. Even in the depths of Covid-19, common borrowing for the pandemic recovery fund required pretending that it would be a one-off. But we have arrived at a point where what Europe’s governments claim to want the most — autonomy, lower funding costs, a stronger private capital market — requires a willingness to issue common debt in permanently large amounts.

The test of leadership, then, is whether the EU leaders accept this. If — or when — they decide to launch a large, permanent pan-European official bond market, the Blanchard/Ubide proposal is not a bad starting place for how to carry it out.

Here is their main idea: given that Europe needs a significantly bigger bond supply to compete with a $30tn US Treasury market, “the solution must be to replace a proportion of the stock of national bonds with Eurobonds”. To be specific, they want to issue about 25 per cent worth of GDP in Eurobonds to refinance national debt of the member states — partly by purchasing such bonds from the market and partly by replacing maturing bonds. They call for specified revenue streams in national budgets (such as a first claim on value added tax) to be dedicated to paying each government’s share of interest costs. In addition, Blanchard and Ubide advocate the consolidation of the existing EU-level bonds issued under different programmes and institutions (as I also proposed a few weeks ago).

There are good reasons to think the new common debt would get a good price (for issuers) in the market — ie it would make it cheaper for governments to borrow. In addition, a large Eurobond market means, Blanchard and Ubide write, “that the rest of the required [financial] ecosystem, such as a deep yield curve, a futures market, and ease of repo for blue bonds, would naturally develop, leading again to lower rates”. They suggest this could have positive effects on remaining national debt and private debt too, as well as on financial integration. Creating a new market could, in other words, put a free lunch on the table (if you will forgive the metaphor).

Blanchard and Ubide stay away from any discussion of the EU budget or whether new borrowing could fund new spending. That is because their priority is to rapidly build a large bond market, and at roughly 1 per cent of GDP, even a fully debt-funded EU budget would not have much to contribute to that goal for a very long time.

But there is no reason why you couldn’t speed up their proposal by issuing more bonds for additional purposes than simply replacing national borrowing. (I have suggested pre-funding the EU budget for many years, for example.) This would amount to building up a debt-funded sovereign wealth fund in order to meet the world’s demand for a safe euro asset.

But a sovereign wealth fund has to invest in something. Beyond national bonds, what could that be? Here are two ideas. An EU sovereign wealth fund could devote a slice of its money to invest in the equity of innovative companies in the sectors the EU wants to promote (perhaps through venture capital funds), or it could create a level of predictable demand for new securitisation structures, the rules for which are being loosened to revive the securitisation market. In both cases, the presence of public funds that are big enough to make a difference but not so big as to swamp the market could encourage more issuance and more liquidity, and thereby crowd in private investors.

Either of these possibilities would require a political decision, of course, and would involve a degree of risk. But it is not a risk that is unheard of. The Bank of Japan, for example, invests in stock market and real estate funds for monetary policy purposes.

All of these are drawing-table ideas. But that is where the discussion ought to be: how, rather than if. So far, however, there is little political impetus behind building a pan-EU official bond market as a policy goal. The sense of political anathema remains. But it is childish. It is rooted in a fear in each country of being on the hook for decisions made in another — whether that is paying their bills or being under their thumb. It is a fear, in short, of sharing risks. But as the pandemic showed, Europeans already share the biggest risks. The objection to risk-sharing is a political relic. Add in climate change, war and security, and it must be obvious that if Europeans don’t hang together, they will surely hang separately. If the time for Eurobonds is not now, then when?

Share any thoughts and comments with me at [email protected].

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