Eurozone Bonds: Learning from Pre-Nuptial Agreements
Friday, June 8, 2012
French President Francois Hollande recently announced that he would be pushing for mutualizing European debt, a step that Germany, the Netherlands, and Finland oppose.
There are historical precedents for mutualizing debts. Alexander Hamilton’s assumption of states’ debts in 1790, for example, is often mentioned as a model. There are significant differences, however, between that situation and the one the European Union is facing now. While the United States eventually managed to shape an “American tribe”—though 70 years after Hamilton, a civil war was fought that shaped this new tribe’s eventual features—the notion of a European "tribe" is not on the horizon.
The Balkan tribes are as divided as they have ever been; the Scots want to separate from the United Kingdom; Italy seems to be almost as divided between South and North as it was in Garibaldi's time; and the chances of Greeks, Italians, Spanish, and French intermingling with Germans to shape a European tribe do not seem much better today than they were in preceding centuries.
Public debt is backed by the government's right and ability to tax. The proposed euro bonds would be backed by expectations that EU citizens can create sufficient taxable wealth. I highlight "taxable" because both Greece and Italy create wealth: Just much of it does not pay taxes.
Creditors must know that the entity who is responsible and held accountable for the debt is also the entity who has the right to tax and regulate. If the two are not the same, the idea of euro-zone bonds loses credibility.
Assume, then, that with the potential euro bonds issue, Greece, Spain, and Italy ("Club Med") would agree to a clause that in case of secession due to lack of performance, the bonds would be exchanged for those of the three national governments. Would creditors buy these new issues at lower interest rates than the Club Med countries are now trading? The answer is no.
After all, the new paper would be backed by exactly the same thing that any governments' outstanding debt is currently backed by: Governments' right and ability to tax. What happens with such clauses in place is that the EU gives up the right to enforce payment on the seceding members, and that right is transferred to the seceding national governments.
This is the core of the issue: Under which political umbrella can the debt be serviced more credibly? Is it under the EU umbrella, with its ability to speed up changes in fiscal, regulatory, monetary, and immigration policies? Or are the Club Med countries separately, outside of the European umbrella, more creditworthy in changing their fiscal, regulatory, monetary, and immigration policies so as to service the debt?
The price that buyers would pay for euro-zone bonds would reflect the option that the Club Med countries would not change their policies and end up seceding, in which case the eventual national governments would be standing behind the debt.
Thus, we are back at the point where we started. Creditors know that government bonds are backed by governments' recognized rights and abilities to tax. If all Europe is held responsible for the additional debt, a credible promise that the debt will be serviced without interruptions or without imposing more taxes on Europe's solvent members would mean that the stronger European countries would have sufficient influence on the weaker countries' fiscal and regulatory policies so that they would be changed in time and prevent default on payments. If solvent Europe does not have the stomach and ability to do this, its creditworthiness diminishes with the proposed euro-zone bonds.
Creditors must know that the entity who is responsible and held accountable for the debt is also the entity who has the right to tax and regulate. If the two are not the same, the idea of euro-zone bonds loses credibility. Either clauses in bond covenants or the side political agreements—if enforceable—are ways to increase such credibility.
This is the core of the issue: Under which political umbrella can the debt be serviced more credibly?
The above analyses are similar to "pre-nuptials" adapted to national levels. Such agreements are by now a common feature of marriage contracts in the United States. In France, they have a longer history. Balzac's classic novel The Marriage Contract (1835) is dedicated to them, with perfect insight into human behavior and with broad implications for today's Europe.
The story is about Paul de Manerville, a wealthy gentleman who decides, against the advice of his friends, to get married at the age of 27. He marries the Spanish Natalie Evangelista, whose financial assets have been declining since the death of her father, a banker. He does not see that Natalie's loyalty is to her "tribe"—her mother, that is—and outsiders, including himself, are way down the pecking order; that Natalie's mother is desperate to assure for her daughter the lavish lifestyle she believes to be her "right"; or that the various intermediaries negotiating the marriage contract are trapping him. Paul ends up in an unhappy and childless marriage—with his wife happily playing the field.
It reads like a good allegory for today's childless Europe, brought into a union by politicians blinded by a non-existent European "democratic ideal," misleadingly traced back to Greece (whose present population has nothing to do with Ancient Greece, except occupying the same real estate), and whose politicians sold every possible right to their constituents without requesting obligations. The Germans and Dutch—not the French—pay the bills, and the IMF and central banks play the roles of the intermediaries, not unlike Balzac's self-interested negotiators, whom he despises, and whose wile he describes with devastating perfection.
If Paul's friends had only managed to convince him to put some enforceable clauses in his marriage contract, linking "secession" to measures of future "productivity" (children, in his case, as they are the only source of future productivity)—perhaps Balzac's story would have had a happier ending.
Perhaps German, Dutch, and Finnish leaders could distribute the book before the next G8 gathering, instead of dealing with IMF intermediaries' Keynesian nonsense and mindless statistics. Then they could discuss the aforementioned clauses in the mutualized debts contracts, and debate if they have the guts to enforce them, knowing that some Club Med countries would surely raise the spectre of "Occupation."
Reuven Brenner holds the Repap Chair at McGill University's Desautels Faculty of Management, and serves on the board and the investment committee of McGill's Pension Fund. He was appointed to be one of a seven-member commission dealing with consequences of the 1995 potential secession of Quebec. The article draws on his books Force of Finance and Financial Options for Countries Wanting a Divorce.
FURTHER READING: Alex J. Pollock writes, “Sovereign Debt and Default – A History.” Desmond Lachman contributes, “Can Euro Bonds Save the Union?” “Greece’s Unhappy Anniversary,” and “Obama’s European Economic Time Bomb.” Charles W. Calomiris reports “The Painful Arithmetic of Greek Debt Default.”
Image by Darren Wamboldt / Bergman Group