OPINION:Government bonds are not as good as gold after all. A collective eurobond is the answer, writes JOHN BRUTON
ONE WOULD have to go back to the 1930s to find politicians with real experience of the sort of problems we face today. In the 1930s, there was:
1) a collapse of confidence in, and between, banks, which paralysed the economy;
2) a gold standard (currencies had a fixed exchange rate with gold, and the supply of gold was limited). This, like the euro, precluded countries using the standard from devaluing or printing money as ways of inflating debts away and thus making savers pay for the mistakes of debtors;
3) a slowdown in the rate at which people spent money (“velocity” is the economic term), which meant there was less bang for each buck printed.
All these things are happening today, 80 years later.
The advantage of the gold standard was that it provided a fixed measure of value. And a banking system needs a fixed measure of value, which each bank can hold as capital, and which provides it with a guide as to how much it can lend.
Since 1971, when the US ceased to exchange dollars for gold at a fixed rate, the world has lacked a fixed measure of value on which to found its banking systems. It has had to improvise.
In the absence of gold, sovereign debts of wealthy governments were pushed into assuming gold’s role as a fixed measure of value, on the assumptions that governments always repay their debts at face value, and that if a bank holds enough government bonds, it is thus a sound bank.
The difficulty was that, unlike the supply of gold, there is no natural limit on the amount of government debt. Indeed the US and other governments issued large amounts of debt to countries such as Japan and China, which wanted to save for the rainy day, and which were prepared to buy the debt at ridiculously favourable prices to the issuer. That led to an over-expansion of the US and other western economies, on the basis of credit fuelled by an oversupply of government bonds, and a consequent artificially inflated capital base of western banks.
More recently the very clever people in the bond markets have discovered, to their apparent amazement, that government bonds are not as good as gold after all. If you have too much of a good thing, it is not good any more. Here is how their eyes were opened.
Political parties in the US threatened, deliberately and unnecessarily, to default on government debts to make a political point.
The Greek government produced deceptive public accounts to allow them to issue more debt than they can afford to service. Governments generally, and many businesses, simply borrowed too much, at artificially low interest rates. Others, like Ireland, expanded services permanently on the basis of tax revenues that proved to be inherently temporary and volatile.
The fact that none of the highly educated people in the rating agencies, banks and accounting firms saw the risk of such errors at the time and adjusted their interest rate accordingly was a result of “tunnel visioned” specialisation that passes for economic and financial education in some leading universities nowadays.
Economics focused insufficiently on economic history, and finance was taught as if it was a branch of mathematical engineering rather than something influenced by psychology and politics.
Is there a solution?
We will get our economies going again only if we can restore belief in a fixed measure of value that will provide a capital base for banks – the role that gold performed in the past. The sovereign bonds of wealthy countries played this role until recently.
This is where the proposal for a eurobond could be helpful. It could be a lot more than a short-term fix. It might work as follows.
All 17 euro area governments could agree to mutually guarantee the repayment of a new collective eurobond. This bond would have first call on, say, a fixed share of all VAT receipts. They might also agree that, while no euro area country would be obliged to issue eurobonds, it could do so in limited circumstances, namely:
1) where its budget law, and five-year projections, had been approved in advance by the European Commission, and
2) where the bond would cover a limited proportion of the country’s total borrowing, as long as the overall debt/GDP ratio was more than, say, 40 per cent.
This would have a number of advantages. It would guarantee a minimum borrowing capacity to all euro area states. And because of the collective guarantee, the interest rate on the eurobond would be less than that on most national bonds.
It would, however, penalise countries for allowing their debt/GDP ratios to go beyond 40 per cent, because they would be forced to borrow commercially and pay higher rates of interest on the extra borrowing. This would be a strong incentive to reduce their debt as quickly as possible to 40 per cent or below. It would also be a better form of discipline than retrospective fines, which we now rely on.
The new eurobond, guaranteed by all euro area governments and with a prior call on VAT receipts, would have real credibility, globally and within the EU. Banks in possession of these new eurobonds would have something of real and certain value in their capital base, on the strength of which they could confidently base their lending decisions. Credit would start flowing again, jobs would be created and permanent structural damage to our economies avoided.
Rather than being the world’s economic problem, Europe could provide part of the solution.
Former taoiseach John Bruton is chairman of the IFSC