Eurobonds, treaties and EU institutions - joining up the dots

There is a way out of crisis for the eurozone, if the political will can be found to introduce radical reforms – including Eurobonds

Rate cuts on bank borrowing raised stock market confidence on November 30, but this should be a very short-term effect. The main problem of the euro area remains. Rising spreads over the Bund for many eurozone countries are backed up by projections for very high deficits for these countries, for the next year. At the same time, financial institutions across the region struggle to satisfy their liquidity needs – primarily, because of fears associated with their holdings of sovereign debt. Even though certain governments are in denial about these, some sort of quantitative easing and the introduction of a Eurobond scheme are the only serious economic tools to ease turmoil. Arguments against these policies are well known. On the one hand, the European Central Bank's primary objective should be inflation and, on the other, the Eurobond enhances moral hazard of high-deficit countries to continue producing deficits.

The two are quite separate issues and we are more concerned with the Eurobond. Its introduction has many advantages, the most important being that weak countries will gain time to reform and turmoil in financial markets will decrease - further easing concerns about banks' health. The German government does not exclude the introduction of a Eurobond-type financial instrument in the future, but rightly recognises the need for treaty changes that make rules on budget deficits stricter. We all know, however, that even since Maastricht we do have a treaty that states explicitly the requirements for the efficient implementation and functioning of the euro area; certain member-states just do not cope. So do we need new legislation to reduce moral hazard and introduce the much-required Eurobond or do we just need efficient supervision of government deficit of - and by - poor-performing countries?

A look at the differences between the quality of institutions, as a measure of effective implementation of law on the books, of the countries with low deficits and those with high ones provides the answer. Ratings from the International Country Risk Guide show that key institutional indices have worsened over the last decade in many of the non-performing countries. In certain countries - like Greece, Portugal and, even, Spain - there is also an element of lack of capacity to implement law on the books. From this perspective, the euro area in general, and the high-performing countries in particular, have failed to provide incentives and inject effective supervision as well as implementation of regulatory changes. This is the primary reason why the Greek government fails to implement reforms.

Different legislation might be needed to set out a roadmap for action. But the action itself requires efficient politicians, bureaucrats and a strong legal system. Reduction of moral hazard incentives associated with the Eurobond requires efficient implementation of policies in non-performing countries, with the aid of countries with strong institutions. Such a strategy has other immediate effects. Lower borrowing rates for problem countries with associated help to promote growth via direct foreign direct investment, will imply a quicker exodus from recessions. Public investment, now collapsing, will be revitalised and unemployment rates - now soaring - will be reduced. The help will be noticeable by domestic workforces and European ties will be strengthened at some short-term, but little long-term, cost for the stronger countries. Of course, a clear targeting scheme, including punishment if non-performers do not achieve the objectives is required – even, if this has to be exit from the eurozone.

It is a time to cooperate not to dissolve. Germany and other high-performing countries have a lot to gain in the future, as they have in the past, if the euro area overcomes this turmoil and leaves member states with stronger political and social entities. The Eurobond is a key element in this strategy. Quick implementation of it alongside a clear roadmap of prudent government behaviour attached to it will help turning things around. After all, economic theory predicts that quality institutions are a prerequisite if reforms are to lead to growth and prosperity.

Manthos Delis is senior lecturer in banking at Cass Business School, in the United Kingdom