EU Debt Crisis: Why Eurobonds Won’t Work

A new bailout mechanism has been proposed for the Eurozone.

From the Associated Press,

Germany has again made clear its opposition to French proposals for jointly-issued bonds from the 17-nation eurozone as a way to create economic growth and ease the region's financial crisis.

At Saturday's G-8 summit, German Chancellor Angela Merkel — under urging from U.S. President Barack Obama and French President Francois Hollande — signed up to a statement that called for mixing painful cutbacks with growth-promoting measures to deal with a crisis that threatens the global economy.

The leaders warned that budget deficits have to come down. But they also acknowledged that an approach that's based mostly on austerity and longer-term reforms can't help countries out of recessions this year or next.

How exactly to encourage growth has become a controversial topic among European leaders, who will meet Wednesday in Brussels to try to find common ground.

France's Hollande has pushed for issuing debt backed by financially strong countries like Germany to finance growth in weaker countries like Greece or Portugal as one solution to the problem. Germany, however, has long and firmly resisted the idea of introducing eurobonds, arguing they would lessen pressure for heavily indebted countries to get their finances in order. They would also likely raise borrowing costs for countries in better shape, such as Germany.

Eurobonds would be "a prescription at the wrong time with the wrong side-effects," Steffen Kampeter, a deputy finance minister, told Deutschlandfunk radio.

"We have always said that as a first step we need solidity in European finances, and that is the fiscal compact," a budget-discipline pact that Merkel championed and Hollande has criticized, he said.

Germany's tough stance against the idea of eurobonds came as France's new finance minister met his German counterpart for the first time on Monday.

The talk about “growth-promoting measures” is patently silly. Such political rhetoric represents newspeak, meant to delude the public from reality.

This crisis exists because the EU governments has commandeered significant share of their resources to political activities (welfare state, bailouts, transfers, bureaucracy and etc.) which represents consumption.

Since governments thrive on taxes, whom are like parasites living off from a host, government activities have NOT been established for production, which means they DO NOT promote growth.

It is COMMERCE that gives the productive economic growth.

Yet these governments are hesitant to make the required reforms to make resources available for productive commercial activities through entrepreneurship, and to make their economies competitive (e.g. labor reforms).

The reality is that each and every government expenditure comes at the expense of private commercial activities. Consumption comes at the expense of production. So there is no general economic growth. There will be growth only for crony industries and companies and on the budgets of these political masters.

The proposed Eurobond is another example of the prevailing bailout mentality. This represents another redistribution of resources from Germans and other productive EU nations to the spendthrift crisis plagued PIGS. So bad behavior will be rewarded, which is likely to encourage more bad behavior.

And that’s why there has been vocal resistance on the overtures for a bailout through a common bond by Germany, whom will bear most of the burden.

Analyst Michael Sedacca at the Minyanville nicely explains the why the mechanism won’t work…

One of the biggest reasons why a eurobond will never work is Germany. It is by far the largest guarantor for anything jointly issued in the eurozone. For the European Financial Stability Facility (or EFSF), they currently guarantee 29.06% (on a GDP weighted basis), which is by far the biggest majority. If, for example, Spain were to “step out” because they needed to take money from the facility, their share jumps to 34%.

Next, the on-the-run 10-year note from the EFSF (rated AA+) carries a coupon of 3.5% and implied yield-to-maturity (or YTM) of 2.86%. For the German 10-year note, it is 1.75% and implied YTM of 1.44% -- essentially, double what they have to pay for their own debt by being tied to the rest of the eurozone. However, they aren't directly affected by these payments because Germany and the other eurozone countries are paying with capital to backstop the new issues and make the interest payments. So there's no direct change of money flow at the German Treasury; there is just a faster depletion of whatever capital is at the EFSF.

In theory, if a eurobond were to go through, Germany would be on the hook for a hefty chunk of this base interest rate change. It gets even worse if you shorten the maturity; the current two-year German bond has a coupon of 0.25% (YTM of 0.05%) and the EFSF note is at 1%. Assuming these bonds would be weighted by GDP, on interest payments alone, Germany would be paying four times what they have to pay for their own debt.

And as I pointed out before, political redistributions through centralization of the EU will intensify political frictions

Mr Sedacca adds,

The biggest change, however, is the ceding of sovereignty. If all of the countries agree to tie themselves to the mast of the euro, the fighting and mudslinging will get even worse than it already is. As it is, when signing up for the bailout of Greece, Finland required additional collateral in order to cover their potential losses. They knew they could potentially be lending into a hole.

Of course all talk about Eurobond may actually be a cover for what is truly intended: massive money printing by the ECB

Mr. Sedacca seem to share my outlook

All of that being said, I think we will see the European Central Bank lending directly to the European Stability Mechanism to buy bad assets directly off banks' balance sheets before we see a eurobond. That will likely be met with a positive reception from the market.

At the end of the day all these kicking of the proverbial can down the road means the worsening of the crisis which is likely to set stage for massive inflation and of the ballooning prospects of the disintegration of the European Union.