Making Strength of Zone's Weakness

The Wall Street Journal

Common Euro Bond Issue, Opposed by Many Leaders, Could Create an Investor Haven

The world is short of secure destinations for investment funds, as shown by Switzerland's dramatic efforts this week to deter the floods of capital entering the Alpine safe haven. Here's a solution: euro-zone bonds, debt instruments issued collectively by euro-zone nations that could offer for the first time a real alternative to the U.S. Treasury market. They have another advantage: They could also save the euro zone.

The U.S. Treasury market is still the destination of necessity for the world's biggest investors. For central banks and others that require huge, liquid bond markets, there is no alternative to Uncle Sam. As a consequence, the U.S. government can borrow at interest rates lower than any major European economy apart from Germany, despite a recent debt downgrading, giant budget deficits and easy money.

The combined size of the euro zone's bond markets is large enough to offer serious competition to the U.S. Total marketable euro-zone government debt is about $8.6 trillion dollars, compared with more than $9.5 trillion in U.S. Treasury paper held by the public.

But an apparent market opportunity isn't why the proposal is moving up the European Union agenda. A growing band of people think it may be the only way to stop the currency union from breaking apart in the face of a deepening and widening debt crisis.

Former leaders such as Gerhard Schröder and Felipe González came out in favor of euro-zone bonds earlier this week. Italian Finance Minister Giuilio Tremonti and Luxembourg Prime Minister Jean-Claude Juncker are also proponents.

As Europe's debt crisis intensifies, many experts are skeptical that proposals agreed by euro-zone leaders in July that are now being debated in national capitals—including increasing the flexibility of the euro-zone's bailout funds—will be enough to stanch the crisis. It is only the purchases of Italian and Spanish government bonds by the European Central Bank that appear to be holding it at bay.

"The crisis in the Euro area is now systemic, and there are only two solutions that are guaranteed to work: an open-ended bold commitment from the ECB to purchase as many sovereign bonds as needed, or the use of euro bonds of some color to relieve refinancing pressure on troubled EU sovereigns," said Sony Kapoor, head of Re-Define, a financial think tank.

The ECB has made clear it is a reluctant buyer. But that isn't the main difficulty: The central bank's Italian and Spanish bond purchases are already creating problems that suggest that, unless things change, the ECB could end up owning a majority of the €1.6 trillion of Italian debt and the €550 billion of Spanish debt outstanding.

The ECB purchases are driving down bond yields to levels that investors don't believe compensate them for the risks of ownership. The auctions of new bonds risk failing—the ECB can't buy bonds direct from governments—as suggested last week when a sale of new five-year Spanish bonds fell short of its €4 billion maximum target.

A more sustainable solution would be common euro-zone borrowing. As a unit, the euro-zone countries are less indebted than Washington. In the U.S., the ratio of government debt to gross domestic product is 100%, according to the International Monetary Fund. For the euro zone, it is 87%. The euro-zone's primary deficit for 2011—total government deficits before interest payments—is projected at 1.7% of GDP, compared with 9% for the U.S.

That doesn't mean the euro zone as a whole would necessarily command a top triple-A credit rating, which would depend in part on how the bonds are structured. But the lack of impact of last month's downgrade on U.S. borrowing costs suggests that may be unimportant.

What is more certain is that most euro-zone governments would be able to borrow more cheaply than they do now.

The rub is that while many members would pay less to borrow, some, notably Germany, may have to pay more. How much more isn't clear. If big global investors were to embrace a competitor to the U.S. Treasury, yields might fall close to those on German bonds. In any case, extra costs for Germany could be compensated by transfers from other governments in the euro zone, say analysts.

If the idea is embraced, there is an enormous amount of work to do on how the bonds should be structured. Should they be a temporary emergency measure aiming at overcoming a debt refinancing crisis? Or a permanent step? How would budget discipline be imposed on member states? Perhaps through the independent budget commissioner proposed by Mark Rutte and Jan Kees de Jager, the Dutch prime minister and finance minister, in a Financial Times opinion column on Thursday. The commissioner would be able to wield sanctions including, ultimately, throwing a country out of the common currency.

For now, euro-zone bonds are still being ruled out politically. Germany is unwilling to take responsibility for the debts of the rest of the currency zone. Chancellor Angela Merkel reiterated her opposition to them again this week: "Euro bonds are the way to a debt-union; we need a stability-union."

Yet, if the only alternative is a break-up of the union, with the enormous costs to all outlined in a research paper published by economists led by Stephane Deo of UBS this week, perhaps even Ms. Merkel would change her mind. "Almost no modern fiat currency monetary unions have broken without some form of authoritarian or military government, or civil war," they say.

Write to Stephen Fidler at stephen.fidler@wsj.com