How to Defend a Post-Greece Euro

5 JUN 16, 2015 2:00 AM EDT

By Mark Gilbert

Bloomberg

With bailout talks between Greece and its creditors collapsing, it seems sensible to start reflecting on what defenses the euro might need against the fallout of a nation leaving the common-currency project. Once euro membership is proven to be anything but irrevocable, the remaining members will need to reassert their unity. And one way to do that would be to resurrect, in slightly modified form, the concept of euro bonds.

Discussing Grexit is no longer taboo in the upper echelons of the European Union. "The shadow of a Greek exit from the euro zone is becoming increasingly perceptible," German Economy Minister and Vice-Chancellor Sigmar Gabriel wrote in Bild newspaper. “Unfortunately, the attitude of the Greek government obliges us to take into account other alternatives, such as a Grexit,” Belgian Finance Minister Johan Van Overtveldt told Trends magazine. "I rule out a Grexit as a sensible solution but nobody can rule out everything," said Greek Finance Minister Yanis Varoufakis. There might still be a deal that saves the day, but the people closest to the action seem increasingly skeptical.

Enlightened self-interest would suggest the EU will have little sympathy for Greece's post-euro needs. Quite the opposite -- Europe would have incentive to let the runaway country suffer in order to show how cold and lonely life can get outside of the protective confines of the euro club, "pour encourager les autres."

The EU will be busy, in any case, attending to its own post Grexit situation. The continent will need to make a show of solidarity to demonstrate to the region's bondholders and the world's currency traders that the euro is the icon of a true economic union, not just a currency-pegging chimera. Otherwise, the euro's weaker members might find themselves picked off one by one by speculators driving their borrowing costs through the roof in pursuit of profit.

Europe could achieve what's necessary by reviving plans for the euro zone (or its remaining countries, in this case) to band together to meet its borrowing needs. And there's a way of pursuing that goal that should overcome the philosophical objections that have previously been raised against the idea.

Both the mechanism and the opposition to common bonds are easily delineated. Instead of Germany, Spain, Italy and so on selling their own 10-year debt, you'd have a regular calendar of issuance from a central borrowing agency. Investors would buy 10-year euro bonds, and the proceeds would be divvied up among the common currency countries according to their needs. Such a system would allow bigger bond issues that would be easier to buy and sell, and a predictable sales schedule eliminating competition among borrowers. A 2011 paper by the Bruegel Institute riffed on those themes by proposing jointly issued "Blue Bonds."

The scheme's opponents, however, don't fancy the idea of joint-and-several liability. They don't want Germany on the hook if one of its weaker partners gets into difficulty and can't make its interest or principal payments. If the bonds were in existence today, for example, Greece's neighbors might be liable for its bond-market debts.

There's a way around that, though. Peter Bofinger, a German economist who's an adviser to Angela Merkel, has proposed something he calls "Euro Bundles" that would avoid the taxpayers of one nation being liable for the obligations of a defaulting country:

A joint debt instrument can be designed without joint liability. The member countries could issue joint bonds in the form of 'euro bundles.' Such a security would package together the bonds of national governments in proportion to the size of their economies, so that a 100-euros bundle would contain a German bond of 28 euros, a French bond of 22 euros, and so on. Each country would be liable only for its part of the bundle.

In December 2013, as a member of the investment committee of King's College Cambridge, I was involved in just such a bond issue. My alma mater had banded together with 17 other Cambridge Colleges to borrow 150 million pounds ($233 million), split between three issues with maturities of 30 and 40 years.

The bonds were sold as private placements to institutional investors; the key to persuading the various Cambridge investment committees to sanction the transaction was a guarantee that no college was underwriting the payments of any other college. So Cambridge Funding, the company set up to issue the securities, was able to create a bond bigger than any of the individual colleges could have managed, with a commensurate drop in the borrowing rate.

So suppose you owned 1 million euros of similarly structured euro bonds today; you risk taking a hit if Greece defaults, because Germany and the rest wouldn't be liable for the shortfall. But you'd only lose money in proportion to how much Greece itself had taken from the issue; and in the meantime, you'd have benefitted from the extra liquidity that a common bond would offer.

Resurrecting the notion of common bonds would be a smart way for the EU to swear allegiance to the euro, using a blueprint that avoids burden-sharing. It would signal a commitment to greater economic harmonization in the future. And, in the turbulent atmosphere that's likely to follow a messy exit by Greece, it might just succeed in overcoming the resistance of its objectors.

To contact the author on this story:

Mark Gilbert at magilbert@bloomberg.net

To contact the editor on this story:

Cameron Abadi at cabadi2@bloomberg.net