With crisis looming over the future of the Euro, the debate over whether Germany is right to dismiss Eurobonds and push for reform rages. The Economist recently published an article arguing that forcing reform on heavily indebted countries would ultimately make it harder to rescue the Euro.  Merkle, on the other hand labelled the recent proposals on Eurobonds as “Extraordinarily Inappropriate.” So, what is it about these bonds that make the German Chancellor shudder? In essence they could, grâce à the free rider phenomenon, encourage profligacy amongst heavily indebted states and reduce the incentive for reform. And it is precisely reform for such states that is so desperately needed if the Euro project is to survive its first major test.

The idea behind Eurobonds, is essentially one of a debt-pooling strategy, i.e. debt is issued collectively and guaranteed by all 17 countries of the Eurozone. The strategy resonates with the fervour of `you´ll never walk alone,’ and aims to reassure markets via mutual issuance of debt. However the overwhelming danger is that the implementation of Eurobonds will reduce governments’ incentives for reform, as debt riddled countries can instead free ride off stronger economies. Instead market pressure should be embraced to force countries into hard hitting reforms. The current rise in borrowing costs is exactly the kind of catalyst required to force governments to make tough choices to restore competitiveness to their economies and sustainability to their government finances.  Such reform measures are required to rebuild near bankrupt economies, provide the foundation for growth in the future and hence ensure the global competitiveness of the Euro. 

Heightened fiscal integration and even common issuance of bonds may be desirable in the long- and medium-term, but this solution is unworkable under the current policy framework.   In the short-term, yields could very well fall, as the guarantee of more fiscally solid nations such as Germany, encourages currently concerned investors to invest in Eurozone sovereign debt.  However, this could potentially lead the next crisis as lower borrowing costs (offset by higher borrowing costs from richer economies) would reduce the pressing need for reform currently demanded by the markets.  Without this pressure, it will be harder for peripheral governments to justify painful reforms opposed by entrenched interests and find a way forward to growth and sustainable finances. 

The temptation to use Eurobonds as a panic measure, as a ‘quickshot’ so to speak, should be avoided. Time is needed to find a political solution in the tradition of the European process of political negotiations to ensure Pareto – optimal results are reached. Nations must refrain from tight handed strategies to appease voters and instead look towards finding a Nash equilibrium for Europe.   Thus, before Eurobonds are considered, it is first necessary to build an integrated fiscal union.