Why does Germany matter so much in this debate?

Germany is the anchor economy of the euro — and if this anchor is questioned by the market, then it’s truly game over for the euro.

Eurobonds are bound to create problems of two sorts. First, how much is the right amount of issuance? And, second, how best to avoid moral hazard?

But don’t the Germans have deep pockets?

Not really. Just remember that German income, on a per capita basis, ranks only ninth in the EU. Over the last 20 years, Germans had to stomach the cost of unification — and even today they still pay a unification surtax of 5%.

Germans’ pockets aren’t really that deep — and the German willingness to pay, even if there were no political limitations, could easily be questioned by the markets.

Why is that significant?

The question “Can Germany hold on?” would then become a question of “Will the euro survive?” Is that what we want to risk?

Still, aren’t eurobonds worth taking all those risks?

If eurobonds were introduced, this would indeed provide cheap financing for overly indebted countries that currently suffer from the high cost of indebtedness, possibly at a few basis points above German bunds. That is the good news.

What’s the bad news then?

The bad news is that we already have implicit eurobonds, issued by the highly indebted countries. Before the crisis, even countries with excessive indebtedness, like Greece, Italy, Spain or Portugal, paid only small spreads over Germany.

Why? Because the market assumed that the “no bailout clause” would be disregarded in a crisis situation. With eurobonds, the moral hazard problem would not only remain, but get even worse.

The biggest problem with the introduction of eurobonds is that they are not a silver bullet.

What’s the way out then?

To avoid, or to reduce, that risk of moral hazard, there must be restrictions attached to the issuance of eurobonds — and there must also be some rules about national economic policy in order to promote economic growth, while at the same time limiting indebtedness.

Assuming eurobonds will come to pass, where is the limit? How many can be issued? Are national governments limited in any effective way in creating common debt?

Yes, a key part of the current discussion is how much debt each country can issue. Up to the Maastricht debt-to-GDP ratio limit of 60% — or some lesser percentage, such as 40% or 50%? Going down this road would create a number of problems.

Such as?

First, governments would have no incentive to issue less debt than what’s permitted at the upper limit. Second, in case of default, what is the ranking between national (by national, I mean without external, Europe-wide guarantees) bonds and eurobonds?

Why is that important?

Because guarantors usually insist on a priority repayment status in order to lower their risk.

So can one maneuver through all this?

As long as Germany does not overextend itself, eurobond interest rates will be close to German rates. By the same token, German rates may not increase significantly, provided the volumes of eurobond issuance are small and the quality of the guarantees of other countries (France, Netherlands, Finland, Austria) is high.

The central question will become, “Can and will the center shoulder the debt burden of the periphery?”

But there’s a downside, isn’t there?

If markets start to worry about France, as they have already in recent weeks, or if they become concerned that Germany is — in addition to its own public debt — accumulating too much contingent debt (in the form of eurobonds issued by other nations), then German rates will increase, and the spread between German and euro rates will widen.

What’s your biggest worry?

The biggest problem with the introduction of eurobonds is that they are not a silver bullet. In fact, it’s hard to get it right — even assuming all the legal and constitutional obstacles could be overcome in time.

Why?

Eurobonds are bound to create problems of two sorts. First, how much is the right amount of issuance? And, second, to avoid moral hazard by having countries issue debt in a more relaxed style, there must be rules and joint decision-making.

Is that difficult to achieve?

By past experience, there is no real hope that that will be more than paper. Either the rules are such that eurobond issuance volume is kept too low to end the crisis. Or eurobond issuance will be so vast that it would help the current crisis countries solve their financing problems — by shifting the crisis from the periphery to the center.

What happens in that case?

Then, the central question will become, “Can and will the center shoulder that burden?” We would end up with an even bigger problem than we have now. There is plenty of talk of legal restrictions on deficit financing in the countries currently at risk, as there is talk about establishing appropriate policymaking frameworks in Brussels. But all of that lacks credibility.

The question is: Will the Germans — and the Finns, the Dutch and a few others — rebel?

Why?

Because we have been there before — and still are. For example, what really prevents a new government in an EU periphery country, arguing about “a new day for democracy at home,” not to respect the agreements entered into by its predecessor?

Remember, in a temporary moment of domestic crisis, the fiscal rules imposed by the Maastricht Treaty were not even respected by Germany, the presumed unbending stalwart of fiscal stability in Europe.

What does that tell you?

Rules, in today’s world, are but rough guidelines. They may even signal intent, but as so often, there is no real supervision and enforcement. That would be considered “undemocratic” and an imposition from abroad. No wonder then, in my view, that such rules fail to be optimal in each and every circumstance.

Any final words of caution?