In response to the eurozone crisis, LSE economists co-developed an influential proposal for European Safe Bonds (ESBies), which would protect the financial system from future shocks.
What was the problem?
The European sovereign-debt crisis exposed serious flaws and inconsistencies in the design of the eurozone financial system. National banks in Europe had portfolios of assets that were heavily concentrated in sovereign bonds of their own countries, since regulators treated sovereign debt as essentially risk-free. As sovereign bond prices fell, bank stocks then plummeted in countries where sovereign debt was perceived as risky. Expectations of a government bailout under such circumstances further increased the perceived credit risk attached to those countries’ government bonds.
This situation, combined with the resulting cut in credit and constraints on public finances, confirmed fears about sovereign solvency creating a mutually reinforcing feedback loop or “diabolic loop” (also known as “debt feedback loop” or “doom loop”), whereby sovereign risk and bank weakness reinforce each other.
A second major problem was how the system promoted excessive capital flows across borders. The lack of symmetric and abundant low-risk assets caused “flight-to-safety” flows of capital away from countries that were experiencing banking or sovereign crises to the safest eurozone countries, such as Germany and the Netherlands, rather than across asset classes, which amplified macroeconomic shocks.
What did we do?
Between 2010 and 2012, eight economists from across Europe, including professors Luis Garicano and Dimitri Vayanos from LSE and Professor Ricardo Reis, who joined the School in 2015, developed a proposal for creating European Safe Bonds (ESBies) to address these two major flaws in the eurozone financial system. In a series of papers and a press commentary they set out the regulatory changes needed to introduce the bonds, the institutional design of a new European Debt Agency, and the necessary governance mechanisms.
They proposed that a European Debt Agency would buy on the secondary market approximately €5.5 trillion of sovereign debt – the equivalent of around 60 per cent of the eurozone’s GDP. The weight of each member country’s debt would be equal to its contribution to the eurozone’s GDP. Each marginal euro of sovereign debt beyond 60 per cent of GDP would need to be traded on a single bond market where prices would reflect true sovereign risk. The European Debt Agency would pool these bonds and issue two tranches. The first, the ESBies, would be senior on interest and principal repayments of bonds held by the agency. The second, the European Junior Bonds (EJBies), would receive the rest, becoming the riskier security, which would take the hit if one or more sovereigns defaulted. The new system would require adjustments to European banking regulations to give banks the incentive to invest in safe ESBies, rather than risky sovereign debt.
This scheme would ensure eurozone banks would hold a well-diversified portfolio of sovereign bonds and not be vulnerable to the diabolic loop. ESBies would also ensure that any flight to safety would take place across tranches – from the junior to the senior tranche – rather than across national borders.
The research team expanded on this proposal and its implications in more depth in subsequent academic papers, addressing implementation issues, regulations, standardisation, and transition. They also developed one of the first formal models of the diabolic loop and examined the effect of ESBies in mitigating its damaging effects.
Since they were first proposed, European Safe Bonds have been considered in virtually all European policy debates on public debt, including in response to the 2020 recession. Almost every member state central bank, debt office, and ministry of finance has engaged with the proposals.
In response to the eurozone crisis, many analysts had initially favoured the idea of eurobonds, which would be issued by a eurozone-wide authority and would involve mutual guarantees across countries. If one country were unable to service its bonds, other countries would be liable for payments. The research team noted, however, that eurobonds would require a common (supranational) fiscal policy, making them politically infeasible, and possibly undesirable given the large moral hazard they would create across countries.
The ESBies proposal offers an alternative to eurobonds that would yield similar economic benefits without requiring a fiscal or political union, which has helped them gain significant traction in the policy debate.
In 2015/16, there was a surge of interest, particularly from the European Central Bank, which established a high-level taskforce within its European Systemic Risk Board to investigate the potential creation of “sovereign bond-backed securities” (SBBS). These would comprise senior and junior claims on a diversified portfolio of sovereign bonds. The senior claims are, in all significant senses, akin to European Safe Bonds. The taskforce was headed by Philip Lane, Governor of the Bank of Ireland and one of the eight economists behind the ESBies proposal. Its report noted that ESBies provided the “intellectual foundation” for SBBS proposals and concluded that a gradual development of the SBBS market could be feasible, with some regulatory changes. A second taskforce at the European Commission produced a comprehensive proposal on how to regulate SBBS, drawing on the original research.
SBBS proposals also feature prominently in European Commission discussion documents and were endorsed by the European Parliament in 2019. Between them, the ESBies’ co-authors have been invited to talk and provide specialist advice on their research to (almost) every central bank and every minister of finance in Europe.
SBBS have been the focus of a lively debate among policy-oriented economists and informed a huge amount of non-academic discussion among policymakers (as well as banks and regulators) across Europe. While there are still significant barriers to the implementation of ESBies, their influence has been such that any solution that is adopted will inevitably be at least responding to, and therefore influenced by, the proposal and the research behind it. To that extent, the ESBies research co-developed at LSE will have shaped whatever safe asset solution is implemented across the eurozone.