Eurobonds Are Likely To Increase The Risk Of Joint Defaults In The Eurozone

By Wolf Wagner, Professor of Economics, University of Tilburg. Cross posted from VoxEU

As government advisors and central bankers race through the different options to save the euro, this column argues that one such proposal, Eurobonds, will actually increase the risk that several Eurozone countries fail together. It shows using basic arithmetic that these bonds, sometimes labelled ‘stability bonds’, may actually be more likely to harm Eurozone stability.

The debate on Eurobonds has received new stimulus in recent days with the EU commission’s president calling for the introduction of ‘stability bonds’. The adoption of such bonds – or some other form of Eurobonds – looks an increasingly likely outcome as Germany effectively remains the only large country opposing the idea. The defining property of most Eurobond proposals is a joint liability for government debt issued by Eurozone countries. Rather than each member state standing behind its own debt, the idea is that all member states will be jointly guaranteeing the Eurozone debt.

The key rationale behind Eurobonds is that they have the potential to reduce sovereign defaults in the Eurozone. They allow countries that come into troubles to benefit from the strength of other countries. This column argues that while this may indeed reduce the risk of sovereign default in individual countries, the reverse is likely to happen for the risk of a default of a larger number of countries in the Eurozone.

The argument is a simple one, and based on the insight that a pooling of resources increases joint failure risk (see Shaffer 1990). Consider the following setup. There are two countries, A and B. In the absence of joint liability, each country defaults if its government’s funds (or the capacity to raise funds), F, fall below some debt threshold, D. In this simple example, joint failures occur when each individual country is below the threshold, that is, when

The funds are subject to country-specific risk – such as that arising from economic and political factors. This is what creates the rationale for common bonds. A country may still run into fiscal problems – but this is fine as long as the other country has enough room to raise funds to cover the shortfall. Suppose that the countries only issue debt for which they are jointly liable. This obviously completely eliminates the risk of individual failures – countries will either both survive or both default. Joint default will happen when the combined funds of the countries exceed their combined debt

Joint defaults necessarily occur more often than with national bonds – as condition (1) is stricter than condition (2). Intuitively, this is because there are no situations in which the introduction of Eurobonds averts a joint failure. When we have FA <D and FB <D, we necessarily also have that FA + FB <2D. However, there are situations where there is individual default in the absence of Eurobonds but joint default with Eurobonds. This happens if one country is in significant difficulties while the other country is close to default but still manages to avert default (consider, for example, FA =0.8*D and FB =1.1*D). Arguably, this is the situation we are facing in the Eurozone where countries with drastic problems (such as Greece) have the potential to drag down other countries that are in a relatively better shape but still weak in absolute terms (Germany).

The potential for Eurobonds to increase joint defaults is exemplified by the Figure below. In the absence of joint bonds, country A and B default if their funds are individually less than D. Joint failures incur in area A. Under Eurobonds, joint failures occur when F is below the diagonal line, which is given by (2). It can be seen that this creates additional failures in areas B and C. Note that the potential effect is quite large – indeed the area of failures is twice as large previously.

The increase in joint failures triggered by the introduction of common liabilities is a relatively robust property and does not depend on specific assumptions on the risks countries are subject to (see Wagner 2010 for a formal analysis in the context of bank failures).

The result is also robust to the possibility of contagion. An objection to the simple setting considered above is certainly that avoiding failure of an individual country can also mitigate systemic defaults because of the risk of contagion. Suppose, for example, that default of one country makes default of the other country more likely by raising the default threshold to D+C. In such a situation, country B strongly benefits from the survival of country A if country B’s funds are between D and D+C. However, it remains true that pooling increases joint failure risk. This can be appreciated by the fact that then all lines indicating default in the above figure will simply shift from D to D+C – preserving the fact that joint failures become more likely under common liabilities.

The analysis suggests that Eurobonds trade off the failure risk of individual countries with the risk of a joint failure of Eurozone countries. As joint failures are likely to be particularly disruptive, Eurobonds are unlikely to be beneficial for overall Eurozone stability. Note that this argument holds even without taking account of moral hazard concerns – which would further increase the risk of joint failures (in the analysis of above – moral hazard at the country level can be interpreted as an increase in the debt threshold D – which obviously will lead to more failures of whatever sort). Of course the introduction of Eurobonds may have other objectives than enhancing stability – such as increasing liquidity in the bond market – but these advantages can be also reaped without joint liabilities.

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  1. Bhikshuni Lozang

    So Eurobond faerie is an exchange of a naked emperor for a much more fat naked emperor?

    …and this is somehow *not* another ponzi scheme?

    Begging pardon in advance for any mistaken understanding of this.

  2. craazyman

    Badly needs a proofread and edit so it can make sense. Also suffers from EVS (Extraneous Variable Syndrome), where by time-dependent extraneous variables are created along indicated discrete pathways of action which then retroactively invalidate the aprior assumptions embedded in the initial static quasi-equilibrium postulation. Condition is Also referred to as OSPMF “Overly Strict Postulating Model Failure”. EVS and OSPMF are difficult to eradicate once they achieve penetration of the ideational immune system and are highly contagious if left untreated. Too early in the am to think this hard, maybe this one is for Europeans only.

  3. MarcoPolo

    This is what is wrong with economics – bad math. This analysis can only apply in cases where each economy is equally weak and economically separated.  In a case like the EU where there are both strong and weak economies, all inter-related, and without Eurobonds, the weak fail at a low threshold pulling down the strong.  Combing both weak and strong economies raises the threshold (D) making any failure less likely.   Either the EU hangs together or they all hang separately. I don’t know what it is about these blockheads that don’t get it. 

    Have a good time at the party. Wish I could be there. 

    1. Paul Tioxon

      Now that’s what I am talking about. The EU will get together on their own terms, in their own way. The strength of the nation state is the ability to control what is going on within the boundaries of your territory, in the face of outside force. The structure of the EU might have been good enough for the Cold War, but not adequate to the task of global capitalism. And it can mean putting the EU in the service of private capital or not, depending on the outcome of political struggle, but without a properly constituted and unitary sovereign entity, able to deal with a single currency, a single market and defend all of that on as many dimensions as possible or may come up in new crisis, then there is not much point in operating the nation state system at all.

      It may come to pass that Germany and France cram down some shitty political stop gap measure. But the point I am trying to make, is that the politics has reached the point, that the entire nation, and their political leadership in Europe and the US, COULD come to a point where they are unwilling to reconfigure themselves at the bottom of every business cycle, to re-do intricate political treaties, at every systemic crisis, to have to manage the private sector’s finances, banking, etc as well as state fiscal policy, when the past arrangement of state with capital was the so called free market was allowed to operate in order to handle all of that economic stuff, in a decentralized manner, with minimal state intervention.

      When the banks failed, and now have led to worldwide political unrest, the cost of keeping an ally that makes you change the nature of your institutional arrangements because of the failure of the private business cycle, and the structural problems of capitalism could well lead to many politicians ending the arrangement, by forming a more perfect union of the EU in order to withstand having to act like some slack jawed CEO that has to jump through hoops every 90 days for Wall St. I can now see why so many billionaires must assume the mantle of the political class as well as run their business, no real class of actors who derive their power from operating the mechanism of state will long put up with the liquidation of their power for the sake of a buck, year after year, decade after decade. While short term is the view of business, it is perpetuation of the state, its survival into the unforeseeable future, against all organized political and other opposition, that is the basis of political power. Only the people directly profiting from the liquidation of a nation’s assets would put up with this, only the rich, the Berlusconis, the Bloombergs. They seek office to displace political opposition that may turn against this.

      Capitalism is cracking up, the entangled EU, as well as the rest of the world does not know how to respond, but nations can not change themselves like some raw meat for a mergers and acquisition orgy indefinitely, not only will people in the street revolt, the revolt can work its way up into the halls of power. But of course, that would involve organizing politically, swiftly, moving to take over existing parties by flooding them like we flood Occupy sites, running candidates, voting for them. It would mean having to become politicians by dealing with power. Because we can’t get on our hands on money anymore, we will have to disintermediate and go straight to the power of the state.

      1. nun yerbizness

        “The strength of the nation state is the ability to control what is going on within the boundaries of your territory, in the face of outside force.”

        you mean like at the point of a gun?

        where does the nation state begin and every place else stop when floating clouds of radioactive releases, noxious pollution and power mad “leaders” floating about willy nilly?

        besides—Corporations have no national identity, no quaint notions of patriotism or respect for a nation’s Constitution, Bill of Rights or rule of law.

        don’t look now but it is the 21st century not the19th, though it sounds like you’d prefer the 18th.

      2. Lafayette

        The strength of the nation state is the ability to control what is going on within the boundaries of your territory, in the face of outside force.

        Yes and a great advantage over the US is the fact that BigMoney has far less an influence over the election of politicians in the EU. Not that there is no interference at all, but nothing that compares to the US (which is looking more and more like a Banana Republic run by plutocrats).

        What most Americans cannot understand about the EU is that national state rights are more important than those of the federated European Union itself.

        Which makes for lots and lots of palaver to assure that treaties are advanced for acceptation on a multi-state basis. And the factor that will surprise Americans most is that the Europeans are smart enough not to elect T-Party (T for Troglodyte) nutters to any real position of power in their national legislatures.

        The system of governance here is very different. If it is pyramidal in the US, in Europe that pyramid is reversed. Which means that only powers that reside on the national level are transferred to federal level. And a country can indeed refuse to legislate those powers nationally.

        Therefore national sovereignty is preserved.

        What we are seeing is the process by which central powers are being negotiated, which will then be implemented or not on a national level. That is a very different manner than in the US.

        And so be it. It’s neither better nor worse – just different.

  4. jake chase

    This is among the most idiotic and irrelevant pieces I have ever read. It shows why economists should never be taken seriously. It is impossible for a currency issuer to default unless it runs out of electricity. For those outside the Eurozone, the Euro (and the bonds) are simply something to trade which does not necessarily have a value but always has a price. The purpose of the whole exercise is to keep the buying and selling going, the food coming in and the garbage going out. These Eurobonds will enable the weakest countries to continue piling up debt and enable the plutocrats to continue looking forward to austerity and the collapse of social safety nets, in other words, to keep the whole globalization, financialization, usury driven growth mania going for another decade or so, by which time Florida will probably be under water anyway, so who really cares? Somebody should remind this professor that in the long run we’re all dead.

    1. Yves Smith Post author

      Ahem, did you miss what the article said? This is about SOVEREIGN default The Euro sovereigns don’t control their own currency. US states can default, not the US (it can VOLUNTARILY default, as in stiff creditors, but it sure isn’t inevitable).

      The proposal is to have individual European states backstop the Eurobonds, rather than the ECB, so the analysis is germane.

  5. Lafayette


    Rather than each member state standing behind its own debt, the idea is that all member states will be jointly guaranteeing the Eurozone debt.

    But this is not the only proviso to the current agreements.

    Wagner fails in his mathematics, I submit, to account for the fact that oversight responsibility of the EU Commission will assure (supposedly) in the future – which it did not in the past – that countries remain within bounded debt limits. The Maastricht Treaty, which founded the euro, called for a debt-limit of 3% of GDP. There is even some talk about a revision to a 2% limit.


    The EU Commission now has an Audit Oversight Responsibility for EuroZone national budgets. That is, a scrutiny of both national budget expenditures and forecast income.

    Given this EU Commission oversight of individual country risk, it is also coordinating overall EU-Zone risk as well.

    However, and this is obvious to all, any “forecast income” depends upon an assumed economic growth. That is where the EU commission, and any EuroZone-country, can get it very wrong.


    The problem at the moment is the mindless manner in which CRA’s lower country bond ratings, thus increasing debt maintenance costs, thus digging countries further in debt, thus worsening their ratings. Which is tantamount to a Vicious Cycle.

    In such a circumstance, I am all for The Merkel Threat. This threat was made to bank representative in Brussels during negotiations regarding the Greek debt. When they refused to increase the debt haircut from 21% to 50%, Merkel simply said, “OK, we’ll not provide Greece with any subvention. It will default. Lotsa Luck!”

    The banks promptly revised their opinion and accepted the 50% haircut on the debt. They too have a vested interest that the Euro does not default.

    It is unconscionable that S&P, which has yet to be found guilty of rating-fraud as regards Toxic Waste, should now carry the cudgel as regards Euro-debt.

    The economic roots of the problem are simple:
    * The only way to promote growth is to spark economies with Stimulus Funding.
    * Countries cannot do so because they are fixated on austerity measures imposed by reductions in their CRA-ratings. They are cutting expenditure budgets willy-nilly.
    * So countries are waiting for an “organic reprise of growth” that is brought on by Consumer Spending.
    * Consumers are in a dither because they fear that the EuroZone will cease to exist and, thusly, they would rather Save than Spend under the unforeseeable circumstances.

    Which means we are in the midst of a “dupe’s game” where no one can win. Everybody dances the dances whilst chance alone makes the music.

    But Wagner’s assumption that “pooling of resources increases joint failure risk” is incorrect, since that supposition assumes that there is no oversight authority scrutinizing the risk-elements (meaning national expenditures vis-à-vis national receipts).

    And therefore all countries do as they please – which has, indeed, led the EuroZone to its present circumstance.


    It may take five years for significant growth (meaning 3 to 5% per annum) to return to the EU. Till then, the banks should be required to extend the debt periods but maintain a constant rate for each national euro-bond.

    Countries could live with that by cutting expenditures and assimilating the sacrifice of high unemployment until growth returns.

    But growth ultimately will return. The EU market is larger in terms of population and total GDP than that of the US. Why should growth not return? When this does happen, the EU returns to the Virtuous Cycle, where growth begets growth due to rising population rates along with a rising propensity to spend. This happened throughout the post-war period in Europe up to only recently.


    It is a sad outcome that the EU should have come to such an unfortunate circumstance. But, politicians here are like politicians in the US … both resemble electricity; they seek the path of least resistance. And in the past, that has meant in Europe managing high unemployment rates with well-stitched safety nets maintained by debt.

    The lesson of that mistake has been learned – and won’t be forgot anytime soon.

    1. nun yerbizness

      “The Maastricht Treaty, which founded the euro, called for a debt-limit of 3% of GDP. There is even some talk about a revision to a 2% limit.”

      and not even germany is meeting the 3 percent why should anyone think a lower limit will have meaning?

      read the massive amount of verbiage written by Der Spiegel alone over the past three years and it becomes very apparent this is the equivalent of Paulson’s “slow walking Wall Street in the aftermath of Bear Sterns” on steroids.

      only questions remaining is which Euro-zone nation will play the role of Lehman Bros and how long will it take the slow walk to find the cliff?

      “The survival of Commerzbank, Germany’s second-largest bank, is at stake, and Berlin is considering a full nationalization of the bank if necessary.”,1518,801827,00.html

      1. Lafayette

        {and not even germany is meeting the 3 percent why should anyone think a lower limit will have meaning?}

        Why shouldn’t it if a country has legislated the Golden Rule that budgets must be balanced?

        Not even America has legislated that rule …

      2. Lafayette

        only questions remaining is which Euro-zone nation will play the role of Lehman Bros and how long will it take the slow walk to find the cliff?

        Thank you for our Daily Dose of Nattering Negativism.

  6. gerold k.b. weber

    With joint-liability Eurobonds we would end high single country default risk and introduce lower probability of joint Eurozone default (PD).

    But the lower probability of joint Eurozone default would be accompanied by much higher exposure at default (EAD) and loss given default (LGD) for investors/speculators if the ECB doesn’t print.

    It is unclear what is preferable here, and I don’t know of any sound considerations of that facet. Therefore I commend Yves for creating some discussion space with that posting.

    Pro Eurobonds you can argue that the ECB would probably print to avert default. And Eurobonds would accelerate Eurozone integration and facilitate internal transfers to weak countries. Contra Eurobonds you can argue that countries are incentivized to live at other countries expenses, as long as there is no common fiscal policy.

    I would argue that as long as we (I am talking here as a citizen of Austria AND the Eurozone AND the European Union) have no realistic perception of the current crisis and forthcoming risks for countries, banks, growth, and employment, we should abstain vom Eurozone risk pooling in the absence of political union.

    And I dont understand how legally implemented debt brakes will fit together with stimulus needs in case of negative growth, or with contingent needs to nationalize TBTF banks.

    I would sleep better if we would go into the direction of ECB induced interest rate caps for Eurozone government debt, and/or rebalancing and reflation for weak Eurozone economies, e.g. by debt relief with newly printed money (see also Steve Randy Waldman’s and Steve Keen’s recent proposals).

    And let us not forget: Eurozone governments don’t have the money, but her wealthy citizens and their firms – like in the US. Thus some ‘we are the 99%’ medicine would be good for Europe too – the US definitely has the edge here.

  7. Jim Haygood

    Meanwhile, back in the real world, here’s what one informed commentator is saying:

    It is early yet but I give the France/Germany proposal [for European fiscal union] about a 5% chance of being accepted by other European nations. I initially wrote “1%” and then I remembered to correct for overconfidence bias. But it’s a long shot however you want to call it.

    The need for us to work out the theoretical risk of joint and several European liability is about as likely as hearing June Cleaver remark on a Leave It To Beaver rerun, ‘Ward — I’m worried about the eurozone!’

    In both cases, if this actually happens, you should consult your physician to determine whether you’re suffering from delusions.

  8. pebird

    The solution is not to take the current national debt situation and apply it to the EZ as a whole, but to implement a structure that provides markets with a risk free alternative in order to price risk, while allowing individual Euro nations to maintain some financial independence.

    Eurobonds should be backed by the ECB, the ECB will issue Eurobonds to “fund” national government spending up to Stability and Growth guidelines (hopefully with some wiggle room in the case of economic downturns/crises).

    Nations could still issue national bonds beyond the Eurobond limit, if they chose to spend more than the S&G guidelines, but that debt would be clearly subject to default risk. Just like US states.

    It is clear to markets: Eurobonds – no default risk, National Bonds – default risk.

    There still needs to be a long-term solution to the internal transfer issue – but Eurobonds are an absolute requirement for a stable currency in the monetary union.

  9. Lafayette

    What is amazing about this thread is the genuflection at the Altar of Negativism that it provokes as regards the EuroZone.

    The EU is a community of a larger GDP and population than the US and, as many Yanks living here readily admit, a higher standard of living as well. Especially as regards both education and health care.

    Seems like a lot of bitter apples …

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