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[...] The fact that euro area sovereign bonds are exposed to credit risk in this way does not mean, in principle, that they cannot also serve as safe assets. The difference is that they have to be made safe through sound fiscal policies, rather than assumed to be safe. And it is indeed clear from the structure of euro area government bond yields that credit risk is partly responsive to the outcome of fiscal policies.
Yet what we have seen in the euro area is that, ex post, sound fiscal policies alone are not sufficient to make sovereign bonds safe. This is because the application of market discipline, when it comes, is often imperfect. Credit risk premia tend not to increase in a continuous way that leads endogenously to better fiscal and economic policies, but are instead non-linear. Credit risk is under-priced in good times when risk aversion is low, and then rapidly re-priced in bad times when risk aversion spikes. The result is excessive price volatility.
And in situations where such non-linearities arise, it may also lead to self-fulfilling dynamics – what economists call “multiple equilibria”. When sovereign bond yields rise and prices fall, demand for bonds should normally rise. But if yields rise steeply to a point that calls into question solvency, demand actually falls, producing a vicious circle. And if there is any correlation between credit risk perceptions across government borrowers, this process in one country can create contagion to others.
Indeed, while eight euro area governments entered the crisis with AAA-rated sovereign issues, today only three have that status. Market discipline has destroyed safe assets more than it has created them.
One response to this, which is now being fiercely discussed in the euro area, is to apply regulatory constraints and/or risk weights to sovereign bonds, thus encouraging systemic sectors – banks, pension funds, insurers – to appropriately consider their risk of default. This would in principle make market discipline more linear and effective ex ante. And coupled with proposals for mechanisms for orderly sovereign default[15], it might also help attenuate the severity of crises.
Yet it would also be a partial equilibrium solution, since it would reduce the ability of domestic banks to act ex post as a contingency liquidity buffer to their sovereigns, and that may leave bond markets even more at risk of multiple equilibria. In the absence of an alternative fiscal backing, sovereign yields might in other words increase more in times of financial stress. All in all, however desirable it may be from a prudential perspective, it seems odd to discuss this proposal without considering its fiscal consequences.
Taken in isolation, such proposals are therefore unlikely to resolve the tension between market discipline and safe assets in the euro area. And this matters, for two reasons.
First, because sovereign debt provides a safe asset for the financial system, which is increasingly dependent on a sufficient supply of such assets. And if sovereigns are not supplying safe assets, then someone else has to.
Second, because sovereign debt provides a safe liability for the government through which it can stabilise the economy. And if governments are unable to perform this role in the euro area, there is insufficient stabilisation at the national level, and by implication also for the euro area as a whole. [...]
Conclusion
To conclude, let me come back to the “other side of the coin”.
Europe needs reforms if its debt is to meet the multiple expectations society attaches to it: as a means of payment and store of value for capital market participants, as a safe liability empowering governments to perform their stabilisation role, and as a gauge of sovereign default risk, setting incentives right for governments and market participants. [...]
Reconciling these different expectations may require a degree of fiscal risk-sharing at euro area level. But there is a common point to both approaches to risk-sharing I have just outlined – the common fiscal capacity and the “blue/red” bond proposal. Although their features are different, both need to be underpinned by a set of rules at euro area level, mutually agreed and enforced by common institutions. [...]