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This could be achieved through a risk-weighted cash contribution system that should increase the financial soundness of the Mechanism in terms of balance sheet structure. In return for the insurance premiums received, the ESM should guarantee the public debts of all member countries, allowing the progressive transition to a single federal debt of the euro area.
These capital injections would give the ESM the opportunity to fund worthwhile investments in stressed countries while supporting the realignment of the economic cycles within the single currency. Instead of an emergency lender to support the financial economy, the ESM would become an ongoing support mechanism to the real economy by boosting productivity in poorer parts of Europe.
This transition scheme would help develop a deep and liquid market for Eurobonds, which could better compete with US treasuries in attracting international investors. Unlike alternatives such as European Safe Bonds, which reject the concept of risk-sharing, my proposal foresees only a temporary segmentation between shared and un-shared.
Once the transition is complete, the entire public debt of the euro area would be under the joint liability of all member countries — the debate about risk weights for government debt within the euro area would become obsolete.
If we really want to prevent the single currency from disintegrating under the pressure of nationalist interests, we must adopt a genuinely federalist perspective. The euro area must graduate from a set of States that shares a currency into a common project. [...]
The Transition Mechanism: risk-sharing and strongest capital structure
I propose a risk-sharing agreement whereby riskier countries pay insurance premiums to the ESM in the form of capital injections. In exchange, these countries receive protection against their own sovereign risk from safer countries.
The new set-up should be enacted gradually: maturing debt securities should be re-issued with new risk-sharing clauses that provide for the joint liability of all euro area members. After ten years, all public debts would be fully risk-shared. Italian, French, or German sovereign bonds would cease to exist, having been replaced by unique euro area debt instruments with a single yield curve (and no credit spread), which represents the undiversifiable risk of the euro area as whole.
Insurance premiums would reduce liquidity risk because of how much they would increase paid-in capital. The Stability Mechanism would replace a contingent equity of €625bn with a certain liquidity injection 6-to-8 times lower.
The additional financial burden would be concentrated on risky countries. Those deemed safe by the markets, such as Germany and the Netherlands, would be exempted from any additional contributions — except in a crisis. Today Germany has a contingent liability to the ESM which is worth €168.3bn, but as net protection sellers, they would not have to pay any premiums.
One might argue Germany should receive the premiums directly, but this argument ignores the risk-sharing premises of the reform. Making the ESM the guarantor is logical because of the need of a super partes arbiter to give credibility to the risk-sharing agreement. For the same reason, the ESM’s governance should be modified to remove the veto rights retained by Germany, France, and Italy.
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