Experience Stern | Faculty & Research

A cleverly designed bond instrument can ensure the euro zone's survival without a fiscal union.

The following is an open letter by the international Euro-nomics academic group (www.euro-nomics.com), composed of Markus Brunnermeier, Luis Garicano, Philip R. Lane, Marco Pagano, Ricardo Reis, Tano Santos, Stijn Van Nieuwerburgh and Dimitri Vayanos.

While the euro zone's crisis reflects deep structural problems, its suddenness and severity are due to flaws in the design of the monetary union, not its intrinsic properties. Many believe that Europe needs large fiscal transfers and euro bonds to end the crisis. But a cleverly designed bond, coupled with key reforms in bank regulation and monetary policy, could ensure the euro zone's survival without a fiscal union.

European bank regulators have treated all sovereign bonds as if they were riskless when computing Basel capital requirements, and the European Central Bank continues to accept all of them as collateral. This encourages banks to hold too much sovereign debt, and to tilt their portfolios toward riskier bonds that pay a higher yield. The result is poorly diversified banks and excessive exposure to the riskier sovereigns.

When the crisis came, this situation turned into a diabolic feedback loop. Doubts about the solvency of the sovereigns fed doubts about the solvency of the banks. Sovereigns, in turn, felt compelled to rescue their banks with public funds, justifying the initial fears about national default.

Breaking free from this trap requires banking regulation under which sovereign bonds possess risk-weights that reflect their true risk. European banks would then become better diversified and hold less sovereign risk, stopping the contagion to sovereigns.

Read full article as published in The Wall Street Journal Europe