Europe should address the crisis of confidence at the European bond markets through a direct equalisation of interest rates. Such a solution avoids the collective liability of Eurobonds and is affordable even if applied to Spain and Italy. This is the result of analyses conducted by Friedrich Heinemann, head of the public finance department at the Centre for European Economic Research (ZEW) in Mannheim.
The basic idea of the proposal is that countries like Germany and the Netherlands use a part of their crisis related interest savings to ease the interest burden of countries with particularly high interest rates. The money of the countries benefiting from historically low interest rates would flow into the "FIRE Fund". "FIRE" is the acronym for "fiscal interest rate equalization". Countries in crisis would receive a compensating amount when their bond issuances suffer from market interest rates exceeding a critical level. This support would be granted for the duration of one year and would be subject to conditions. FIRE programmes would only be extended if the benefiting country would be able to submit proof of its reform progress. The establishment of such a FIRE Fund would result in an acceptable interest burden for new bond issues of troubled countries. Their efforts for consolidation would no longer be undermined by the high interest rates on the market.
The analyses conducted by the ZEW researcher clearly show the advantages of the FIRE concept compared to Eurobonds, which are currently dominating the discussion. Eurobonds work with joint and several liabilities, whereas FIRE does not imply any kind of mutual guarantee. As opposed to Eurobonds, FIRE only reduces but does not eliminate interest rate spreads entirely. Transfers within the FIRE approach are, in sharp contrast to the hidden subsidies coming with Eurobonds, completely transparent. According to Heinemann, the high degree of transparency would also reduce the danger of troubled countries relying on permanent support and slowing their reform efforts.
With respect to FIRE's financial feasibility, Heinemann comes to a cautiously optimistic conclusion. Germany would clearly come off cheaper with this system than with Eurobonds. Eurobonds imply a total interest rate levelling and thus conceal a significantly higher transfer volume. Calculations show that the elevated interest burdens of the troubled countries are comparable in size to the savings of the creditworthy countries. Assuming that FIRE finances a cap on Italian and Spanish interest rates at five per cent, this would require an annual equalisation payment of 5.7 bn. euro for these two countries' 2012 issues. The financing would be split among Germany (90 per cent), the Netherlands (8 per cent), and Finland (2 per cent), according to the advantages each country draws from low interest rates.
According to Heinemann, FIRE would be the better way compared to an extension of liability, notwithstanding the burdens linked with this concept: "The interest rate equalisation could be helpful to avoid the gamble on German prosperity which is a consequence of collective liability", says Heinemann.
Please find further information on the FIRE concept, a graphic on the yield of ten-year state bonds, as well as a table including the sample calculation for Italy and Spain in the ZEW policy brief.
You can find a long version of the FIRE concept at: www.zew.de/fire2012
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