Government bond markets within the euro zone may have fallen victim to a selffulfilling crisis of confidence. A strategy of structural reforms and consolidation is unavoidable. But this strategy alone could be insufficient to restore a stable equilibrium due to its long impact lags. Eurobonds may contribute to stabilization in the short‐run but would imply destructive disincentives and incalculable risks for joint and several guarantors. Monetary interest rate equalization through the ECB government bond purchase program poses risks for the central bank’s credibility.
A superior strategy is available: fiscal interest rate equalization (FIRE). With FIRE, countries that benefit from very low interest rates as a consequence of market panics would invest some of their savings to subsidize the borrowing of crisis countries within a conditional fiscal scheme. Conditional on reform and consolidation measures, the scheme involves a partial equalization of the fiscal burden from differing government bond yields in the market.
This study presents FIRE’s principles, discusses its advantages over alternative stabilization approaches and suggests options for its institutional details. Furthermore, a simulation is presented which would shield Italy and Spain against interest rates above 5 percent. The results indicate that a FIRE scheme is financially feasible and affordable for the safe haven‐countries.