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EU Treasury Bond Proposal Nov 2013

Johann Müller eutreasuryproposal(at)gmail.com

EU Treasury Bond Proposal
Abstract
In the Euro area, many countries have large debt stocks exceeding 60% of GDP, which lead to the Euro crisis and fuelled doubts on the debt sustainability in certain countries. To avoid similar events in the future, this paper proposes to change the EU treaties allowing EU to raise a 4% VAT in Euro area countries. In return, the EU assumes debt of up to 60% of GDP for each Euro area country by issuing EU Treasury Bonds. Countries with less debt get cash, so all countries benefit by a similar amount. In addition, article 125 of the Treaty on the Functioning of the European Union is strengthened by explicitly stating the possibility of default. Because the tax is controlled centrally and only used for repayment of debt, the new Treasury Bonds are as secure as the safest asset in the Euro area and expected to pay no higher interest rate. Also since member states themselves are not burdened by any additional liabilities, the potential conflict with the German Grundgesetz is likely to be small. Some positive externalities of this proposal are reduced VAT fraud and improved tax collection; potentially lower borrowing cost by creating a new safe reserve asset; additional incentives for non-Euro EU countries to enter the Euro area; lower tax collection cost for countries; together with banking union, issues in individual countries become less important, hence Maastricht criterion become less relevant for joining the Euro; continued pressure to keep finances in order; sets example for future integration; little sovereignty lost by countries.

Introduction
There have been numerous proposals for the creation of Eurobonds during the height of the Eurocrisis. However, the debate quickly abated despite persistent debt overhang1 in many countries. At the same time, a reopening of the EU treaties is discussed to enshrine the banking union, and other changes pushed by the larger EU countries. In this setting, this proposal intends, by making explicit treaty changes, to circumvent some of the shortcomings of previous proposals like the potential vicious circle issues that most previous proposals shared. Moreover,
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Debt above 60% of GDP, the maximum level of debt allowed under the Maastricht Treaty

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EU Treasury Bond Proposal Nov 2013

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the proposal intends to resolve other issues regarding tax collection or tax fraud due to the current legal fragmentation or issues enforcing laws. These large benefits are achieved without significant loss of sovereignty for member states and maintain market pressure to promote budget discipline and draw in part from existing proposals.
Existing proposals

Some of the most prominent previous proposals include the EU Commission Stability Bond Proposal, the Blue Bond Proposal by Bruegel and the Redemption Fund Proposal by the German Council of Economic Experts. A more complete comparison can be found in Claessens et al. (2012). The Blue Bond Proposal wants to split current debt into two categories. Blue bonds up to 60% of GDP are jointly and several guaranteed2 within the Euro area, while red bonds for amounts exceeding 60% are only guaranteed by individual member states. As up to 60% is jointly guaranteed, interest rates on this part should be equal for all countries and considerably lower for some and moderately higher for other countries. This creates a large joint bond market, which can be used as a reserve asset. At the same time, countries with debt exceeding 60% are likely to pay higher interest on their red bonds, encouraging them to keep their budget in check. While this proposal alleviates some of the pressure for the highly indebted countries, there are shortcomings to this approach. In addition to the treaty change to allow member states to become liable for the joint issuance there are additional national hurdles, in particular in Germany with the Grundgesetz. There are some potential implementation difficulties regarding the GDP threshold during recessions, as the blue bond might become more than 60%. A larger issue with this proposal is the potential vicious circle that is not broken: Assuming that one country is not able to pay any debt, then the blue bond liabilities of all remaining Euro area countries increase - this increase could repeatedly cause the next weakest member state to default as well until only one country is left. Assuming the last country was Germany, the largest country in the Euro area, with a GDP share of around 30%, it would have to stem blue bonds of

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Every member state is liable for all the debt.

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EU Treasury Bond Proposal Nov 2013

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200% of GDP in addition to its red bonds. If any other country was the last country, much worse ratios would be obtained. The Redemption Fund Proposal wants to take all the debt exceeding 60% of GDP and create a redemption fund that pays the debt off over 20-25 years. Each country still has to pay the interest on its share, but there is joint and several guarantee to lower the interest rate. Due to its one off nature, this proposal should maintain the incentive to keep the budget in check in each country. Compared with the previous proposal, the impact on interest rates should be smaller, as less debt is mutualized, but still relieve the highly indebted countries. Similar to the previous proposal, the potential vicious circle remains, even though the risk became much smaller, as the outstanding debt exceeding 60% is much smaller than the amount below. Also, the additional liability might have the same additional national hurdles as the previous proposal. These hurdles might even be higher, as countries with higher debt can mutualize more debt relative to their GDP level. The EU Commission Stability Bond Proposal outlines three cases with different degrees of common issuance in the Euro area. The first case assumes joint and several guarantee for all bonds (but each country still pays interest on its share of bonds). As all bonds become the same, member states pay the same interest rate, where highly indebted countries benefit more from this proposal. While this creates an even larger bond market than the Blue Bond Proposal and hence more liquidity, there is no more incentive for countries to keep their budget in check. In addition, this does not break the potential vicious circle described above and creates the stronger national hurdles due to asymmetry. The second case is essentially the same as the Blue Bond proposal, except that the threshold for joint and several liability is left open. The third case is very similar to the second case, except that member states are only several liable 3, but there is collateral. The only interest relief several liability with collateral might give to countries is due to higher liquidity. However, this relief might be small which puts the ability to deal with the debt overhang into question. Due to the several guarantee, there is no potential vicious circle.

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Liable up to their share

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EU Treasury Bond Proposal Nov 2013

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As can be seen from the critical description of the previous proposals, either there is a potential vicious circle due to joint and several guarantee (which likely requires a treaty change) and national hurdles or the effect on the debt overhang is not clear.

The EU Treasury Bond Proposal
My proposal suggests that the EU assumes 60% of GDP of its Euro area member state’s debt as a one off measure. Member states with less government debt than 60% of GDP get a nominal credit amount for the difference that they can use as they like. It needs to be taken into account that some member states were in a recession for some time and hence their debt to GDP ratio mechanically increased. Hence 60% of the highest GDP value since 2007 or some cyclically adjusted GDP value should be used. Over the next two decades, the EU is bound to reduce this debt to 40% of Euro area GDP. In return for assuming this debt, the EU is allowed to levy and control a 4% VAT. If member states collect the tax on behalf of the EU, the EU must at least be allowed to send its own officers to check that the tax is collected correctly. To calculate what this implies in terms of income, Germany is used. In 2012 it collected € 194.6bn in VAT at 19% (destatis) on total final consumption expenditure in 2012 of € 1490.5bn. Neglecting the lower VAT rate for certain goods in Germany, a 4% VAT tax corresponds to a revenue of € 146.2bn for the entire Euro area with total final consumption expenditure of € 5320.3bn in 2012 (Eurostat). Euro area GDP was at € 9483.8bn, hence this tax could pay 2.57% interest on bonds4. Given that the bonds are a nominal amount and VAT returns grow with nominal consumption growth, the increases in revenue over time can be used to repay some of the debt until a debt to GDP ratio around 40% is achieved. If there are additional revenues at this point (up to 3.85% interest could be paid then), they can be used to reduce the payments made to the EU budget by Euro area member states. If the required payments are exceeded, additional revenues flow back to member states. As member states would have to pay interest on their bonds and an amount to the EU budget anyway, this should be a very small loss in sovereignty.

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This does not include administrative cost or the reduction of VAT fraud

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EU Treasury Bond Proposal Nov 2013

Johann Müller eutreasuryproposal(at)gmail.com

To insure repayment of EU Treasury bonds, while excluding unnecessary tax increases, the tax can only be increased by a qualified majority of Euro area countries in the council and parliament under two conditions: Either the interest rate increases and hence the tax is not able to pay for the debt service anymore, or if Euro area member states decide that the EU has to pay for new programs like parts of an Euro area wide employment, pension or health insurance. Note that if unanimity were required, this could question the repayment of the debt. As soon as the overall debt level reaches 40% of GDP, this debt level should be maintained by new issuance by the EU to ensure that EU Treasury Bonds are sufficiently abundant to keep them a highly liquid asset. This creates additional revenue which should flow back to the member states at their respective GDP shares. Assuming real GDP growth in the Euro area at 2% and inflation at the same number, this generates revenues of 4% of GDP for each member state. Given that this revenue only depends on Euro area growth and not individual member state growth, it is able to insure against some individual member state growth risk. For example, if the Euro area grows nominally at 4%, but a member state is in a recession, it still gets this revenue.
Entry of other EU countries

Introducing EU Treasury Bonds at the Euro area level only immediately raises the question about entry into the Euro area and if this option should be available for the entire EU, not just Euro area member states. If an EU country does not take part in the Euro but in this proposal, there are several issues regarding the tax and the debt. If all debt is denominated in Euro, there is exchange rate risk in the tax and the debt to GDP ratio of the EU. Denominating some EU Treasury Bonds in some other currency than the Euro might circumvent some of the risk, but increases administration cost and makes the implementation more complicates while some of risks mentioned above remain. Also, countries without the Euro can pursue monetary policy independent of the ECB, complicating things further. If a country joins the Euro area, it should be allowed to transfer some of its debt to the EU in return for letting the EU levy the 4% VAT. The amount transferred should correspond to the current debt to GDP ratio at the EU level but not exceed 60% of GDP. This implies that a country
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EU Treasury Bond Proposal Nov 2013

Johann Müller eutreasuryproposal(at)gmail.com

joining at the start can transfer up to 60% of GDP (cyclically adjusted), while a country joining very late can only transfer 40% of GDP. Hence, there is an incentive to join early on. If the debt to GDP ratio of the country is below the allowed level, it gets the cash amount as described above. This creates an additional large incentive to join the Euro. As both governments and the ECB made it clear that the Euro is irreversible, the case of exit is omitted.
Administration cost and tax fraud

As stated above, both administration cost and VAT fraud have been omitted so far. As White (2011) noted, the administrative cost of VAT is around half a percent of the revenue collected, which would equal less than € 1bn if € 146.2bn is collected. One way VAT fraud works is as follows; a company transfers goods or services from one country to another, reclaiming VAT in one while not paying VAT in the other. Eurocanet found in 2006 that the four largest Euro area countries lost more than € 8bn together due to this kind of VAT fraud. If some of the tax is collected at the EU level, VAT has to be paid to the EU in either case. This makes this fraud easily detectable, as the VAT has to be paid in at least one member state as well. Assuming that the € 8bn are Euro area wide and this reduces fraud by at least 75%, € 6bn more revenue should be generated. If this new revenue is split between member states and the EU according to their VAT level, this should give the EU an additional € 1.2bn, if the average Euro area VAT is assumed at 20%. As the estimated administrative cost is less than €1bn, the reduction in fraud should easily pay for the administrative cost. If the legal framework was made more coherent across the Euro area countries, the administrative cost should fall, in particular for member states, as the EU is already checking the VAT receipts. In countries that have difficulties collecting their taxes, the EU controls should help increase VAT receipts significantly. The additional administrative cost for debt management should be minimal, because there is already issuance at the Euro area level with the EFSF and ESM.
Interest rates of Treasury Bonds

One main obstacle to creating EU Treasury Bonds is the fear of higher interest rates for fiscally sound countries. As there is no additional liability on any individual country, the interest rates
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EU Treasury Bond Proposal Nov 2013

Johann Müller eutreasuryproposal(at)gmail.com

on bonds of fiscally sound countries should not be affected beyond some potential liquidity effects. However, this still raises the question, if the overall interest burden increases, as fiscally sound countries pay more for the joint bonds than they would have paid without joint bonds. Or if the taxes raised by the EU are larger than what a fiscally sound country would have paid on its share of bonds. The Euro crisis showed that some countries have difficulties collecting some of their taxes. If the EU is allowed to send officers to check VAT receipts, this issue should be reduced considerably, as the potentially most stringent tax collectors within the Euro area could be used in the entire Euro area. In addition, increasing the tax by qualified majority, if necessary, ensures that all the debt is repaid including interest. This makes EU Treasury Bonds as secure as the debt of the countries that are fiscally most sound. Moreover, the EU Treasury Bond market would become the second largest bond market, which creates liquidity and could even become a very successful international reserve asset. It would also likely become the reference asset in the entire Euro area, reducing the current market fragmentation. All these things should lower the interest rate further. While some of this liquidity is at the expense of large member states with sound fiscal policy, they in turn benefit by the increased liquidity of the Treasury Bonds. All in all, there should be no additional interest burden on the countries with lower debt and deficit, while they gain from higher revenue due to lower tax fraud. They also gain through more political certainty due to a strengthening of article 125 of the Treaty on the Functioning of the European Union, which currently states that no member state can be made liable for the debt of another member state and neither can the EU (see below, article 125 henceforth). Countries, which currently have higher interest rates might see an increase in the interest rate on debt that has not been assumed by the EU. However, this increased burden should be more than balanced by the savings on the EU debt, the increased revenue due to better tax collection and lower VAT fraud.
Maastricht criteria changes

The Maastricht criteria allow up to 60% debt to GDP ratio for EU member states. Adding the proposed 40% to GDP of the EU to this amount would lead to a debt to GDP ratio of 100%. To
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EU Treasury Bond Proposal Nov 2013

Johann Müller eutreasuryproposal(at)gmail.com

keep the ratio at overall 60%, the Maastricht criteria must be adapted. Also, if the EU assumes the debt, this creates a precedent violating article 125 and could increase moral hazard for individual member countries. If the 60% ratio is to be maintained, this implies a debt to GDP ratio of up to 20% for Euro area member states. Note that this restriction should only apply for Euro area member countries and not countries outside the Euro. As this ratio automatically increases in recessions however, it might be better to have an even stricter target for normal times. Assuming a two year recession with a fall in GDP of around 2% and 3% to GDP deficits in both years, this would mechanically imply an increase in debt to GDP by more than 10%. Given that this scenario is quite pessimistic, a 10% of GDP gap between the debt allowed in normal times and the debt allowed in recessions could be a solution. Hence member states can have 10% of debt to GDP in normal times and up to 20% in recessions. Article 125 states that no member state can be made liable for the debt of another member state and neither can the EU. This has already been weakened through the creation of the EFSF and ESM. If the debt to GDP ratio of 10% is enforced, member state debt is very small compared with Euro area debt. Due to this, a default of any member state might cause difficulties for this member state, but it is unlikely to completely disrupt the financial markets of the entire Euro area. Hence, article 125 can be strengthened by explicitly allowing defaults if commitments cannot be met by any country or local government on their individual debt. As the Treasury Bond cannot default with the almost automatic tax increases, this still leaves a “safe” asset for the entire Euro area, even if individual member states defaulted on their individual debt. Note that the ESM, can still provide credit lines to countries in trouble, however, default becomes an explicit possibility. This setup is similar to some member states, where regions within the member state can default, without affecting the central government debt of that member state. Allowing defaults should put pressures on governments to keep their finances in check and avoid any moral hazard issues. This might also be a stronger pressuring device than putting further restrictions on (structural) deficits or debt consolidation in place, while causing a smaller loss in sovereignty, as market pressure leaves less leeway.

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EU Treasury Bond Proposal Nov 2013

Johann Müller eutreasuryproposal(at)gmail.com

As many countries would have a higher individual debt to GDP ratios than the allowed 10% after the creation of EU Treasury Bonds, it might be helpful to put a moratorium on the defaults for the first few years. This way, member states have some time to consolidate their debt before market pressure might make it more difficult.

Benefits
This proposal shows a way to help member states handle their debt overhang, while significantly reducing the future risk of any event similar to the Euro crisis. Also, a large common bond market independent of national markets is created, which creates a potential new reserve asset. There is very limited loss in sovereignty and together with the banking union, debt related issues in individual member states become less important for the entire Euro area. All member states should benefit from the partial risk sharing due to the revenue when maintaining the 40% debt to GDP level highlighted above. This proposal will look at some specific use cases as well to show the benefits for each case.
Member states with low debt/deficit

Member states with low debt and/or deficit have some distinct benefits. Countries with debt levels below 60% of GDP gain cash, which they can use to invest into any projects they desire. For example, they can use the cash to invest into infrastructure projects or education. Unlike proposals with joint and several guarantee, this proposal should not put any additional debt burden on member states, and the interest rate for the common bond market should not be higher than the lowest interest rate in the Euro area. The rule that no member state is liable for the debt of another member state is maintained, while article 125 is strengthened. Due to proportionality of the debt relief, the low debt/deficit countries are not paying for the debt of other governments. The probability of any future Euro crisis is minimized, as market pressure remains with explicitly possible defaults and small national bond markets relative to the new bond market. VAT fraud should be reduced significantly with the EU controlling the part of the VAT it is collecting.
Member states with neither large nor small debt/deficit

Member states with Euro area average debt should see some debt relief, as the interest rate on debt assumed by the EU falls. The interest increase on the remaining debt should be balanced
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by the lower interest rate on EU Treasury Bonds. Given that these countries’ debt is average, strengthening article 125 should not have any direct effect on them. But there is an indirect positive effect, because the tail risk of another, potentially more severe Euro crisis is reduced. As all countries within the Euro area, there should be a considerable reduction in VAT fraud.
Member states with large debt/deficit

Member states with large debt and/or deficit should see a considerable debt relief, reducing any debt sustainability issues in two ways. On one hand, interest paid on a large part of the debt should be reduced considerable and on the other hand, the total amount of debt at the country level has fallen significantly. A potential moratorium on defaults could give these countries some further time to consolidate their debt, before market pressure increases the interest rate on the debt not assumed by the EU. However, even without a moratorium, there should be some clear interest relief for these countries. The fact that part of the VAT is checked by the EU should ensure tax collection and reduce tax fraud, helping these countries to reduce deficits and debt significantly.
Non Euro area/EU country

Countries that are currently not in the Euro area were adversely affected by the Euro area crisis. This tail risk would be reduced for these countries. At the same time, most changes only affect countries in the Euro area. Hence, as long as they remain outside the Euro, their sovereignty should not be much affected. However, there are some additional consequences when joining the Euro. Joining the Euro could lead to a significant debt relief (or additional cash, if the debt to GDP ratio is small) and a clear reduction in VAT fraud. Due to the reduction in systemic risk for any Euro area member country, some of the requirements for joining the Euro might be reduced. These additional benefits and lower requirements might be enough to convince some of the Euro skeptic countries to join. Indeed, the sooner countries join, the more debt relief they gain as described above. The additional benefits of Euro membership might also increase the benefits for non EU countries, which might consider joining sooner.

Bibliography
(2011). European Commission Green Paper on the feasibility of introducing Stability Bonds. http://europa.eu/rapid/press-release_MEMO-11-820_en.htm
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Claessens, S., Mody, A. and Vallée, S. (2012). Paths to Eurobonds. IMF Working Paper. http://www.imf.org/external/pubs/ft/wp/2012/wp12172.pdf Doluca, H., Hübner, M., Rumpf, D. and Weigert, B. (2012). The European Redemption Pact: An Illustrative Guide. http://www.sachverstaendigenratwirtschaft.de/fileadmin/dateiablage/download/publikationen/working_paper_02_2012.pdf von Weizäcker, J. and Delpla, J. (2010). The Blue Bond Proposal. http://www.bruegel.org/publications/publication-detail/publication/403-the-blue-bondproposal/ White, J.R. (2011). VAT- Potential Lessons for the US from other countries’ experiences. Testimony Before the Committee on Ways and Means, House of Representatives. http://waysandmeans.house.gov/uploadedfiles/white_testimony.pdf

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