When fiscal discipline meets macroeconomic stability: The Euro-stability bond

Abstract

We study the consequences of introducing an Euro-stability bond mechanism that implies sovereign debt mutualization in the Eurozone without any significant short-term redistribution across countries or perverse incentives to fiscal profligacy. In a simple structural model of the economy, we theoretically show that this mechanism is able to reproduce the market fiscal discipline while increasing the social welfare of all countries with respect to the real market discipline. Relying on a GVAR model including 10 Eurozone countries, U.S., Japan and China, we then analyse the future evolution of public debt (and other key macroeconomic variables) over time by comparing the predicted forecast in the baseline and in a counterfactual scenarios with the Euro-stability bond. We find no significant differences in the future path of public debt-to-GDP ratios in the two cases, but a consistent reduction in the forecast’s uncertainty in the counterfactual scenario. The reduced uncertainty of forecasts of public debt and other macroeconomic variables highlights the potential capacity of the Euro-stability bond to immunize the Eurozone from classical macroeconomic instability shocks that derive by the very existence of high sovereign debts and the related significant rollover and contagion risks in a framework of decentralized fiscal policies. To this extent, we finally exploit the results of the GVAR model to assess the capacity of the proposed scheme to reduce the probability of adverse macroeconomic events.