The Great European Debt Breakup

BRUSSELS – Financial markets almost just succeeded in breaking up the eurozone. So the idea of harnessing the power of the market and of financial engineering to guarantee the euro’s long-term viability might seem paradoxical. But this is precisely what our proposal to split eurozone sovereign debt into senior and junior tranches aims to achieve.

The senior tranches would comprise debt totaling up to 60% of the GDP of each participating country. These countries would then pool this debt and issue a joint and several guarantee. The resulting “Blue Bond” (named after the color of the European flag) would be an extremely safe and highly liquid asset, comparable in volume to United States T-bills, thereby helping the euro’s rise as an international reserve currency and ensuring low refinancing costs for the bulk of eurozone debt.

By contrast, any debt beyond 60% of GDP would have to be issued as junior “Red Bonds” under purely national responsibility. These “Red Bonds” would make borrowing beyond 60% of GDP more expensive, thereby enhancing fiscal discipline and reinforcing the targets set by the Stability and Growth Pact.

Moreover, Red Bonds could be conveniently ring-fenced so that they do not destabilize the banking system, thereby ensuring that the no-bailout clause that applies to them becomes a credible proposition. For example, the European Central Bank should exclude Red Bonds from its repo facility and a standardized collective-action clause to facilitate debt rescheduling should be made mandatory for Red Bonds.