No silver bullet

Eurobond: Desperate measures for desperate times. Some European Union members are pushing for a euro zone bond to fight contagion in government debt markets. The idea is as old as the euro, but its advantages look clearer now that investors have stopped buying volatile peripheral debt. It probably comes too late to end the current crisis.

A key problem is that a common bond without full fiscal integration would engender moral hazard. Weaker countries would lean on the credit quality of stronger ones to borrow, with investors confident they would be bailed out.

An alternative scheme, proposed by two EU finance ministers, is for countries to issue a certain proportion of communal, guaranteed bonds, funding the remainder through unguaranteed, national debt. Because the national debt is exposed to losses in a default, investors would demand higher rates to buy it, forcing countries to run tighter budgets and solving the moral hazard problem. The bonds could be introduced quickly through debt switches, in which holders of bonds trading at a discount swap into the guaranteed debt, taking a loss in return for greater security.

It might work in principle. Imagine the scheme had been introduced 15 years ago; peripheral governments would have run tighter budgets, and they might have avoided jeopardising their credit quality by assuming bank liabilities, as Ireland did.

But introducing such a system now would be tough. For one, countries won't want to surrender control of their debt to a central EU body. Even if they were, the proposal may not solve Europe's sovereign crisis. Investors would buy the guaranteed bonds, but demand for the unguaranteed, subordinated debt would be weaker. Given the state of some government finances, a lot of the riskier bonds would need to be issued, even by countries such as Belgium or Italy. Unguaranteed debt could be brought down through the discounted debt switches, but holders would still need to be willing and able to take a loss; something many banks still can't do.

The most likely buyers for the riskier debt would be domestic investors. But governments might be less willing to restructure if the main loss-bearers were their own taxpayers and banks. Call it political hazard.