--- by Theo Vermaelen ---

Linking compensation to sovereign borrowing costs could discourage politicians from buying votes with other people's money.

Theo Vermaelen

Angela Merkel is opposed to euro-zone bonds, or collective guarantees for a portion of euro-zone countries' debt. The chancellor's opposition is understandable: We already had de facto euro-zone bonds before the crisis, when the small spread between Greek and German yields reflected an implicit contract to bail each other out in the event of a debt crisis. This encouraged reckless borrowing and spending by some countries, so it is fair to think that turning this contract into an explicit commitment is hardly a solution to the problem of unsustainable government spending.

However, Mrs. Merkel's preferred approach is to give unelected eurocrats the power to reject national budgets. Greater fiscal union is likely to face opposition from a large fraction of the euro zone's population, especially in France, where nationalist and socialist politicians are starting to compare her with Otto von Bismarck. Some are wondering whether Germany, after several failed attempts, will finally unite Europe—and this time without firing a shot.

A different approach is necessary. The current discussion is too focused on the stick and not enough on the carrot. By punishing countries instead of their leaders for violating EU budget constraints, those responsible walk free. A better method would impose fiscal discipline by incentivizing politicians to be fiscally responsible. Euro-zone bonds could be an ideal tool to implement such a system.

Proposals like the one put forth by Bruegel, a Brussels-based think tank, would allow euro-zone countries to issue so-called "blue bonds" and "red bonds." Blue bonds would be jointly guaranteed by all members of the euro zone and allow member states to borrow up to 60 percent of GDP. To fund borrowing beyond that, countries would have to issue red bonds, which would be backed only by their national treasuries and therefore trade, under most circumstances, at higher yields.

To complement joint bond issuance, I would suggest that all euro-zone politicians receive a significant part of their compensation in the form of blue or red bonds. If a country has to issue red bonds because its debt-to-GDP ratio exceeds 60%, politicians would be paid in red bonds. Otherwise they would be paid in blue bonds. Bonds would have to be held for five years but would be convertible: If the debt-to-GDP ratio falls below 60 percent, red bonds would be converted into blue. Likewise, if this ratio rises above 60 percent, blue bonds would be mandatorily converted into red bonds.

This way, politicians would be rewarded when their countries are able to borrow cheaply and punished when their countries' cost of funds goes up. Politicians would be well-compensated when their countries are perceived as solvent; they would take heavy losses if their countries fell into serious financial difficulty. Under such an arrangement, blue bonds would be similar to the contingent convertible (CoCo) bonds that are now used in some banks to structure bankers' bonuses to discourage them from engaging in reckless behavior.

Far from encouraging profligacy, as Mrs. Merkel fears, common euro-zone bonds could be used to provide a counterweight to politicians' tendency to buy votes with other people's money. This discipline would be imposed without giving power to unelected eurocrats, who, as fonctionnaires on fixed salaries, have incentive issues of their own.

Theo Vermaelen is a professor of finance at INSEAD. The article was originally published in The Wall Street Journal on December 7, 2011.

First published: December 9, 2011

Last updated: December 9, 2011

SK/MR 12/11