A Euro Bond without Treasty Changes?

It has been long and widely recognized that a critical flaw in Europe is a monetary union without fiscal union. Although the founders of European integration back in the late 1950s seems to see the customs union as simply the first step toward greater union and were drawn to the idea of a United States of Europe, the desire seems to be lost on the current generation of officials. Nevertheless, the crisis arguably is pushing Europe back into that direction.

Fiscal coordination in terms of the German insistence that countries enshrine austerity in their national laws (constitution) or that all members reduce deficits even though some members are experiencing contracting GDP or others, as France showed earlier today, stagnating does not seem sufficient. One measure that has been talked about, but rejected by Germany and others, is a European bond. As of July 21, a majority of members were still opposed. As recently as earlier this week, Germany said that it would adhere to the July 21 agreement but no more than that--seemingly to dismiss increasing the size of the EFSF or a European bond.

There is more than one way to skin a cat.

First, we recognize that the ECB bond purchases, which both the initial decision and the one to resume the purchases, took place over objections from German members of the ECB. Second, the ECB actions seem to blur fiscal and monetary policy. Third, we will learn on Monday the extent of the ECB bond purchases as they indicate the size of the neutralization/sterilization operation so as not to have its bond purchases increase money supply (or be what Trichet has suggested would be quantitative easing).

Up until now the ECB has using 7-day deposits--like selling 1 week CDs--to banks to absorb the extra liquidity. As the amounts gets larger, the ECB may consider offering additional instruments, perhaps of longer-term duration. Since the ECB has indicated it will hold the bonds it buys to maturity, so a longer-term security need not be confined to a say 90 day deposit, it could be even longer, say a year to two years.

Like a fetus that develops for nine months in utero and then continues to develop after birth, so too with EMU. It is still developing. European officials move slowly and the ECB, sometimes over the initial reluctance of Trichet himself, move into the apparent vacuum. It may do so again.