Recently I learned about a proposal for Euro denominated “accountability bonds”. They are basically a clever way to enforce the stability and growth pact. I don’t like the pact, so I don’t support the proposal which I made by Clemens Fuerst here . The idea is that borrowing beyond the level allowed by the stability and growth pact could be financed only by special junior bonds. Owners of those bonds would lose everything before owners of senior bonds lose or taxpayers who finance the ESM risk anything.
The key part (which I don’t support) is that currently outstanding bonds are senior to these new bonds. This means that the reform will cause a windfall gain to current bond owners. The value of their bonds will not be diluted by the junior bonds. The risk that it would be diluted by regular bonds issued above the stability and growth pact levels would vanish. Importantly, this windfall would not be openly paid by the Treasury issuing the junior bonds – on its face, the reform regulates only the interaction of those Treasuries with new investors. The windfall would be paid by other investors who value the old bonds more highly. The old bonds will be more valuable in case of default, because they will be more senior than the average outstanding bond (the average including the junior bonds). Since investors in junior bonds won’t pay this cost in (at least subjective) expected value, the issuing Treasury will.
If no junior bonds are issued, old bonds are average bonds so there is no windfall and no cost. Byt the reform appears to only regulate the interaction between issuing treasuries and investors in new bonds. It is a penalty to be levied by investors thinking of their own interests, so it is a penalty which will actually be levied.
I don’t like the windfall (which Fuerst might consider the whole point of the reform). It implies giving people who are on average wealthy something for nothing. It isn’t hard to come up with a proposal for junior and senior bonds, related to the stability and growth pact, which does not create a windfall. The problem (or whole purpose) is that old bonds are senior to the average bond. The solution is to require that, in case of default, recovery ratios for old bonds are equal to average recovery ratios.
My proposal is that as of the start date T, there is a limit on the issuance of new senior bonds. Beyond that limit, new bonds must be new junior bonds. In case of default, first payments (coupons plus face values of maturing bonds) are divided into the proportions due to newer than T and older than T bonds – so payments to old bonds are
(total payments)(amount owed on old bonds)/(total amount owed).
The remaining payments must first go to new senior bonds and any money left goes to new junior bonds.
Discussion of the effects of such a plan after the jump.