Bloomberg
October 21, 2011
The euro area is burning and policy makers seem increasingly powerless to douse the flames. Meanwhile, we can only stand by and watch this nerve-wracking spectacle.
Yet the situation may not be utterly hopeless. In the last month or so, researchers have floated proposals for the creation of synthetic euro bonds that may offer a way out. The idea rests on three principles: No cross-subsidization between countries; safety; and the replacement of risky sovereign debt by synthetic bonds in European Central Bank repurchases.
I know what you are thinking: Are these people out of their minds? Collateralized debt obligations? Synthetic securities? That is what got us into this mess in the first place.
Let’s take a closer look. The proposals all start with some version of an open-ended mutual fund that would hold euro-area bonds. Ideally, the fund would hold these assets in proportion to the gross domestic product of each member country. It would then issue certificates that would be fully backed by these bonds. If there is a partial or full default on one of the securities (Greek 10-year bonds, say), then the mutual-fund certificates would lose some value.
In the case of a small country or a partial default, the losses would be small. So, the certificates would be reasonably safe.
The most important aspect, however, is that there would no mutual bailout guarantees, no cross-subsidization between countries and no need for high-level political brinkmanship. This is the core of the proposal I put forth with my colleagues Thorsten Beck and Wolf Wagner, of Tilburg University in the Netherlands.
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