Eurobonds could cost Germany up to €47bn per year in additional interest, according to the Ifo institute for economic research at the University of Munich, in a presentation to a press conference in Berlin on Wednesday

Eurobonds which would be issued across the 17-member-country common currency area, are the subject of an intense debate in Europe, with struggling economies in favour while the prudently run economies would see a hike in the cost of servicing sovereign debt.

Last weekend, Giulio Tremonti, Italian finance minister, again called for the introduction of such bonds, saying, "We wouldn't be where we are now if we had had eurobonds."

It's an interesting comment from the top official of a country that could only manage average annual growth of 1% over the past decade. In the context of the latest crackdown on tax evasion, in recent weeks a court deposition has disclosed that Tremonti paid a former aide €1,000 in cash weekly, for the rent of an apartment in Rome. 

Jean-Claude Juncker, prime minister of Luxembourg and the chairman of the Eurogroup of Eurozone finance ministers has also advocated the launch of eurobonds as has Olli Rehn, the EU Economic and Monetary Affairs commissioner, claiming that that they would restore stability by stopping speculative attacks on the debt of individual Eurozone member countries

Following the two-hour meeting in Paris on Tuesday this week between Nicolas Sarkozy, the French president and Angela Merkel, the German chancellor, Merkel reaffirmed that eurobonds were not part of the solution. Rather, the goal is to solve the debt crisis in a step-by-step fashion: "I do not believe that eurobonds would help in that regard," she said.

The French president however said eurobonds could be a possibility in the future: "Perhaps one could imagine such bonds at some point in the future at the end of a process of European integration. But not at the beginning" of it, he said in reference to a proposed 'economic government' for the Eurozone.

Eurobonds will not be on the agenda until agreement is reached on new Eurozone governance rules.

Der Spiegel, the German news magazine, says that the pro-business Free Democratic Party (FDP), junior partner to Merkel's Christian Democrats, has ruled out the creation of euro bonds. Their leader, Economy Minister Philipp Rösler, reiterated his opposition to them in an interview in the Die Welt newspaper on Monday, saying they "lead to equal interest rates in the whole euro zone and thereby undermine the incentives for a solid budget and economic policy in the member states."

Germany's opposition Social Democrats and Greens have both said they would support the introduction of eurobonds provided that certain conditions were attached to them, including a tighter control of nations' fiscal policies. Green Party leader Cem Özdemir said the volume of eurobonds should be limited to 60% of a nation's gross domestic product.

The Ifo institute said on Wednesday that at the end of July, the yield of 10-year German government bonds was 2.0 percentage points below the Eurozone average. For 5-year bonds the yield spread was 2.6 percentage points; for two-year bonds it was 3.0 percentage points. The average yield spread therefore depends on the term structure of German government debt. Assuming an average maturity of 7.5 years, this results in a yield spread of 2.3 percentage points. Based on the overall current level of gross debt of the Federal Republic of Germany of €2,080 billion (as of the end of 2010), additional interest expenses of €47 billion per year would result.

Ten-year bund yields fell nine basis points to 2.23% on Wednesday.

Germany is not the only country that opposes eurobonds.

Finland and Greece on Tuesday reached an agreement on collateral for Finland's participation in the latest Greek bailout, Jutta Urpilainen, Finnish finance minister, said Tuesday.

"I am very pleased with the result of the negotiations," Urpilainen told a news conference in Helsinki, without disclosing details.

Urpilainen said Greece will deposit a still-to-be-decided sum of money with the Finnish state for Finland to invest.

"When Greece has managed all its obligations with the European Financial Stability Facility, Greece will receive the original installment and all of the accrued profit," Finland's finance ministry said in a statement.

Last month, European leaders agreed a new €109bn bailout package for Greece,

Presentation by Prof Kai Carstensen at the Ifo press conference "Eurobonds – What they will cost the taxpayer – After the meeting between Merkel and Sarkozy" on 17 August 2011 in Berlin – - Download (in German)

Given the current debate over the introduction of eurobonds, the Ifo Institute has updated its estimate of the costs for the German government. The calculation is based on the assumption that eurobonds will lead in the long run to the communitarisation of the sovereign debts of all countries in the euro area, guaranteed according to the ECB's capital shares of the individual countries.

The nominal interest rate differences between government bonds, as have been determined by the markets, reflect the different default probabilities of the countries and cause the effective interest rates of the countries (in terms of mathematical expectation values of the interest rates) to be similar.

Eurobonds give all states the ability to finance themselves regardless of their default probability at the same nominal interest rate. In so doing they push the effective interest rates of countries, to the extent of the annual default probabilities, under the common nominal interest rate, implying a subsidy of the financing costs of the unsound countries.

The nominal interest rate convergence (and effective interest rate divergence) that is a part of the eurobonds has the effect its proponents desire that the interest rates of unsound countries falls significantly. Since the creditworthiness of the euro countries is communitarised, the creditworthiness of the eurobonds also reflects only the average credit quality of the participating countries. The interest rate of the eurobonds will thus likely settle in the vicinity of the value that would otherwise have resulted in the average of all countries. The effective interest rates of the unsound countries will in some cases even be negative.

At the end of July, the nominal interest rate on ten-year government bonds in the euro area averaged 4.6%, according to the European Central Bank, while for Germany it was only 2.6%. Italy had to pay interest of 5.9%, Spain 6.1%. Portuguese and Irish government bonds were traded with a yield of around 11%, and Greek bonds were traded at almost 15%.

The nominal interest rate differences moved in the same order of magnitude as in 1995, one year before the start of nominal interest rate convergence that went along with the announcement of final fixed exchange rates in the euro area. At that time, nominal interest rates on ten-year government bonds in Italy, Portugal and Spain were, on average, as much as 5 percentage points higher than German interest rates, whereas at the end of July 2011, they were only 3.7 percentage points higher.

Even France had to cope with a slightly larger interest rate spread of 0.69 points than at the end of July 2011, when it amounted to 0.65 points. However, Greece's interest rate premium at the time was 10.1 percentage points, which is slightly below the 12.4-point level reported in July this year.

For Germany, a pooling of liability by means of an artificially induced nominal interest rate convergence (and effective interest rate divergence) would in the long term result in substantial additional costs. These additional costs can be calculated for the period after the expiration of all conventional German government bonds under the assumption that the nominal interest rates of the eurobonds would potition themselves at the average interest rates in a regime without such bonds and that interest rate spreads without the eurobonds would remain where they have been as of late.

At the end of July, the yield of 10-year German government bonds was 2.0 percentage points below the euro area average. For 5-year bonds the yield spread was 2.6 percentage points; for two-year bonds it was 3.0 percentage points. The average yield spread therefore depends on the term structure of German government debt. Assuming an average maturity of 7.5 years, this results in a yield spread of 2.3 percentage points. Based on the overall current level of gross debt of the Federal Republic of Germany of €2080 billion (as of the end of 2010), additional interest expenses of €47 billion per year would result.

The calculation is lower if instead of the interest at the end of July the average values of the first seven months of 2011 are used as the basis for comparison. Average German interest rates in this period were not 2.3 percentage points lower, as at the end of July, but 1.6 percentage points below the euro area average. Consequently, using this as a basis, additional interest expenses of €33 billion per year result.

The calculation shows that the expected additional annual expenses depend on a number of assumptions. The additional costs would be lower if debt in the euro countries is reduced, that is, if austerity programmes are implemented in the euro area that go beyond the requirements of the German statutory debt-reduction requirement. This, however, is extremely unlikely. On the contrary, it is to be feared that eurobonds will reduce the incentive for consolidation in the euro area since the disciplining effect of interest rate spreads would be eliminated. Whatever country is more indebted than the average drives up the interest rates for eurobonds slightly, but this disadvantage mostly affects the other eurozone countries and not the country itself. The smaller the country, the smaller is the share of the negative consequences of additional debt that affect this country and the stronger the incentive to carelessly take on additional debt. And the debt incentive as such exists for all countries, including the larger ones. The debt of the euro area is thus likely to grow even faster than in the past, which will increase the interest rates for Eurobonds that the capital markets will require.

It is above all to be feared that investors will doubt that the more solid countries will actually be able to shoulder the risks that come along with the liability union. After all, even Germany with a debt ratio of 83% is far above the limit of 60% permitted by the Maastricht Treaty. This would result in a loss of confidence and renewed turmoil in the financial markets, which would then also affect Germany directly.

Some may be inclined to counter the negative incentive effects by limiting the eurobonds to a certain proportion of GDP, for example 50% or 60%; debt that goes beyond this would be the responsibility of the respective countries. But this proposal sounds better than it is. What would happen under this system is that the debtor countries would first refinance their debt with eurobonds alone until the debt limit is reached. For the first few years the debt limit would thus only be on paper and would have no real meaning. And when in time more and more countries come close to the debt limit and fear having to pay higher interest rates for new debt, they will exert political pressure to set a higher debt limit. Past experience with political debt limits in the euro area unfortunately leave little doubt as to what will happen.

Some proponents of eurobonds argue that they would have a high recognition value and for the investors of the world would thus suggest greater liquidity than the individual government bonds in the euro area. This feeds hopes that they can be placed at lower interest rates than the current average of euro interest rates. The liquidity effect is conceivable but likely to be of lesser importance. Surely it will not match the importance of the credit rating effect on which the above calculations are based. The liquidity of the eurobonds will likely not come close to that of German government bonds, and even if it did, their creditworthiness would not even remotely match that of current German government bonds since the liability is offered by countries whose ability to pay is increasingly being doubted by the markets. Thus Germany will certainly have to pay much higher interest rates as would be the case if it did not join the liability union.

One might conclude from this that in contrast to the above calculation the eurobonds would have to carry the joint and several liability of all participating countries. In fact, there is a fictitious scenario in which lower interest rates than the average for the euro countries would come about because the eurobonds would be serviced completely even if only one single euro country survived and assumed the debts of everyone else. But this scenario is completely unrealistic because even Germany as the largest country with the best rating so far would be driven to default in such a case. After all, the GIPS countries alone and together with Italy have more debt than Germany by half, and Germany today with a debt ratio of 83% is far beyond the 60% limit of the Maastricht Treaty. Those who maintain that with eurobonds interest savings could be achieved over the present average assume unrealistically that Germany, although jointly and severally liable, is not exposed to a greater default risk than is the case today.

Even in the case of the proportionate liability for the eurobonds on which we based our calculations, the Ifo Institute strongly advises against the introduction of eurobonds. Even if Europe had the strength to form a federal state, it would make no sense to communitarise the liability for government debt that has been taken on. Even in the United States of America, which exists as one country, one state is not liable for the other. The principle of liability is the basic principle of any rational economic activity and one of the cornerstones of a market economy. Whoever abandons this places Europe's future in jeopardy.