Euro bond can't solve spread problem: Paul Taylor

-- Paul Taylor is a Reuters columnist. The opinions expressed are his own --

By Paul Taylor

PARIS (Reuters) - Anyone looking for a silver bullet to protect the euro zone from yawning bond spreads would be well advised to forget the idea of a common European bond.

As the gap between borrowing costs of governments in Greece, Spain, Italy and Portugal and the prime rate paid by Germany has widened in the financial crisis, policymakers have begun to debate some form of mutualization of European debt.

But legal and political obstacles make any such move hard to conceive in time to be useful in the current crisis.

For one thing, the treaty that created the single European currency explicitly rules out the EU collectively or states individually assuming the liabilities of a member state, except when jointly underwriting a specific project.

That didn't stop Italian Finance Minister Giulio Tremonti calling last week for the creation of a "union bond."

Luxembourg Prime Minister Jean-Claude Juncker, who chairs the Eurogroup of finance ministers of the 16-nation euro area, gave the idea credence when he said in late December: "We have to think about a better way of jointly managing our public debt.

"You could even imagine, for example, creating a European agency capable of issuing 'euro-bonds'," Juncker told France's Liberation newspaper.

The biggest hurdle to any common European bond issuance or mutual credit guarantee is the principle of individual national liability for public debt.

European Central Bank president Jean-Claude Trichet told Reuters: "The present system of the euro zone has been that there would not be bailing out of any particular fiscal policy."

In other words, peripheral euro zone countries must simply take the pain of public spending cuts, tax increases and lower wages to cope with the impact of the financial crisis.

GERMANS WON'T PAY

Germany's finance minister and central bank chief were quick to stamp on the euro bond notion, saying each country must be responsible for its own public finances, and Germans would not pay more to lower the borrowing costs of others.

A German general election year is the worst time to float such ideas, reviving old angst about the fitness of "Club Med" countries to join the euro.

"Being a German, I have to think of the taxpayers in my country. Creating euro bonds by definition means some countries would pay a bit less than they pay now and others would pay a bit more," said Wolf Klinz, a member of the European Parliament.

"I could not see any way to sell this to the taxpayers in my constituency," he said in a telephone interview.

Klinz, a member of the liberal opposition Free Democratic Party, said southern European countries such as Greece and Italy had enjoyed a huge advantage in lower borrowing costs by being members of the euro zone.

For the first decade after the creation of the euro in 1999, members of the single currency paid only fractionally different rates to raise funds despite wide differences in their public debt stock and budget deficits.

Spreads widened last year as risk aversion grew, heightened by the collapse of Lehman Brothers investment bank in September.

They ballooned last month when ratings agencies downgraded the sovereign credit ratings of Spain, Greece and Portugal and issued warnings on Ireland's outlook. That prompted some market talk of a possible break-up of the euro zone, although leaving the single currency would be economic suicide for any country.

Greek bond spreads with the benchmark 10-year German Bund hit a record 300 basis points on January 26, but had tightened to 240 points by Wednesday. Spreads on Italian, Spanish and Irish debt have also narrowed significantly in the last week.

With interest rates falling everywhere, only Greece is actually paying more to raise funds now than it did last year. EU officials and most economists insist there is no risk of any euro zone government defaulting on its debt.

IMF TO THE RESCUE?

Asked what would happen if a euro zone country did get into payments problems, the official answer is it would have to seek help from the International Monetary Fund, which imposes strict austerity conditions for its assistance.

Ironically, while the EU has given Hungary and Latvia emergency balance of payments aid as part of IMF-led rescue packages, lending them billions of euros at prime German rates, it is not allowed to do the same in the euro zone.

Yet there would be strong political reluctance to seeing any euro zone country go to the IMF, which could hurt confidence in the whole currency area.

"We should be thinking about how we do inside the euro zone what we do as partners of the IMF outside the euro zone," said Austrian conservative Othmar Karas, a member of the European Parliament's economic and monetary affairs committee.

"How do we develop a common umbrella? Whether a loan or an agency is another question. Those ideas look seductive at first glance, but the devil is in the detail," he told Reuters.

Any joint action would have to preserve the principle of national responsibility for fiscal policy, Karas said, adding that EU lawmakers have not even begun discussing the ideas or a legal basis for such moves.

The euro zone is likely to weather this stress test long before such arrangements can be devised.

Only then will it be possible to debate the case for a more efficiently integrated supply of European government debt to rival the U.S. and Japanese sovereign bond markets.

(editing by Chris Pizzey)