Europe Needs More Than a Bundle of Bonds

The European Commission has been thinking about ways to strengthen the euro zone, and is proposing a plan for a new “sovereign bond-backed security.” Give the commission credit for putting its finger on an important defect of the euro-zone system. Unfortunately, its remedy falls far short.

The defect is the so-called “doom loop” between governments and banks. Banks in Europe have preferred to buy bonds issued by their own national governments. As a result, alarm over government finances (typically caused by earlier overborrowing) can infect national banking systems. The new security takes aim at this dangerous concentration of risk by bundling sovereign bonds from different euro-zone countries into a single instrument. The idea is to encourage banks to diversify their bond holdings, so that a fiscal crisis won’t automatically turn into a banking crisis.