Pandemic crisis as a catalyst for a common European safe asset

The European Union will soon join the European Stability Mechanism (ESM)/European Financial Stability Facility (EFSF) and the European Investment Bank (EIB) as a major issuer of common European safe assets – low-risk highly liquid assets. After years of academic discussions, it took an unprecedented health and economic crisis for European countries to agree to such large-scale common issuance. In this blog post, we argue that this increased European safe asset issuance will bring benefits to the European economy beyond the direct benefits of financing economic recovery by, for instance, enhancing financial stability, improving the monetary policy transmission, and contributing to the international role of the euro. Luckily, the euro area can reap these benefits through existing supranational institutions such as the ESM, already at work fulfilling this role.

For years, many have argued in academic circles that Europe and, in particular, the euro area, would benefit from the increased size of a common European safe asset, similar to the highly rated bills and bonds that sovereigns and supranational institutions like the ESM/EFSF, EIB, and the EU are already issuing. Until recently, no policy initiative seemed sufficiently mature to result in an agreement that would substantially increase the volume of European safe assets. The pandemic response is changing matters, and the rise in issuance will help to bolster European integration and the European economy in ways well beyond its intended purpose.

First, it will support financial stability by providing an opportunity for European banks to substitute their holdings of national government bonds and bills with the European safe asset. Such diversification will help reduce the spillover of risks between the sovereign and the banking sector, known as the bank-sovereign nexus. Sufficient holdings of such safe assets will also reduce the possibility of destabilising flights-to-safety by investors during crises.

Second, a large pool of European safe assets will improve the transmission of the common monetary policy in the euro area and the functioning of the key short-term financing, or repo markets, making them less fragmented. Using the common safe asset as high-quality liquid collateral and store of value will also facilitate cross-border financial activity.

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