Who is Afraid of Eurobonds?

The current Euro Area policy framework exposes its members to the opposite risks of deflation and high inflation because it does not separate the need for short-run macroeconomic stabilization from the issue of long-run fiscal sustainability. We study a new policy framework that addresses this deficiency. A centralized Treasury issues Eurobonds to finance stabilization policies, while national governments remain responsible for the country-level long-term spending programs. The centralized Treasury can run larger primary deficits during recessions, followed by primary surpluses during expansions. However, following an exceptionally large contractionary shock, the centralized Treasury can coordinate with the monetary authority to reflate the economy and avoid the zero lower bound. The policy acts as an automatic stabilizer and removes the risk of deflation. At the same time, the proposed policy framework removes the risk of high inflation and fiscal stagflation because it does not require suspending the fiscal rules designed to preserve long-run fiscal sustainability.