Eurobonds without moral hazard can create a new global trade order.
How Europe can fight back against the US trade war by reshaping global trade.
This post outlines a financial and geopolitical innovation that allows the world to transition away from the American-led currency reserve system by creating a new type of sovereign bond with built-in carrots-and-sticks to create a safer asset than the US Treasury bond that is not dependent on any nations’ currency.
But first, let’s look at the stated objective of the US trade war.
Why did the US start a trade war?
The Trump administration has made it clear that it wants to bring back a share of global manufacturing and that it sees the downside of being the world’s reserve currency as the main reason that their manufacturing base has eroded.
Moreover, they believe that this manufacturing base is necessary to underwrite global security which is an argument that has merit which is well argued in the recently published remarks of Trump’s economic advisor.
However, their solution amounts to a form of vassalization where countries that want to be part of the US security umbrella have to either pay tariffs, eliminate their trade deficits with the US or otherwise just outright pay them for security.
The argument is that the US is creating two global public goods that can not be sustainably be created by the US in the future:
1. Underwrite global security including freedom of navigation
2. Provide reserve assets that facilitate global trade
In order for countries to have both available to them, the US is using tariffs as a mechanism to transfer the burden to other countries but it is also open to other methods of burden sharing.
It all amounts to economic distortion in favor of the United States which is in line with America First approach of the Trump administration.
The US wants to externalize the downsides of being the world’s reserve currency
The US is doing this because historically, great powers have failed when they overleveraged as argued by Ray Dalio in the book "Principles for Dealing with the Changing World Order: Why Nations Succeed and Fail"
The US has reached 124% Debt-to-GDP ratio and was well on track to overleverage, however DOGE and its many spending cuts are designed to solve this.
What Trump is doing makes perfect sense… for America.
He wants to keep the US Dollar as the reserve currency while having none of its negative effects and he wants to remain the world’s most dominant geopolitical power.
Tariffs are meant as negotiation leverage to achieve a new big alliance where countries pay the United States for both the privilege of using the dollar and US government debt as reserve currency assets AND pay for the cost of securing the world.
If not, you can still enjoy the US dollar as a reserve asset but your companies will have to pay the tariff.
There’s just one problem
“Having the reserve currency is an Exorbitant privilege” – Valéry Giscard d’Estaing
Other countries really want to be the reserve currency too.
It’s already a privilege because you can borrow money for almost zero cost until you overleverage to the point that the country’s solvency is in doubt.
Central banks are in essence required to hold your sovereign debt because it is used as collateral in global trade.
They are holding the asset in “reserve” for when they have to settle currency-swaps with other central banks.
In essence, this means the world is buying your debt regardless of what you do and the very high demand for treasuries means you pay almost no yield on it on top of your own country’s central bank interest rate.
This means your government deficit spending is almost free and an Exorbitant privilege according to the former French minister of finance, Valéry Giscard d’Estaing.
Trump has, unsurprisingly, been very clear he wants to retain the US Dollar reserve currency status
Steve Marin has argued that the world does not have an alternative and that’s very true. He also argues that the world has no real alternative than to sell to the US consumer, which is mostly true.
Trump wants to have an extremely exorbitant privilege
He essentially wants to make it not only free for the US to raise debt, he also wants other countries to pay it off. Either through tariffs, investment, buying overpriced defense equipment or just by direct contribution to its treasury.
Trump’s vision is having the cake and eating it too: Keep the dollar dominant, keep borrowing costs low, but push the costs of global security and trade imbalances onto others
What alternative do other countries have?
The US is making this bet because they have rightly called that there is no alternative to the US Dollar T-bills today and that the US has such a large share of global trade that they can push countries to accept this new order.
But there is no real reason the US Treasury bill has to be the world’s reserve asset, it’s just that it is denominated in dollars (obviously), very safe (the US is not going to default), extremely liquid (huge market demand) and there is enough US debt to support global trade transactions.
The Eurobond could take its place but it’s not denominated in dollars so it wouldn’t actually help underwrite trade invoiced in dollars.
But first, let’s look at the biggest reason we don’t issue Eurobonds.
How to fix moral hazard in eurobonds
The EU has played with Eurobonds and Mario Draghi has highlighted that trade in the EU would benefit from having a common safe asset.
However, countries like Germany and the Netherlands rightly object to burden sharing with heavily indebted countries like Italy.
Common debt issuance brings moral hazard and cannot be used at-scale like the US 10Y Treasury note is and personally, I think EU countries are way more at risk to overleverage because they are not the reserve currency and have very high debt loads regardless.
That’s where Contingent Convertible (CoCo) Bonds come in.
Contingent convertible bonds are bonds that can convert into other instruments based on a “trigger”. The rules can be automatic and contractually set in advance.
Contingent convertible bonds allows for swapping the bond with other bonds, a good bond supported by the good countries and a "punishment” bond for the badly behaving country
They’re known as CoCo bonds and typically bond buyers price them a bit higher because they see the extra optionality as a potential negative. However, they can be freely defined by the contract binding them and you could perfectly design a CoCo bond that is much safer than a typical bond.
This can be used to “contract away” the moral hazard risk.
Where does the moral hazard come from?
The moral hazard is caused that if a bond is backed by all EU countries that one country could just default on its obligations, leaving the rest to hold the bag in order to defend their reputation.
This is the nightmare scenario, where one country defaults or worse, explicitly starts to rely on the others paying for them.
CoCo Bonds can mitigate moral hazard by punishing the defaulting country
Suppose a bond was issued in 10 parts, and one country defaults.
That means that only 90% of the bond is still performing, however one could use the CoCo to swap the bond into a “good bond” which has a similar fair bond value as if 90% of the money would have been raised. This would be 90% at AAA rating.
The remaining part would have to be replaced at fair bond value of the defaulting country. For simplicity sake, let’s assume the repayment of the principle of their bond will increase by 20%, making it a very high interest bond. (Let’s call it a “Bondage bond” :-)
This means there is no transfer when the country defaults, which eliminates the moral hazard.
Investors are made whole automatically at the ongoing market value and the country bears all the risk.
The buyer of the bond will now be paid 110% on maturity and get more interest but if he wants to sell both on the open market he will have the same fair bond value as the 100% AAA bond he originally bought.
In fact, the good countries could automatically tariff the bad country to repay the bond investors if completely default like Argentina did.
CoCo Bonds can manage default risk by requiring low deficits
It’s not necessary for countries to default in order to be “thrown out” of the bond.
You could set conditions on currency spreads, low deficit spending, …
You could even make extremely harsh punishments for breaking peace and going to war with each other.
CoCo Bonds spread the benefit of reserve currencies to all participating countries
In order for that to work, one have to see that the repayment of the bond can be done in the country’s own currency.
The money raised together as reserve currency assets will have a currency basket but the buyer can chose which currency he wants to be paid in.
The bond can be bought in any currency and this would be the reference currency for regulating the bond payouts
This allows the bond, even when backed by many countries around the world, to have just local currency strengthening effects and not transfer all the currency strengthening effect to the United States.
For example, Trade between India and Indonesia can be backed by such a reserve bond but the payment currency can be Indian rupees. This allows the Indian central bank to buy them in their own currency.
Alternatively, they could buy dollar-referenced bonds but swap the payout currency to their local currencies so that the market value is always denominated in dollars but there is no need to actually hold dollars.
When another country receives the bond as payment, they can swap the payout currency to their own currency at the going exchange rates but always in line with the reference currency.
This avoids the use of the dollar and therefore avoids unnecessary strengthening the dollar.
So why would countries bother buying into such a system?
In essence CoCo bonds come with a huge carrot:
CoCo Bonds allow all participating countries to raise at AAA ratings
In essence it’s a securitized bond where countries who don’t pay get punished harshly so as long as it is a low percentage of the countries’ total outstanding debt acts as a senior tranche in a securitization transaction.
Countries wouldn’t dare to default on their part.
The total amount of reserve currency assets needed is strongly correlated to global trade volume and the countries’ GDP.
They scale from eurobonds to global bonds
As long as the moral hazard is managed and countries can repay in their own currencies into the bond (and potentially have to pay a bit more to cover for FX rate fluctuations) then I don’t see why this can’t work for all countries.
Adding harsh punishment for countries engaging in unfair trade practices would add real teeth to policing trade disputes as well.
Compliance can be enforced through tariffs set by all participating countries to ensure even the most recalcitrant country pays bank the bond holders at fair value.
There are big sticks to defend investor’s wealth and punish bad countries
The system is resilient against bad countries trying to game it.
Artificially weaken their currencies: They will have to pay more as their payment is regulated against the reference currency.
Spending unsustainably: Get kicked out of the system and have all CoCo bonds convert to a new CoCo bond and one bond of your country which has to make up for the entire investor loss by increasing either interest rates or amount.
Tariffs can be used to collect on foreign countries’ debt to make investors whole when a country defaults
Defaulting: All countries part of the system raise tariffs on you to make the investor whole.
And let’s not forget that countries that break the contract would no longer be able to raise debt cheaply.
What can America do?
First, America would lose its reserve currency status which goes directly against what Trump desired.
That would also eliminate the economic adjustment effects they are counting on that externalize the cost of the tariff.
The China tariffs were offset by weaking China’s currency and the US consumer winded up only paying a negligable amount more for the same goods.
The bonds can replace America’s security guarantees to some extent
Significantly less global policing would be needed if countries that break the peace are immediately tariffed and penalized with heavy debt burdens.
That said, the countries most likely to break the peace would probably not participate.
The bonds could be a NATO against war and tariffs
The system could automatically impose tariffs on nations imposing unfair tariffs on any of the members and potentially this can be extended to war scenarios where punishing tariffs are automatically imposed on any nation going to war with a member.
It can be combined with America’s security umbrella
Countries could issue debt through this system and follow the guarantees but also still pay America for security.