The Modest Proposal in 600 words

17/12/2010 by

I was just asked to prepare a shortened version (600 words) of the Modest Proposal for publication in the UK Government Gazette. Since some of you may be interested in a handier, punchier version, here it is:

It is now abundantly clear that each and every response by the eurozone to the galloping sovereign debt crisis has been consistently underwhelming. The reason is simple: The eurozone is facing an escalating twin crisis but only seeks to address one of its two manifestations – the sovereign debt crisis afflicting many of its member states. This the EU does by confronting the debt crisis with (a) huge, expensive loans to, effectively, insolvent states, and (b) massive austerity drives.

Meanwhile, a second crisis, of equal significance, is spiralling out of control – that of Europe’s private sector banks. Over-laden with worthless paper assets, they constitute black holes into which the European Central Bank (ECB) keeps pumping oceans of liquidity that, naturally, only occasion a trickle of extra loans to business. Moreover, the EU’s policy mix against the sovereign debt crisis constrains economic activity further and fuels the expectation of future sovereign defaults. In a never ending circle, these bilaterally negotiated ‘bail outs’ (e.g. Greece, Ireland) pull the rug from under the bankers’ already weakened legs. And so the crisis is reproducing itself.

Is there an alternative? Yes there is, and one such is sketched out below. It would attack both manifestations of the crisis head on, create the circumstances for Europe’s recovery and, crucially, is immediately implementable under the eurozone’s existing institutional framework (thus bypassing any need for substantial, politically infeasible, Treaty changes).The proposed resolution comes in three steps.

The first step is for an invitation to be jointly issued by the ECB and the EU Commission to (a) the heads of the fiscally-challenged member-states, and (b) representatives of the European banks holding the former’s bonds. In a meeting that would not need to last for more than an hour or two, a deal is brokered according to which the banks swap the existing bonds issued by debt stricken states for new ones with a much lower face value and longer maturity. In exchange, the ECB offers the banks guarantees of continued liquidity for at least five years. The mere announcement of this deal will signal to the bond markets that, while no bondholder will be taking a haircut (except for the participating banks), the European periphery’s debt burden is immediately reduced. Spreads will fall and even banks will be boosted by the news that their liquidity lifeline will last well into the future.

The second step will deflate the debt burden further: The ECB takes on its books forthwith a tranche of the sovereign debt of all member states equal in face value to (the Maastricht-compliant) 60% of GDP. To finance this, it issues EU bonds that are its own liability (rather than by eurozone members in proportion to their GDP). Just like the US Treasury backs its bills, without reference to California or Ohio, so should the ECB back its own eurobonds. (It is high time Europeans were reminded that President Roosevelt did not fight the Great Depression by buying up the debt of California or Delaware, nor by asking them to guarantee Treasury Bills.) Member states thus continue to service their debts but at the lower rates secured by the eurobond issue.

The third and final step seeks to pave the ground for a future of growth with fiscal rectitude: Empower the European Investment Bank to fund, drawing upon a mix of its own bonds and the new eurobonds, a pan-European large-scale eco-social investment-led program by which to put in place a permanent counter-force to the forces of recession in peripheries that keep dragging the rest of the currency union toward stagnation. With this European Surplus Recycling Mechanism in place (without which no currency union can survive for long), it will then be possible to put in place (as the Germans are constantly requesting) mechanisms that enforce fiscal discipline at the member-state level.

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