Two challenges to the Modest Proposal Redux

14/01/2011 by

Soon after posting the 2011 version of the Modest Proposal, I received two repudiations: One from a convivial ex banker (whose views have appeared on this blog before) and one from my comrade-in-arms, George Krimpas. Their objections are important and this is why I am posting them here, along with my answers.

From JG (ex banker), 13/1/2011

Yani, thanks for the update. I see a number of problems with your proposal:

Step 1a. It would be impossible to distinguish between sovereign bonds held by private banks from those held by private banks but held as collateral for ECB funding, those bought outright by the ECB, and bonds held by private investors like state pension funds, which are crammed full of the stuff. So the haircut would affect all holders and probably gut the very pension funds and local banks that need to be kept afloat, and also impose winging losses on the ECB itself, calling its credit worthiness into question.

Step 1b. In any case, as soon the idea started to become concrete, there would be a panic selling on the part of everyone, thus driving the price of debt down to the level of the haircut, with no buyer of last resort except the ECB, who would either have to print money or increase its capital – Germany would see this as a put to Germany.

Step 2. Germany and France are opposed, rightly seeing this as driving up their own funding costs. I’m ignorant of the ECB charter, but what makes the US Fed creditworthy is that its backed by the whole US economy and political structure. I’m dubious that this is the case for the ECB (though I might be wrong here). If the ECB is backed just by its own capital, one would need the explicit joint and several guarantees of all member states, which I doubt is feasible. I also the doubt the explicit guarantees of the member states would be worth the paper they’re written on, as sovereigns can’t be sued.

Step 3. Greece can’t even absorb half the funds already earmarked for it. Presumably, you would want the EIB investments to be productive. It would take a very long time for appropriate projects to be designed (by committee of civil servants), approved (by another committee of civil servants and politicians), and implemented (with all the attending public tenders, lawsuits, corruption and  inherent entropy). Years.

Of all of them I am most pessimistic about Greece, because it lacks the supply side friendliness of the Irish, culturally is opposed to the supply side, and has a bureaucracy and political culture that is poisonous to private investment, entrepreneurial growth, venture capital, and competition. GP is trying to prove how deserving he is by lifting the one end of the barbell, but like the good socialist he is, cannot shake the conviction that increasing the governments share of GNP is the solution, not the problem. He has done little, if anything, to assist competition, supply side reform, venture capital formation, or deep seated reform of the bureaucratic procedures and corruption that has to be done.

Addendum: I think I gave the wrong impression in my objections to Point A – the forced haircut of 50%. I do agree there will have to be re-scheduling, and with either a haircut or an extension of maturities with a fixed, and much reduced rate of interest – probably both, but not 50%. Otherwise the new debt maturities will simply allow interest to build up even further. But my main concern is that this be negotiated with all parties and not imposed unilaterally by the administrators of the EU/IMF or Greece, that thought has to be given to the effect on pension funds, and that the new bonds are structured such that they allow a secondary market to develop. It would be a fun exercise to calculate the exchange rate vs. the euro, if Greece had its own currency “the neuro?”, and that currency had been trading at parity with the euro for the last say 5 years, and was now to devalue to a rate which equalized it’s purchasing power parity vs the euro, what the percentage devaluation would have to be. It might be 50% but I would guess around 35-40%.

YV’s response:

Thanks for the comments. A great deal of nourishing food for thought.

On the matter of the extent and precise nature of the haircut, I am not at all dogmatic. It is an empirical matter to work out the optimal level (perhaps 30% would be better, I concede – given that this is the implicit haircut that the ECB is requiring from banks when lending to them in return for their junk bonds). Judging by your follow up email, we seem to be in agreement that a debt restructure is sine qua non. Where we disagree is in your view that it “…would be impossible to distinguish between sovereign bonds held by private banks from those held by private banks but held as collateral for ECB funding, those bought outright by the ECB, and bonds held by private investors like state pension funds, which are crammed full of the stuff.” Simply put, I fail to see this.

Let me explain: I have it on good authority that the ECB knows exactly which bonds it is keeping as collateral on behalf of private banks and which it has bought outright since last May. So, there is no difficulty telling them apart and treating them differently if it so wishes. Furthermore, the bonds held by private investors and pension funds will not be touched if my proposal is adopted – as long as they are held to maturity. Naturally, their value at the secondary market will plummet in accordance to the haircut. But is this such a bad thing? Why should those who want to sell early be guaranteed, by the taxpayer, their capital? Given the severity of the crisis, pension funds and private investors cannot complain if they are guaranteed to get their money back when the bonds mature.

In the original version of the Modest Proposal, I was recommending that an: ” invitation … 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.”

I changed my mind on this in view of the escalation of the flow of liquidity that the ECB is making available without receiving anything even resembling serious collateral in return. The ECB reacts to this reality by giving out loans of no more than 70% of the junk bonds’ face value that it receives as collateral. Bankers cannot at the same time expect to receive public monies from the ECB and complain when the ECB imposes upon them a haircut vis-a-vis sovereign bonds. The problem with the tripartite negotiation that I used to champion, and which you are suggesting, is that god knows what will happen if you put politicians, bankers and central bankers in one room – especially at this juncture. And given that it is quite unnecessary. For example, the ECB could say that continued provision of un-collaterised liquidity (that is, liquidity in return for effectively junk bonds) will continue only if the haircut that the ECB already imposes (around 70%) in these transactions is extended to the sovereign bonds still held by the banks – and passed on to the states in the form of reduced obligations.

Moving on to the ECB-backed bonds, I truly disagree that their issue will increase Germany’s borrowing costs. The current eurobonds issued by the EFSF threaten to do that because they are structured along the lines of a CDO – incorporating different tranches guaranteed by different member states that pay different interest rates and present different risks. Interestingly, even these CDO-like toxic eurobonds are attracting extremely low interest rates at the moment (almost as low that those of the German bonds). This simply goes to show what huge demand there is out there for alternatives to US Treasuries. Imagine if the ECB was  given the green light from the EU Council to issue bonds itself, either through the EFSF or directly, that are explicitly backed by the eurozone as a whole (and not on the basis of different tranches being backed by different countries). Technically this is feasible and legally not too complicated. The interest rates of (genuine) eurobonds would then plummet – perhaps even below the level of German bonds.

On Step 3, your pessimism regarding the EIB is puzzling. Are you seriously assuming that bureaucrats cannot pull off a large scale, truly productive investment program? How did the Marshall Plan get implemented? By market players? And how did China effect its massive public investment program during the past two years?

Though I share your feelings about the poisonous Greek state and its inability to pave the ground for serious investments, it is unfair to generalise at the European level and wrong to remain wedded to an ideological antipathy to state functionaries. Even Greek officials, stung by the current crisis, can be forced to change their spots. Or am I being too optimistic?

From George Krimpas, 12/1/2011 (YV’s answers in blue)

First, with respect to the haircut.  This will no longer fly as nobody is willing/able to get the two sides to sit and have it out.  But asking the ECB to decide on the size of the haircut and particularly on the relativities is asking more than too much.  The one point that is certain to me is that in the judgment of those who matter their banks come first, everything else way away second.  So I think that the restitution of some justice for the crime will have to wait for another day of judgment.  At least, the ECB is providing liquidity with hush-hush haircuts and this will go on until … Weber.

YV: You seem to be in agreement with JG. I continue on my lonely path then. My main point is that the proposed partial haircut is not at all a question of justice or retribution for past bad deeds. It is, rather, sine qua non in the struggle for containment. Eurobonds will, by themselves, not do the trick of significantly reducing the debt mountain. The haircut is of the essence in arresting the freefall. When you say that it “will no longer fly”, you may be right. But this will spell the end of the euro as we know it. So, while I agree that “for those who matter their banks come first”, the very same people, I submit, care even more for the preservation of the euro. Or at the very least, they will realise that they do when its demise becomes imminent. They will then have to find different ways to look after their precious banks (e.g. increase the flow of liquidity even more) while asking them ‘nicely’ to bite the haircut bullet.

Anyhow, the bonds that the banks have passed on to the ECB as collateral have already been discounted by 30%. All that I am proposing is that ECB passes this haircut on to the member-states at the time when the bonds mature. Plus that it makes continuing liquidity to the same banks conditional on the latter accepting a swap of the old sovereign bonds that they still hold for freshly minted ones of a lower face value (by at least 30%). Then, the ECB can accept these new bonds as serious collateral, and refrain from imposing a further haircut itself.

All in all, and as I wrote to JG (see above), bankers cannot at the same time expect to receive public monies from the ECB under conditions that clearly break ECB rules and, at the same time, complain when the ECB imposes upon them a haircut vis-a-vis sovereign bonds. Indeed, the ECB should take in its stride the idea of extending and formalising the haircut that it has already imposed on bonds that it accepts as collateral to all existing sovereign bonds. As a policy it would come to pass without much resistance. Like a hot knife through butter.

Second, the Eurobond plan, which I thought from the beginning as the crux of the proposal.  This is not well thought out.  Whilst claiming, with some constitutional justification, that all national debt up to 60 per cent of gdp is ipso facto European, there is no reason – and no power, to compel individual governments to allow the ECB to abscond with what they owe and with it their debt management policy [although of course some would like to be rid of both to an infinite value].  Instead the ECB can offer to transfer up to 60 per cent and with it to undertake the servicing thereof, financing both capital and servicing with a Eurobond – thus making money.  This is what truly translates national junk bonds into AAA eurobonds.  And this can be justified as monetary not, repeat not, fiscal policy, thus leading toward a proper unification of monetary policy, at least in the absence of federal union.  There is no reason why this shift in debt agency should increase the cost of borrowing to any member country, per contra it will certainly reduce the fear of bankruptcy of any member country.  Strong conditionality is certainly compatible with this shift of agency, which should strengthen the hand of the likes of Scheuble and weaken the hands of the likes of Merkel and of course Issing.  The aim of the game should be to put the horrible special vehicle out of business before it has become entrenched [say, Portugal] and before it has the time to be tested [say, Spain], when it is likely to fail.

YV’ s response: For the life of me I cannot see where we disagree here. The Modest Proposal is not about “absconding with what states owe” but, rather, and as you are also suggesting, it is all about transferring a tranch of old debt equal to the Maastrich-compliant level to the ECB. In this, the Modest Proposal Redux is unchanged in relation to its previous variant – the one you agreed with.

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