Further debate on the Modest Proposal for the Resolution of the Euro Crisis

16/01/2011 by

JG, a regular contributor to this blog (see here and here) and ex City of London banker, suggested to me that Step 1 of the Modest Proposal should be rethought in the context of the experience with Brady bonds; the financial instruments US Treasury Secretary Nicholas Brady devised in order to tackle the Debt Crisis of the 1980s (involving mostly Latin American countries, plus Poland and Bulgaria. I remind the reader that Step 1 of the Modest Proposal involves a reduction in the existing debt of eurozone members that is held by cash-strapped banks, those currently kept alive by the ECB. The idea is to make continued ECB support for them conditional on their acquiescence to a direct swap of the old sovereign bonds that they are holding (of Greece, Ireland, Spain, Portugal, Italy, Belgium, even France) for freshly minted ones of a lower value and longer duration. My reaction to this suggestion (that the Brady bonds be looked at for inspiration) follows below. Also, I continue my exchange with George Krimpas on Steps 1 and 2 of the Modest Proposal.

My reply to JG follows: If this crisis were similar to the Latin America 1980s debt crisis, a Brady bond of sorts would have been the obvious instrument to use. But it is not. The main difference here is that the banks are themselves insolvent and kept alive by the ECB. Imagine if in the 1980s the commercial banks holding Argentinean, Mexican and Polish bonds had themselves been bankrupt and kept alive by wave upon wave of Fed charitable liquidity injections (note that Irish and Greek banks have received 230 billion euros in the last year alone in exchange for collateral that everyone knows to be junk). Would the US then go ahead with Brady bonds? Of course not. It would, and should, have demanded that the banks take a direct hit in exchange of continuing Fed support.

The important task ahead in the eurozone is how to target the haircut so that it only affects the insolvent, ECB-reliant, banks. Not the pension funds, or the private investors. In fact, it turns out that this is much simpler than in the 1980s case: The ECB can easily condition continuing liquidity support for the banks on their acceptance of a swap between existing eurozone sovereign bonds and new bonds of a smaller value. Simple and easy. This does not affect the non-bank investors at all (leaving the secondary market if anything more buoyant, as the old bonds will continue to trade under a less cloudy sky) while helping reduce the total amount of debt inexorably. I see no flaw in this at all. And what is wrong with conditionality? If loans to bankrupt Greece and Ireland come with multiple strings attached, why should liquidity for bankrupt banks be unconditional?

Moving on, here is my continued conversation with George Krimpas on the Modest Proposal. Readers are advised to read first the debate’s first part in this post.

GK: The haircut is indeed being done [by the ECB] at the margin, but what a margin!  Need it be formalised and announced?

YV: Absolutely. The point here is that little Greece, Ireland and Portugal and not so little Spain, Italy and Belgium must be given debt relief. This means that their old bonds, both those that the ECB is already holding (on behalf of the bankrupt banks that it is keeping alive) and those kept by the banks (that are only alive because of the ECB’s kindness) must be exchanged with new ones of a smaller face value. That the ECB is lending against them with a haircut is neither here nor there. It is standard banking practice, as Jerry rightly said in a previous communication (click here).

GK: Might this, in removing a future danger of zone-wide unsustainability, not trigger off instead a bout of equally zone-wide unsustainable marginal unsustainability [say, Portugal’s successful auction being blown out rather than assisted by ‘discreet’ ECB secondary market purchases, noting also that the ECB’s naughty behaviour is also hush-hushed by all the powers that be, for now and perhaps forawhile yet.

YV: No, no and no! Portugal’s recent auction was stitched up. It was nowhere near a ‘success’ story. But they could only stitch it up, to buy themselves a little time, because it was tiny. When Spain requires €280 billion from the markets in the coming months, then you will see that there is no way that the ECB can stitch those auctions up in the same manner. It simply lacks the deep pockets to do something of the sort. Anyhow, I think exactly the opposite will happen to what you are suggesting: The markets, mindful of the fact that we are in a grossly unsustainable situation, would take heart following the announcement that the ECB’s haircuts are passed on to the stricken states. At least it will give them hope that the remaining bonds (the ones held by hedge and pension funds) will be more likely repaid.

GK: Your point about ‘them’ wanting the Euro more than protecting their own banks is pertinent].  A confidence trick may be effective despite or indeed because it is a trick.  Our difference may therefore arise from a different attitude toward the absolute size of the current problem:  for me it is no longer a matter of weeks, or indeed days [as would have been the case if Portugal had flopped] but rather months and [invoking your point once again] quarters etc.  The fact remains that European aggregate debt is much smaller than the American equivalent – remember Gavin Davies’ excellent piece on compromise.  So the prospect is to some significant extent a matter of relative stupidity.

Yes, Davies is right. But as long as the eurozone area sovereign debt is distributed in inverse proportion to the capacity to pay, and on top of that we have mountains of bets taken out on defaults, we have the equivalent of the subprime debacle. Come to think of it, that debt problem was puny. The whole subprime black hole was $500 billion. Small fry. Only these were loans sitting on the shoulders of the weakest and, more importantly, there were $8 trillion of bets resting on these very same shoulders. The situation in Europe today is worse. Around €2.5 trillion in iffy sovereign bonds plus another trillion on junk private bank bonds. The recent Portuguese auction, let me repeat, meant nothing. You are probably right to say that the collapse is not days away (given the ECB’s understandable conniving to buy time, delay the inevitable) but I am convinced that it is not too many months off. Unless…

GK: If we agree about the eurobonds then I should be inattentive though not inconsistent.  In the Modest Proposal, the ECB having transferred Maastricht-legitimated national eurozone debt to its books, the servicing of this debt will remain with the country of issue. But, a eurobond to me is that which is united, with the asset and liability side held by the same agency, here the ECB, giving triple A+ status to both capital and interest.  Guaranteeing capital but not interest is certainly a lesser value and the markets will use this to continue the post-domino game [I endorse your transformation of a table-game to a real danger game, I might only have used a sailing metaphor instead – have you ever seen a boat capsizing?].

YV: The Modest Proposal is closer to your thinking than you think. The ECB issues its bonds to cover both capital and interest repayments for the tranches that are transferred to it. The buyers of these bonds get a full guarantee from the ECB, backed by a eurogroup decision if need be. In this sense, the ECB bonds we propose are fully homogeneous, perfectly massif, from the buyers’ viewpoint. But at the same time, when the tranches are transferred, the member states undertake to repay the ECB, on maturity of the old bonds, the original capital plus an interest calibrated to the level secured by the ECB for its own bonds.

GK: The objection may be that this overturns the bail-out clause.  But this is certainly not so, there is no transfer of money involved and none is needed.  It is, rather, a simple application of the principle of central banking, legitimated in practice since Bagehot and beyond.

YV: It is a matter of interpretation. If the member states undertake to repay the capital plus interest to the ECB, there will be no excuse for evoking the ‘no bail out’ clause. Moreover, nothing stops the ECB from issuing a few eurobonds more to cover its costs and even make a small profit by which to expand its own capital. On the other hand, if member states are simply excused these tranches, then the ‘no bail out’ clause will be bandied about and a political consensus will be impossible to achieve.

GK: As a postscript, I would suggest that we see the financial part of the eurozone crisis in terms of great power politics.  Finance within the eurozone and the real world counterpart to this are not a congruent fit. Imbalances among great powers are of course an entirely different matter, the fit is congruent and thus more dangerous.  In our little village in Gaul we must merely seek the intelligent potion.  It may be that, over the past week, I am more impressed by the apparent commitment of all who matter to the euro, though remaining profoundly doubtful as to the ability of Germany to handle her pivotal role and of France to fashion it into a universalizeable doctrine. Forgive and, perhaps, forget,

I agree. This is nothing more than a political tussle. But I also get exasperated at the thought that this is a clash without a (real) cause.  It would be so easy to do as you suggest, with the ECB taking over the whole damn thing (paying back a large portion of the outstanding debt and arranging for a haircut for the remaining amount) in return for a formal mechanism by which the member states’ finances are centrally audited and controlled. It would make perfect sense. But under the constraints of limited intelligence we labour, we cannot even begin to suggest that. Thus, the Modest Proposal that (a) the ECB helps impose a haircut only on bonds held by banks that it is keeping alive (Step 1) and that (b) the ECB issues massif eurobonds so as to help reduce the interest on the remaining debt on condition that the member states repay their full post-haircut capital plus the small eurobond interest (Step 2). But let’s not forget Step 3 either – the need for a new Marshall Plan to be effected through the good offices of the European Investment Bank.

And here I rest my case, for now.

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