Breaking News: No Redemption for Greece, for Ireland or for Europe. And an interesting query regarding the ECB's role under the Modest Proposal

Sad news from the EU summit (that the media are presenting as yet another ‘breakthrough’):

Just  heard the news that our EU leaders are making progress in reaching an agreement on extending the Greek EU-IMF loan repayments by a few years and reducing the interest rates for Ireland by 1%. The possibility of allowing the EFSF to buy bonds is also under consideration by the surplus countries in exchange for the rest agreeing to Mrs Merkel’s sad Competitiveness Pact (click here for Walter Munchau’s explanation of why it is a terrible idea). This would have been excellent news if the euro Crisis were a crisis of liquidity to be dealt with by means of loans on terms that do not turn a liquidity problem into a case of insolvency. But as things stand, in the midst of a crisis that at once (a) is gripping the banking sector, (b) annihilates productive investment in most of Europe and (c) takes it toll on a rising debt to GDP ratio, the news of the EU’s latest agreement is quite hideous.  It assists with the perpetuation of the myth that Europe is caught out in a debt crisis to be solved by offering the indebted better loan conditions, and by buying their bonds, is tantamount to prolonging the Crisis and increasing its long term costs on European prosperity, integrity and democracy. The remedies continue to be more lethal than the disease. Why? Because making the German taxpayers borrow money (or guarantee loans) in order to lend more money to insolvent states, while at the same time ignoring the parallel banking catastrophe and the negative effects of austerity on GDP, is a textbook case of how to deepen the Crisis. Putting out fire with gasoline, as David Bowie once sang.

A query regarding the ECB’s role under the Modest Proposal Version 2.0

Meanwhile, a reader (Manos Makrakis) responded to our Modest Proposal Version 2.0 with a reasonable query: The analogy of the ECB in a US context, he writes, should be the FED and not the Department of Treasury. So, how can we suggest that it issues its own e-bonds? Should that not be the job of a common EU Treasury? How can it obtain ratings from Moody’s , Fitsch, S&P for bonds in its name, and how would it raise the funds to pay back the bondholders? Wouldn’t that change its role as the mechanism of controlling inflation/deflation and printing money? Here is my answer:

Your query is pertinent and potentially insightful. Until the eurozone came into being, every currency union on the planet sported a common Treasury that issued common debt while, as you say, the Central Bank concentrated on monetary policy. The Treasury was answerable to Parliament and the Central Bank was either accountable directly to government or was run as an independent institution subject to its own Parliament approved charter. The problem with the eurozone is that we tried to do things differently: it has an independent Central Bank, whose purpose was meant to concentrate on monetary policy, while debt issues and management are matters left to member-states. Importantly, the member-states are also responsible for their national banking system (which they must bail out in times of trouble). The US equivalent would be to retire the US Treasury while keeping the FED and making the State of California or the State of Nevada responsible for their own debt and their own banks.

What the Crash of 2008 revealed, and the currently unfolding crisis confirms, is that our eurozone’s architecture cannot withstand a massive shock, like that of 2008, without crumbling. Compare and contrast, briefly, Ireland and Nevada. Both were hit badly by the real estate crisis, especially their banks that were left badly exposed to real estate deals gone wrong. The difference is that the State of Nevada did not have to bail out Nevada’s banks. Nor did it have to pay for the unemployment benefits of the hordes of workers who lost their jobs. In sharp contrast, the Irish state had to do both, the result being that a real estate crisis turned into the collapse of the Irish state and the inexorable squeeze of the Irish taxpayer. Taking the analogy a little further, consider the US and EU remedies: In the US, the Treasury sponsored some public investment programs in Nevada and the debt burden involved fell on its shoulders. Meanwhile, the FDIC and other agencies took up the task of bailing Nevada’s banks out. What did the EU do in the Irish case? It forced the Irish state to take on its books large, expensive loans on behalf of the banks and to try to prevent its inevitable insolvency crisis by austerity measures which, alas, cause Ireland’s GDP to shrink. The comparison leaves no room for doubt: The EU medicine is worse than the original disease. And no amount of tinkering with the loan conditions can help change that brutal reality.

In short, all attempts to ‘sort out’ a mess whose causes lies in the euro’s problematic structure by means of loans from surplus to deficits nations, and by member-state bond purchases by the Central Bank, are doomed to the most spectacular of failures. Thus, the EU is facing a stark choice between three alternatives:

  1. Break up the eurozone
  2. Federate
  3. Come up with an innovative solution to deal with a unique problem (which is what our Modest Proposal is trying to achieve).

Since (1) would be catastrophic for all, and (2) is politically less feasible than introducing socialism at a planetary scale by next Monday morning, (3) seems to me to be our only choice. You are, of course, right in saying that in the annals of economic history no Central Bank has played the role that our Modest Proposal has assigned to the ECB (under Policy 1). True enough, the Fed does not issue bonds. But then again, the ECB is unique in economic history in that it is the only Central Bank not to be supported by a common Treasury. So, unique circumstances call for unique solutions.

Come to think of it, there is no reason why a Central Bank, or indeed any organisation, cannot issue its own bonds – as we suggest the ECB should.  The fact that no Central Bank has done so hitherto is a simple reflection of the fact that it has not had to. In the case of the ECB, and in the absence of federation, we believe it can and it must. From a technical point of view, there is no impediment. Anny organisation can issue its own bonds, even you and I can. And once it does, the credit rating agencies will rush to give it a triple-A rating. (Not to mention the fact that it does not really matter if they do. Indeed, the ECB should seriously consider setting up, in association with the European Commission, its own credit rating agency, by which to break up the monopoly of the criminal organisations that have cornered this particular market.)

I leave the juiciest point last: How can the ECB combine its new role, as debt manager, with its traditional role of guardian of the currency’s integrity and supply? The answer lies in the important proviso that the operations we suggests, under Policy 1, are revenue neutral. The ECB simple acts as an intermediary between the international money markets and the member-states. It helps the latter secure loan interest rates for their Maastricht-legal debt. Its e-bonds are paid for to the last penny by the member-states and by swaps with the private banks. In this sense, the ECB keeps its debt operations separate from its monetary policy. Indeed, and this is of interest, the policy we propose is far more in tune with the ECB’s remit than what is happening at the moment: the ECB buying on its own account Portuguese and Irish bonds in the secondary markets in order to prevent the inevitable.

In conclusion, perhaps (though not necessarily) a Federal Europe would be the optimal Comprehensive Solution to the current Crisis. Yet, it is politically infeasible. This is why we call our suggestion a Modest Proposal: because it attempts to simulate a federal outcome without proposing politically suicidal moves toward formal federation. If the price we have to pay for going down that road to a rational resolution is that the ECB adopts new, innovative strategies and functions, so be it.

3 Comments

  • Dear Yani,
    I appreciate a lot your response to my query. It definitely clarifies details of the thought process of your idea that were not directly obvious to me up front.
    I think very few people will disagree that the way the eurozone system has been structured, lacked a clear design that it would have allowed it to efficiently respond to a systemic financial crisis like the one we started experiencing in 2008. Reading up on your response, I cannot help but notice, that your proposal at least on point one, suggests a solution that at least in my view, seems to have a bigger political weight and lesser of a technical one as I think you seem to imply. This means that your proposal would most likely need an amount of effort and political will that would come close to the one necessary to support the construction of a federation which, I totally agree with you, does not appear to be likely to happen anytime soon.
    So if then the ECB acts as an intermediary, servicing debt on behalf of member states in the eurozone, and is clearly prohibited from mixing monetary policy operations with operations in this new role to avoid causing a potentially catastrophic global monetary crisis or to the very least Euro crisis, here’s a question.
    Who/what is the guarantor of this debt then? What is the collateral? You clearly do not want to have the ECB in that role because the ECB can only really create fiat currency and you want to clearly separate the two as I think we agree. So, since you do not have a federal government yet, I gather it will have to be the collective creditworthiness of the economies of the member states it services. Its credit rating would be such as to represent a weighted average credit rating of each state’s participation in the scheme. And in the event that a state failed to pay up its debts, then the funds would have to be raised collectively by the remaining state members (remember the ECB cannot print money to service this debt). If my thought process is correct aren’t we coming back to a problem that is primarily a political in nature with federal government mechanics in place that clearly the current EU scheme doesn’t have?
    Also one more question that is a result of the implications of having the central bank service up to 60% of the GDP of member states government debt. Today the ECB provides liquidity to member states banks by accepting government bonds as collateral. If you have it issue in its name part of this debt, wouldn’t that also imply that banks would not be able to use the same to borrow from the ECB? If yes how would you replenish this lost liquidity and what might be the consequences on inflation?
    You brought up a lot of points in your post and very quickly I want to comment on a couple:
    1. In the US , nor the FDIC not the government bailed out all the banks everywhere. I think the analogies you make to the European problem are not exactly 1:1. Clearly no federal entity bailed out any state banks. Here’s a comprehensive list from FDIC of the banks that failed since 2002 (the majority are after 2008 as you may imagine). They bailed out the big offenders (banks or not) that clearly posed a systemic risk to the US and global financial system after the consequences of letting Lehman collapse. Definitely not state banks.
    2. The European debt crisis is not of the same nature everywhere. In Ireland it was a result of the problems of the banking sector, in Greece the crisis was clearly a result of unmanageable government debt that did not originate in the banking system.
    3. I am with you in terms of punishing, regulating and allowing for more credit rating companies to operate enhancing competition. Though having the ECB (or any other government run organization) setting up an agency of its own that would provide credit ratings on its own bonds I think you start with a good amount of conflict of interest that you’d have to address. I personally would have serious concerns about its ratings.

    Apologies for the length of my comment.
    Best

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