Modest Proposal 2.0, as presented at the European Party of the Left Athens Conference, on 12th March 2011

This post is for those of you who wanted to read my presentation of the Modest Proposal  Version 2.0  at the conference on the Debt Crisis organised by the European Party of the Left, 12th March 2011,  in downtown  Athens. The text follows. (As it happened, a dearth of headphones meant that most of the audience  would not have access to a greek translation. So, I delivered it in Greek, desperately trying to translate my own English speech as I was going along.)

Introduction

This morning, our media were rejoicing with the splendid news that our European leaders, against all odds, struck a deal that will, allegedly, stop the crisis in its tracks.

Did they now? What exactly did they agree on?

They agreed that:

  1. Ireland would get a 1% discount on the interest rate it pays to the EFSF (as long as it ditches its ultra low corporate tax rate).
  2. Fellow basket-case Greece will get a similar discount plus an extension in the period during which it must repay the 110 billion it borrowed from the EU and the IMF.
  3. The EFSF will be empowered to buy a limited number of bonds directly – an admission that Europe’s indebted member-states would, otherwise, have to default come 2013.

In short, our EU leaders are unrepentant.

They continue to behave as if the problem with their May 2010 response to the Crisis – the so-called Greek bail out and the establishment of the European Financial Stability Fund (the EFSF) – was one of detail regarding the loan conditions.

  • As if there is no banking sector crisis that caused the whole disaster in the first place and which has been undermining any attempt to mend things since then.
  • As if this is a Crisis of Liquidity to be dealt with by means of more loans for already insolvent states.
  • As if the toxic financial instruments, like the EFSF, that are used to raise the loan funds, and which contain in their DNA a vicious default dynamic that increases the likelihood of contagion within the eurozone, is the way to go
  • As of the associated massive austerity drives will not reduce the GDP of the nations burdened with these new loans
  • As if the debt-deflationary spiral in the periphery will leave the surplus member-states untouched

For a year now every EU summit, every meeting of the wise and the good, every new institutional fix, every announcement of some ‘final solution’ for the eurozone crisis results in some new policy initiative which leads with saddening precision to nothing but failure after failure.

Today’s announcement is no exception. After a lull, the Crisis will be back with a vengeance. Meanwhile, the investment strike, the drop in living standards, the burgeoning inequalities, towering poverty, the unravelling of the euro’s foundation, all these forces of evil will gather strength, together with their counterparts in xenophobia, divide-and-rule politics, the disintegration of the European ideal.

One weekend in the 1930s Neils Bohr, the famous physicist, had a fellow physicist visiting him at his summer house. The visitor, noticing a horseshoe pinned above the entrance door, playfully told Bohr: “I did not know you believed that a horseshoe could protect you from bad luck.” Bohr, with his usual sharp wit, responded:

“No, of course I do not believe it protects me from bad luck but, then again, my housekeeper tells me that it works even if one does not believe in it.”

Bohr’s reply captures the essence of the EU’s posture during the unfolding eurozone crisis. If you watch television later tonight, take a look at our leaders’ faces. Look at Merkel’s, Sarkozy’s, Papandreou’s expression. Do they look like people confident that their policies will work? I submit that they do not. But, just like Bohr’s housekeeper, they keep living in hope that their policies, their very own horseshoes, may well work even though they do not believe in them.

So, what do we do? We deploy rational arguments to counter this Wall of Obfuscation, this Tsunami of Double-Speak. At the very least, we must use Reason to infuse some optimism into our dispirited societies. And nothing can do this as effectively as a sensible proposal for ending the Crisis. So, here is my offering. Before outlining the three policy proposal that my colleague Stuart Holland and I call The Modest Proposal, a few words on the nature of the beast to be put to the sword:

On the Nature of the Crisis

The eurozone is facing an escalating triple crisis: a sovereign debt crisis, a banking sector crisis and an under-investment crisis

The current policies cause the crisis to be recycled from one realm to the next. Consider what is happening as we speak in the banking sector. Over-laden with worthless paper assets (both private and public), they constitute black holes into which the ECB keeps pumping oceans of liquidity without any strings attached. What happens to that money? It is hoarded. Oceans of liquidity in, a trickle of extra loans to business out.

Consider now the austerity drives, which are the condition for the new loans to the states. Bankers know full well that austerity means a shrinking GDP and that a shrinking GDP means more likely future state defaults.

Moreover, given the EFSF’s toxic architecture, the default dynamics are disastrous. With each country that leaves the bond markets, and seeks shelter in the EFSF, the next ‘marginal’ country faces higher interest rates while the average country’s burden also rises. This is a dynamic from hell. It is like watching a tragic accident happen in slow motion.

Thus, the vicious circle between the neglected banking sector and the debt crisis: The ‘bail outs’ for Greece, Ireland and the rest pull the rug from under the bankers’ already weakened legs who in turn respond with policies that strengthen the recession’s ill winds. And so the crisis is reproducing itself. As Marx taught us long ago, capitalism has a tendency never to overcome its crises but, rather, to recycle them. Well, eurozone-style capitalism has elevated this recycling of crises to the status of an Olympic sport.

Basic principles of a genuine Comprehensive Solution

So, what should the principles of such a truly rational Solution be? We propose three principles:

Principle 1: All three crises (debt, banking and under-investment) must be tackled simultaneously

Principle 2: The emphasis must fall equally on the debt crisis of the periphery and on the potential  (but well hidden) losses of banks that are increasingly dependent on the ECB for their survival. Bank losses and portions of sovereign debts must be cancelled out in a rational and fair manner

Principle 3: German, Dutch, Finnish and Austrian taxpayers should not be asked to shoulder new loans for the insolvent countries. The debt crisis requires a structural change, not more loans to be piled up on already weak shoulders while weakening (with little effect) the stronger ones

The trick, in designing a genuine rational Solution is to strike a fine balance between:

  • the deep, structural changes in the euro’s architecture while
  • proposing policies that can be implemented immediately under the eurozone’s existing institutional framework thus bypassing any need for substantial, politically infeasible, Treaty changes.

Here is what we have in mind:

Policy 1Addressing the sovereign debt crisis

  • The objective here is to restructure the eurozone’s sovereign debt at no cost to the German taxpayer, or to any of the surplus member-states taxpayers but at some cost to the banks that draw liquidity from the ECB without posting creditworthy collateral.
  • The motivating idea is that the ECB helps member-states, at no cost to itself, to reduce their debt. How?
  • Recall that each member-state is ‘permitted’ by Maastricht to bear debt equal to 60% of its GDP. Let’s call this Maastricht-compliant debt.
  • Member-states ought to be allowed to apply to the ECB for a tranche transfer of that Maastricht-compliant debt. These bonds can be registered by their owners with a division of the ECB which undertakes to service them.
  • The ECB then issues its own long term e-bonds. They are its sole liability, with no requirement for any member-state to issue any guarantees or cash.
  • The ECB then open a debit account for each participating member-states in which it begins to pay the ECB back at regular intervals and long term, at low interest rates reflecting those of the ECB’s e-bonds.
  • The fact that the bonds of each participating member-state are registered with a division of the ECB gives the ECB the power to discriminate between bonds held by the bankrupt banks it is keeping alive from other innocent investors, like pension funds. It can, for example, choose to impose a 50% haircut on banks that seeks its assistance
  • This eclectic haircut will reduce the overall debt burden of the eurozone’s member-states at zero cost to taxpayers and without a generalised haircut that would adversely affect pension funds and private investors. Only the bankrupt banks that rely on the ECB’s free money to stay alive will be subjected to a haircut, as they should.

Summing up: Tranche Transfer to the ECB of the Maastricht-compliant debt, ECB-bonds, Fiscal neutrality, selective haircuts on bankrupt banks

Policy 2 – Tackling the banking sector crisis:

  • The purpose is to cleanse the banks of worthless public and private paper assets so as to allow them to lend again to enterprises and households at decent interest rates.
  • The problem, currently, is that if the banks come clean, they will most probably have to declare themselves bankrupt. Thus, Europe’s authorities need simultaneously to lean on them to come clean but also to help them do so.
  • To force them to come clean, we need effective stress tests
  • Then we need compulsory of recapitalisation for banks that fail the stress tests
  • What if they cannot raise the necessary capital? They must be forced to take it from the EFSF in return for shares that the EFSF keeps on behalf of the European citizens. Afterwards, once the cleanup of the banking sector is complete, the EFSF can orchestrate the resale of the acquired equity and thus repay, possibly with interest, its loans and any loans that member-states took out, or guaranteed, on its behalf.

Summing up: Real Stress Tests, and forced recapitalisation financed either by the private sector or by the EFSF in exchange for equity.

Policy 3 – A Recovery Program to counter the under-investment crisis:

  • The first two policies will reduce but not eliminate the eurozone’s sovereign debt and banking sector burdens. Only development and real recovery will do the trick. Thus, the eurozone (especially the periphery that has been in the doldrums for years) requires a productive investment drive. A new Marshall Plan for Europe no less.
  • This is a task well suited to an existing institution: The European Investment Bank – EIB.
  • The EIB has a formal commitment to contribute to both cohesion and convergence, where key cohesion areas include health, education, urban renewal and the environment. Also, it has the capacity to unleash an investment spree on Europe. So, what stops it from doing so?
  • The 50-50 co-financing split between the EIB and the member-state. Note that the EIB’s 50% does not count against national debt but the 50% of the member-state’s contribution, if borrowed, does.
  • At a time of fiscal squeeze, the member-states that need investment more simply lack the money to provide their 50%. Once, however, member-states have debit accounts with the ECB, as we suggested, there is no reason why the member-state’s 50% co-financing of a worthy investment project should not be funded from that debit account against the ECB’s e-bonds).

In summary, we propose co-financing the national component of EIB projects courtesy of the ECB’s e-bonds. A new Marshall Plan for Europe can materialise in this way, focusing on infrastructure, green energy, health, education, urban renewal, innovative, high-risk ventures on behalf of small and medium sized enterprises as well as participatory enterprises that utilise novel networks jointly owned by participating consumers and producers.

Conclusion

Our Modest Proposal outlines a three-pronged Comprehensive Solution to the eurozone crisis:

  • that deals with all facets of the crisis at once
  • that helps cancel out bank losses and portions of the member-states’ sovereign debt, without imposing a general haircut on bonds
  • that requires not one cent of (German) taxpayers’ money
  • that requires no moves toward federation, no fiscal union and no transfer union.

It is in this sense that it deserves the epithet modest.

Three existing European institutions are involved in this:

  • The ECB plays the self-financing role of mediating a restructure of the Maastricht-compliant sovereign debt of member-states and imposes a highly selective haircut on the banks.
  • The EFSF is relieved of the role of dealing with the member-states’ sovereign debt crisis and, instead, acquires the role of recapitalising the banks in exchange for public equity in them.
  • The EIB is given the role of effecting a new Marshall Plan for Europe. By empowering the EIB to fund a pan-European large-scale eco-social investment-led program the EIB will be turned into a European Surplus Recycling Mechanism; a mechanism without which no currency union can survive for long.

In recent months, much ink was spilled in debates about debt buy-back schemes, new loans by the EFSF to indebted member-states, changes in the terms of existing EU loans to Greece and Ireland etc.

The dust that these debates generated clouded our judgment and hid from our vision a simple truth: That no large scale crisis (like that occasioned by either 1929 or 2008), especially one within a currency union, can be overcome by means of loans and other market operations.

Roosevelt did not fight the Great Depression by buying up the debt of California or Delaware, nor by asking them to guarantee Treasury Bills. Our Modest Proposal attempts to apply this simple lesson to the current eurozone institutional design and to recommend politically feasible policies that rationally restructure sovereign debt, effectively deal with our troubled banking sector and promote development in areas that are essential for Europe’s long term well being.

So, to the trillion euro question: Why are our leaders deaf to a proposal like this? The answer is predictable. Unable to comprehend the nature and destructive potential of the Crisis, they are jostling for position.

The heads of surplus countries are worried that a rational resolution will boost their workers’ demands and diminish their own power in the Council of Europe. They also know that to solve this crisis they must lose once and for all the right to leave the eurozone.

The heads of deficit countries, in contrast, fear antagonising their surplus patrons, and their own banks, far more than they fear the crisis.

Bankers are, paradoxically, the only ones who understand, and even wish for, a rational solution like the one I presented. But they would not dare suggest it themselves, lest their banks’ shares plummet immediately.

Over the past year, I have been addressing various audiences. To my initial surprise, my views were welcomed enthusiastically by two kinds of audiences: By lefties for whom being in power is unimportant and bankers, hard core entrepreneurs, the Korean Minister of Finance, rightwing journalists working for the FT or the BBC. In contrast, centrists who are either in power or are craving power treated me like a half crazed idiot. I think that this observation is packed with useful insights.

Last but not least, I think it is important to take a step outside of Europe and look at our continent as if from the outside. Europe may be old and wrinkled but it retains the capacity to damage the rest of the world in profound ways. If we Europeans fail to deal with our ongoing crisis, we may well prove the spanner in the works; especially in view of an ungovernable United States of America finding it extremely hard to regain its poise. We may, I fear, export our unnecessary stagnation, thus causing a new global recession.

Europe has taken the world down with it at least twice in the past century.

If it does so again, it will have been the third time in a century that we will have taken the world down with us. Our collective future will then be a bleak landscape strewn with the corpses of a generalised global depression, indelibly marked by our generation’s failure to meet its social and environmental challenges head on, immersed in the petty antagonisms between peoples and persons who failed to discern their common interest. In history’s austere judgment, we will be blamed for the new, postmodern 1930s that is the most likely product of our dithering.

Both times when Europe brought misery to the world, the Left failed to stop it from doing so. This time, the Left is weaker than before. But, hopefully, we are wiser and can use the power of  reasoning and argument more effectively to expose the gross political failure of our ruling elites. We are, in the end, all responsible for the outcome. Those with power and those without. To quote something that John Maynard Keynes wrote in 1920: Perhaps it is historically true that no order of society ever perishes save by its own hand. Europe proved him right a few years later. I hope the Left plays an active part in proving him wrong now.

4 Comments

  • Dear Mr. Varoufakis,

    Congratulations for your illuminating blog. I follow you from Seville, Spain. In my corner of the world would be very useful translate to spanish your “Modest Proposal 2.0” and other posts, to give to them a bigger diffusion through trade unions and left movements.

    Waiting for permission,

  • Came across your interesting proposal. Although I am not 100% clear, its main elements I understand are:
    1. force banks to take haircuts(& force them to re-capitalise) = reduce part of outstanding peripheral debt
    2. use the ECB to fund up part(up to 60% of GDP) of sovereign debt thus reducing cost of servicing
    3. use the ECB to fund a new ‘Marshall Plan’

    One 1., I think, you are absolutely right. Of course there is the question of the level of the haircut, but that can be worked out.

    On 2., I am not sure I understand the mechanics you suggest, but why not use the ECB as you suggest? True it is nothing but a trick (so that surplus nations do not appear to be burdened), but it is a trick that UK and US have used unashamedly (in their case to fool their taxpayers).

    However, because I believe it is only a trick, it should be used as a temporary tool. Your proposal seems more permanent. My view is that fiat money is a big illusion and a too serious one to jeoperdise in this way. Therefore I would aim to replace the ECB, after things calm down, with a EURO bond.

    Another potential problem is moral hazard. You are dealing with this by imposing a ceiling on the debt ECB can finance.

    An unknown remains with respect to the balance between the 60% limit – and say – Greece’s 120% GDP debt and rising! I would doubt haircuts (limited to banks) deal with all of this. The unknown is whether this balance (+ new deficits) are financeable. I assume that the 60% ECB financing is senior, so whoever finances the balance takes mezzanine-style risk. If they are not willing to do so, you are back to square one.

    On 3., it is where I take the most issue with. Peripheral countries have in fact suffered from over-investment – investment that mostly went into unproductive property investment. I think you are right to see deep recession as a problem, but I am not sure a huge investment drive is what is needed (its a matter of scale).

    I think my disagreements arise from the fact that apart from over-indebted sovereigns (to be fixed by haircuts) the only other problem I see is confidence (lack of). There is no structural issue leading to lack of (reasonably-priced) funding or capital for investment. I think there is lack of confidence – mainly that peripheral countries will manage to stay in the EURO. Solve that, and funding cost/investment will solve themselves.

    Hence, I am more keen on sharp shock tactical moves rather than permanent mechanisms.
    – Haircuts
    – Fiscal consolidation plans
    – followed by ECB embarking on bond-buying (see UK)

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