A fresh rationale for, and a new variant (Version 2.1) of, The Modest Proposal for Overcoming the Euro Crisis

By Yanis Varoufakis and Stuart Holland, 24th March 2011

Introduction to the new version of the Modest Proposal (to go straight to Version 2.1 of the Proposal, click here)

The response to our Modest Proposal Version 2.0, of 10th March, has been overwhelming with more than 100 thousand downloads within a few days. As if by osmosis, on 21st March George Soros published a piece in the FT in which he adopts two of the three main policies of our Modest Proposal, while strongly hinting at a mindframe consistent with our third policy proposal. So, it seems that, unlike the EU which is persisting on a path heading straight down a blind alley, our proposal resonates nicely with an increasingly widespread consensus.[1]

But there also have been many requests that we clarify its wider analytic and political context, the degree to which it does not imply Treaty changes in the EU, and its technical implications. The result is this post, which draws on our Modest Proposal 2.0 and seeks to deepen and widen its case in such a wider context. Additionally, we have taken this opportunity further to develop the proposal itself. Because the changes are important but not as wide ranging as those that led to Version 2.0, we call the newest offering Version 2.1.

We begin by clarifying the analytic motivation behind all the versions of our Modest Proposal. Needless to say, the current crisis of the euro has been taxing the EU’s leadership greatly. It must be said that, over the past year or so, the EU has moved a long way from its original state of denial that there was something the matter with the design of the eurozone and its basic institutions. Many of the taboos have crashed and burnt, under the pressure of the unfolding euro crisis, and some new institutions have been pieced together in the piecemeal manner that is the EU’s trademark. Nevertheless, we are deeply worried that one taboo, indeed the most debilitating, has not been challenged yet. And that until it goes, the euro crisis will worsen and the European project will continue to unravel, this time under the pressure of not only the economic crisis itself but also of the accompanying political storm from which only xenophobia and the enemies of European democracy benefit.

What is this surviving taboo? It is an unstated assumption upon which the EU’s policy mix for dealing with the sovereign debt crisis (which has been the same over the past year or so) is founded. Economists know it as the ‘crowding out hypothesis’. The idea is simple: As public debt rises, it crowds private investment and expenditure out of the economy; it, effectively, steals the private sector’s thunder, pushes interest rates up and, generally, discourages business and potentially productive individuals from genuine income generation.

The ‘Crowding Out Hypothesis’ behind the EU’s anti-crisis policy mix

To see that this ‘crowding out hypothesis’ lays behind every recent EU policy for dealing with the public debt crisis, consider the EU’s stated objective ever since Greece was ‘bailed out’ last May: To help indebted countries service their debt by lending them large amounts of money (at relatively high interest rates) on condition that they reduce their public expenditure so as to enable the private sector to enter the scene and provide the engine of growth. In other words, the idea is that, as the state drastically recedes (reducing its expenditure and privatising public assets), the private sector will pick up the pieces left behind, rally to the national cause, and over-compensate for the loss of aggregate demand. How is it meant to do that? By generating enough expenditure and jobs not only to replace the losses in employment and investment but, indeed, to create more of each so that the economy re-enters a period of growth (without which the debt to GDP ratio will never shrink).

But is this right? So far, every cut in public expenditure in Greece, Ireland, Portugal or Spain has reduced investment and employment. This would not have surprised John Maynard Keynes who famously pronounced that “[t]he modern capitalist is a fair-weather sailor. As soon as a storm rises, he abandons the duties of navigation and even sinks the boats which might carry him to safety by his haste to push his neighbour off and himself in.” [2] It is a fate that the European periphery is experiencing to its detriment as we speak. The debt-recession combination gets worse, the storm is gathering strength, and the more government expenditures are cut the greater the tendencies of the captains of industry to bail out.

Proponents of the  ‘crowding out hypothesis’ argue that the problem is that the state has not retreated sufficiently. That the medicine will work if the dosage is increased, even if for the time being it causes a worsening of the symptoms. But what are the grounds for such confidence? The first serious proponent of the ‘crowding out hypothesis’ in the postwar era was Milton Friedman. However, his belief in this hypothesis did not extend to periods of mass unemployment and negative net investment. Indeed, he had little to say in favour of cutting public spending or of the ‘crowding out hypothesis’ in periods of recession. To the contrary, recessions require the state to annul the escalating gloom and doom via the expansion of ‘easy money’ that will bolster the psychology of consumers and producers and do battle against the self-confirming, highly recessionary, expectations of entrepreneurs. Without such interventions, Friedman warned, a double dip recession, a second slump even, are in the offing.

To sum up, the EU is assuming that the eurozone is subject to the ‘crowding out hypothesis’. Our leaders do not say so explicitly yet they base every policy move upon it. What are the scientific or even discursive arguments in favour of their veiled assumption? It is hard to answer the question. The thought of John Maynard Keynes does not support the idea that ‘crowding  out’ is a sound hypothesis during a recessionary period. Even Milton Friedman, the main advocate of the said hypothesis, would not have proposed it for a juncture like the one we find ourselves in. So, who would raise their hands in its support? The answer is: Only those who believed before the Crash of 2008 that the private sector is incapable of crashing out like it did in 2008!

In short, the EU is adopting one policy after the other for the purposes of dealing with a major crisis on the basis of a theoretical assumption that is accepted only by economists whose mindset was (and remains) incapable of explaining the crisis. It is a little like employing flat-earthers as navigators on a round the world sailing expedition.

Lessons from the New Deal (that Europe is refusing to learn)

A key historical context is the contrast between what Eurozone governments are attempting now and the 1930s New Deal in the United States of America.  The Roosevelt administration did not seek to put the US economy on a path to recovery by cutting public expenditure. Indeed, when it temporarily sought to balance the federal budget, based on evidence that the crisis had subsided in certain states and sectors of the American economy, recovery stalled and the crisis was back with a vengeance everywhere.

Europe, we are afraid, is about to learn the same lesson the hard way. But there is another, even more crucial, lesson that European leaders must learn: the only way of dealing with a debt crisis during a recession is by restructuring it and by channelling new borrowing toward the mobilisation of investment (public and private). In the US case, this involved borrowing to invest in infrastructure and social projects through US Treasury bills (or bonds). In Europe no such mechanism exists and, alas, none is being debated by our leaders.

At this point, it is important to compare and contrast the two approaches: Europe is forcing upon its surplus states the task of raising (or guaranteeing) loans for the deficit states that are to be used not for investment purposes but in order to repay the quasi-bankrupt banks. Banks whose books are so problematic that they hoard whatever funding they receive, thus behaving like black holes which absorb, and waste, the continent’s economic dynamism.

Moreover, to receive these loans, the deficit states are compelled to cut public expenditure at a time of bleeding firms and burgeoning unemployment. In turn, the accelerating recession causes a greater shift of capital and people from the deficit to the surplus states while, in aggregate, demand falls throughout the Union. Had Roosevelt followed that model, instead of issuing US Treasury Bills to fund the recovery, he would have forced California and the State of New York to guarantee loans for Illinois and Ohio that would be dispensed if only the latter experienced reduced state and federal investment on their territory. It would have been a recipe for disaster that not even Roosevelt’ predecessor (the hapless Herbert Hoover) would have fathomed. And yet, this is precisely what we are witnessing in the eurozone masquerading as an antidote for the crisis.

The natural counter-argument to make here is that EU is not a federal state. Be that as it may, the problem it faces respects no labels. Whether Europe is federal or not, it sports a common currency that binds surplus and deficit states together, with the latter caught up in a vicious debt-recession cycle and the former suffering under the strains of a banking crisis. Our Modest Proposal offers a simple way of cutting the Gordian Knot. Of allowing the eurozone to restructure its public debt as if it were a Federation without having to become a Federation. Policy 1 of the Modest Proposal squares the policy circle neatly and requires nothing more than minimal tampering with existing Treaties. Policy 2 deals with the banking crisis by utilising one of the new institutions (the EFSF now and the ESM after 2013); institutions unfit for the purpose they were ostensibly designed (to lend to the bankrupt states) but perfectly good for acting as a bulwark by which to recapitalise the banks. Lastly, Policy 3 presses the European Investment Bank into service, turning it into the engine of growth and recovery that Europe is missing soarly.

Does the proposed tranche transfer require changes to the Maastricht and Lisbon Treaties?

For reasons that we explained in a recent post (in reply to a point raised by James Galbraith), the answer is negative (if you have read the relevant post, you can skip this section with no loss of continuity). We came to this conclusion after carefully re-reading the various relevant Treaties, from Maastricht to Lisbon. Though not legal experts, we trust that a tranche transfer is allowed, provided of course the political will is there. Our reading of the treaties is that they ban outright two things:

  1. The purchase of member-state bonds by the ECB, which effectively rules out the financing of members states from the ‘centre’.
  2. Cross-financing between member states – the no ‘bail out’ clause which renders each member-state wholly liable for its debts (in association with 1 above)

The point of these two prohibitions was, of course, to preempt any attempts to free ride (that would have inflationary effects) and to segregate fully and unequivocally monetary control from control of member-state budgets. If the ‘letter of the law’ was to preclude direct ECB member state bond purchases and transfers between member-states, the law’s spirit was about maintaining the fabled discipline.

Interestingly, in terms of the ‘spirit of the law’, both objectives have broken down as a result of the crisis: Despite these strict provisions, discipline broke down, the ECB has been forced to purchase bonds (albeit in the secondary markets), the ESM has been empowered to purchase more bonds in the primary markets after 2013 and the Greek deal and the EFSF have been, for some time now, been ‘bailing out’ (admittedly at penal interest rates) Greece and Ireland. In short, the Treaty prohibitions already lay in ruins. Of course our leaders have been very skilful at packaging the EFSF/ESM loans in a manner that allows them to argue that the no bail out clause is respected. But our point here is that the tranche transfer we are suggesting is far closer to both the ‘spirit of the law’ and the ‘letter of the law’ than current practice.

The reason is straightforward: The tranche transfer is neither a bond purchase nor a form of direct financing. If the ECB could create, under current Treaties, a portfolio of bonds purchased in the secondary markets, it can surely create another one in which the transferred tranches will reside. These are not new bonds, they are not bonds purchased by the ECB, and they do not constitute any form of fiscal transfer as long as they continue to be serviced, long term, and, in a fiscally neutral manner, by the member-states.

To recap, Policy 1 of our Modest Proposal (which stipulates a tranche transfer of the Maastricht compliant member-state debt with a parallel issue of e-bonds by the ECB) is far less in breach of the Treaties than both the current ECB assets purchase program and the EFSF shenanigans.

Do we need a common debt agency that issues all euro-area bonds under strict rules (e.g. debt breaks, constitutional amendments and balanced budget conditions)?

No, we do not. Take for instance Lorenzo Bini Smaghi’s proposal to create a European agency that issues centrally all government bonds on behalf of the member-states, in return for strict central control of member-states finances. Given that the EU is not a Federal State, and thus does not feature a democratically accountable Department of Treasury, allowing a central debt agency (possibly under the aegis of the ECB and the Commission) to set the limits of member-state borrowing would be extremely deflationary, especially during a downturn. Given that Policy 1 introduces eurobonds as means of financing only the Maastricht-compliant debts of member-states, and Policy 3 extends the use of these ECB-issued eurobonds only for investment projects that are approved, on strict banking criteria, by the European Investment Bank, there is no need for central control of all borrowing. Member-state borrowing over and above the Maastricht limit will carry its own, market determined, risk premium. Investors then take that risk and that’s the end of the story.

The Political Context

If we are right, exactly why are the European powers-that-be so opposed to policies of the kind included in our Modest Proposal? The simple answer is threefold: (1) Because the surplus countries do not want to forfeit their right of exit from the eurozone (a right that renders them extremely influential, within the EU, at a time of crisis[3]), (2) because of a general reluctance to admit to the true state of their banking sector, and (3) because they find it easier to muddle through rather than to coalesce around a far-reaching redesign of the euro’s architecture.

A further key political context is that, in seeking to placate rating agencies (which famously deemed toxic debt in banks and hedge funds as triple AAA until they proved insolvent), governments are convincing electorates that markets rule rather than that they govern. This poses a major legitimation crisis not only for the future of the eurozone but of democracy itself.  It is no accident, in such a context, that Martine le Pen has overtaken Nicolas Sarkozy in opinion polls in France; a sad fact that caused the French President to bomb Libya at the great cost of restoring a modicum of legitimacy back to the Despot of Tripoli.

The democratic and political deficit that the EU’s policies help expand highlights not only the need for technical solutions (such as we address in the case for a ‘tranche transfer’ of national debt to Europe) but also a ‘learning up’ both from the New Deal and realisation that, while Europe is in a Gordian knot of debt and banking losses, trying to untie it by market-based means will simply not work: Only cutting it will do the trick. The way to cut the knot and stabilise the Eurozone is not by fiscal transfers but by transferring a share of national debt to Eurobonds issued by the European Central Bank.

Our simple point is that member-states are deep in debt while the EU itself had none until the ECB started its bond purchase program last year. Now, at this point, orthodox austerians climb on the rooftops and scream two words at us: Moral hazard! Their point is that, if the ECB takes on its books part of the periphery’s debt, this will give member-states an incentive to lessen their efforts to reduce debt and, in the future, spread the word that they can spend freely with an accommodating ECB picking up the bill(s). Well, this is nonsense. For if the transfer were up to 60% of GDP (as Policy 1 recommends), it would not give the highly indebted countries (e.g. Greece and Ireland) any leeway to indulge morally hazardous profligacy. All it would do is reduce the default risk for the most exposed member states, lower their debt servicing costs, and signal to financial markets that governments have a proactive response to the current crisis, rather than are victims of unelected credit rating agencies.

Moreover, such a ‘tranche transfer’ would not be a debt write-off. The member states whose bonds are transferred to the ECB would be responsible for paying the interest on them, but at much lower rates and in the fullness of time that the ECB can secure for them. By the transfer, the remaining debt held by most member states would be within national SGP 60% limits. For countries like Greece, it would be over this but with a manageable excess next year of 27% rather than 87%. If the objective is to preclude a disorganised Greek default without strangling the country or encouraging moral hazard, Policies 1&2 of the Modest Proposal are a perfect suit.

Yet debt stabilization alone is not the answer to Europe’s political crisis. The eurozone needs to realise its 2008 commitment to a European Economic Recovery Programme by learning up from Roosevelt’s New Deal, whose success gave Truman the confidence to fund the Marshall Plan from which Germany herself got the chance of an astounding rebirth. The key to the New Deal was not debt reduction through cuts and further cuts. The key was borrowing to invest through US Treasury bonds. Interestingly, these do not count on the debt of US states such as California or Delaware. In exactly the same manner, there is no need for the eurobonds (that we suggest as tools for energising the European Investment Bank (EIB) – see Policy 3 of the Modest Proposal) to count on the debt of EU member states.

To those who find fiscal transfers and a fiscal union unacceptable, our message is simple: Net issues of ECB-eurobonds that will (a) partially fund EIB investments into Europe’s recovery and (b) reduce the debt burden of effectively bankrupt member-states neither implies fiscal transfers nor a buying out of national debt nor national guarantees. The EIB, already double the size of the World Bank, has issued bonds for decades without such guarantees. Eurobonds issued by the ECB would, in addition, attract surpluses from the Central Banks of the emerging economies and from Sovereign Wealth Funds eager to diversify out of the dollar.

These modest changes to Europe’s existing institutions would transform the eurozone’s currently debilitating weaknesses into major strengths. Some readers queried the EIB’s significance by arguing that it has a history of funding large scale infrastructure of questionable productive potential (e.g. bridges to nowhere). But even if the EIB has funded some white elephants, it need not do so in the future. In fact, the EIB, since 1997, has a cohesion and convergence remit from the European Council to invest in health, education, urban regeneration, environmental technology and small and medium firms. Since then it has quadrupled its annual lending to over €80bn, or two thirds of the ‘own resources’ of the European Commission, and could quadruple this again by 2020, making a reality of the European Economic Recovery Programme and a New Deal for Europe. The EIB investments that we envisage, matched by globally subscribed eurobonds (see Policy 3), can, in this context, be targeted, of medium scale, and with a view to promoting real value creation that will benefit both the member-state in which they take place and the eurozone at large.


Eurozone finance ministers failed on 14th March to agree how to increase the EFSF bailout fund, needing a new meeting on 21st March only days before this week’s European Council. Today, the Council meets under a cloud  of discord, to discuss Germany’s and Finland’s objections to the fiscal transfers necessary under the EFSF and, post-2013, the ESM. Germany, all of a sudden, is reeling under the pressure of having to put €120bn into the ESM at a time (2013 and beyond) when its ruling coalition wants to be offering the electorate tax cuts. Chancellor Merkel, thus, finds herself in a bind: On the one hand she has agreed to this fiscal transfers and yet, on the other, she cannot mobilise enough support within her government coalition to sign on the dotted line (not to mention the threat she is facing from a constitutional court challenge). Meanwhile in Finland the rise of the xenophobic True Fins party has effectively blocked that government’s assent to the extra cash and guarantees that Finland has committed to the EFSF.

Our main point is that none of this is needed. As argued above, the euro crisis can be dealt with without any fiscal transfers, with no taxpayer-funded bond buy-backs and without even changing the existing Treaties. All it takes is a commitment to end the crisis and to kickstart Europe’s recovery. Our Modest Proposal has a simple purpose: To explain how this can be achieved. And, in the process, to spread hope in what is becoming an increasingly hopeless eurozone. Hope that a rational alternative to the EU’s current policies exists. That the speedy resolution of the eurozone crisis is feasible. Hope that the forces of Unreason, Xenophobia and Discord can be dealt with efficiently and in a manner that unites all of Europe’s progressive forces at a time when the European project is at its most vulnerable.

The new features of Version 2.1  (compared to 2.0)

We have:

  • Re-written the first principle and added a fourth one under the heading Basic principles of a Comprehensive Solution
  • Offered a new rationale for the European Investment Bank’s involvement (which portrays it as the guardian of recovery, in juxtaposition to the ECB which retains its original role as guardian of the common currency – see Policy 3)
  • Added a new rationale for the involvement of the European Investment Fund (see Policy 3).


[1] To that we add the Yuncker-Tremonti proposals, Willem Buiter’s suggestions, and Breughel’s recommendations.

[2] John Maynard Keynes (1932). ‘The World’s Economic Outlook’, The Atlantic Monthly

[3] Presently, and given that every euro of debt currently corresponds to one member-state (with, perhaps, the sole exception of the sovereign bonds purchased in the secondary markets by the ECB), Germany or Holland can up their tent and move out of the eurozone. They, obviously, do not want to do this. But, given the unfolding crisis, the fact that they can do it (unlike deficit countries that are well and truly locked in), gives them inordinate power and authority within the EU decision making units. See this post for more.


  • A couple of remarks, which coming from a non economist as myself might sound simplistic…

    Nonetheless, I believe that the detriments to Germany’s exports in the case of it exiting the Euro (substantial revaluation of a new German currency) are not stressed enough, or the Germans avoid thinking about them.

    Second, in Greece in particular, we have not witnessed much reduction in public expenditure or privatization of public assets, but rather increases in taxes and other measures aimed at increasing public revenue. Hence, the current Greek recession is largely a result of private funds being sucked up by the state, and a psychology driven aversion to any private spending, (on top of banks eliminating most lending for investments). Speaking from my own experience, being an architect, I have clients that, although they have cash, they are either too afraid to invest in construction (halting ongoing construction projects), or are currently spending their funds on paying state fines (τακτοποίηση ημιυπαιθρίων). Hence, once again we are in very particular bind of our own…

    Anyway, just my two cents worth of thoughts.

    Other than that, thank you for your articles, which seem to be one of the few rays of sanity in this country’s dialogue.

  • I was just wondering if one could apply the Policies of your Proposal “locally”: would it make sense for the Greek State to fund the Banks by the 30 billion Euros, as it does, but ask them for a “haircut” on Greek Government Bonds they hold, in return?

    Thank you in advance, and keep up the good work!

    • I am afraid not. Greek banks require more than mere guarantees to be recapitalised sufficiently. And the Greek state is bankrupt…

  • I very much like your references to the New Deal and your proposal of allowing the EU to act as a Federation without being or becoming one. Allow me to add another fine, recent example, that of the results achieved through the TARP program in the US. As I understand, the program is costing the US government much less than initially calculated while also achieving great results. You might wish to read an analysis about it by Robert J. Samuelson, to be pubished in KATHIMERINI – I believe on Saturday, April 2nd -, an article translated by me. Allow me to also ask a simple, yet very complex, question. Why do people, our political leaders, have to reinvent the wheel? That is what it seems they are seeking to do, obviously having learned very little from the past.

    Sincerely Yours,

    Demitra Katramadou

    • Your point, regarding the TARP experience, is quite telling. When it came to replacing Wall Street’s ‘troubled assets’ (aka, their burnt out toxic money), US authorities ride into town all guns blazing and issued the guarantees plus the freshly minted public money necessary for the task. Something similar happened here in Europe, on the sly of course, regarding the same variety of toxic money: The ECB replaced it all, against its own charter, with fresh euro notes (or their digital equivalents). But when it came to publically issued paper (i.e. Greek government bonds and the like), suddenly they baulked. Moral hazard, ‘no bail out’ principles, the ethical duty of the serially profligate… all these fine principles stopped them from doing with the public paper titles that which they had no qualms doing (on both sides of the Atlantic) with their private counterparts. In effect, the culprits who brought us the Crash of 2008 were treated with kid gloves and the states on whom the latter turned for assistance were treated like criminals. Why are our leaders dithering and attempting to reinvent the wheel? I tried to answer that poignant question (at least partly) in this post: http://goo.gl/atuDh