Why Italy? Why Spain? And why the EFSF’s size does not matter

Italy and Spain are tumbling because one problematic structure (the European Financial Stability Fund, the EFSF) has been conjured up in order to prop up another problematic structure (the eurozone). The result is that both structures are reaching the end of their tether. Enlarging the newer of the two problematic structures (the EFSF) will not make a difference as long it remains… problematic. Italy and Spain, in this sense, are mere casualties of Europe’s determination to retain the EFSF’s structure as is. 

Contagion to the eurozone’s core was inevitable because of a potently toxic ingredient deeply buried inside the EFSF’s funding base; not because of its (admittedly puny) size. While all this has been said before (see here and here), the powers-that-be did not listen, the Crisis predictably intensified, and the time has come to say the same things again, perhaps with a little more analysis added for good measure. [Readers averse to a little algebra and geometry are advised to glance at the cobweb-like picture and jump to the conclusion.]

The toxic ratio within the EFSF’s foundations

A eurozone member-state’s debt-to-GDP ratio is the harbinger of ill winds. Especially during a debt crisis, all eyes are on the size of that ratio and on the nation’s growth rate. If the growth rate of member-states with a high debt-to-GDP ratio falls below a certain level, spreads rise and a run on the nation’s bonds is only a matter of time. Once the run is on, the knee-jerk reaction of introducing austerity compresses GDP growth further thus making the problem worse and the run on the member-state’s bonds fiercer. From that moment onwards, the country either defaults or is bailed out by the rest of the eurozone.

This is what happened, for very different reasons, to all the ‘fallen’ eurozone member-states so far (Greece, Ireland and Portugal) and it is the predicament currently felt in Rome and Madrid (with Belgium and France not far behind).

The creation of the EFSF was forced upon Europe by the eruption of the Crisis. Once Germany accepted that the periphery’s fall would signal the eurozone’s end, the search was on for a funding body that would extend loans to the ‘fallen’ albeit without jeopardising the principle of perfectly separable debts (PSDs). PSD means one thing: Each euro of public eurozone debt, including that incurred to bail out the ‘fallen’, must be assigned to one and only one member-state. In practice, it meant that, to remain faithful to the PSD principle, each EFSF-issued bond contained sliced or tranches of debt and each one of these was the liability of a single eurozone member-state ‘donor’.

A byproduct of this toxic structure was that a new, and rather weird, debt-to-GDP ratio entered our lives inconspicuously. Let me explain. Suppose that of the N member-states, F (e.g. 3, as is the case at the moment of writing) have ‘fallen’ out of the money markets and into the EFSF’s bosom. The EFSF must then finance their debts entirely until the Crisis ends. To do so it must seek loan guarantees from the N-F still solvent member-states. It is extremely easy to show that the contribution (as a portion of their GDP) of the N-F solvent member-states to the ‘fallen’ member-states, let’s call it αF (where the subscript indicates the number of ‘fallen’ states that must be supported) equals some newfangled debt-to-GDP ratio: The numerator is the total debt of the ‘fallen’ and the denominator is the total GDP of the still solvent member-states. (See here for a brief proof.)  The reason I choose to call αF a toxic ratio is that, with every member-state that ‘falls’, this ratio rises even if GDP and debts remain the same. Moreover, every new casualty boosts the toxic ratio αand guarantees that yet another member-state will join the rank of the ‘fallen’. And as if this were not enough, nothing can stop this process while everything else remains the same. Including the potential size of the EFSF. The next section explain this dynamic fully.

The explosive EFSF and its poisonous web

This section must be read in conjunction with the adjacent cross diagram (click here for a pdf of the same diagram). The purpose of any cross diagram is to combine four diagrams in one in a manner that makes it easier on the eye to see the interconnections between its parts. To read this particular cross diagram, please note that all axes are positive. For instance, in the bottom right part of the diagram, a downward movement signifies an increasing α(F). Similarly, in the top left part, a leftward movement signifies an increase in s, the eurozone’s average spreads. Having established these simple conventions, it is time to define our four axes.

Top right diagram: The horizontal axis counts the number of solvent member-states. At the outset, i.e. just before the Crisis set in, all N member-states fell in that category. After the first member-state ‘fell’ (i.e. Greece), the number of solvent member states diminished to N-1 (see the horizontal axis) whereas the number of ‘fallen’ states F (see the vertical axis) went up to one. With every member-state that ‘falls’ we climb one notch up the straight line.

Bottom right diagram: Here we find the relationship between the EFSF’s toxic ratio α(F) and the number of ‘fallen’ member-states F. With every new member-state that ‘falls’, we move to the left of the horizontal axis and α(F) rises along the thick red curve. This simply signifies that as more countries fall prey to the Crisis, and require official bail outs from the rest, the remaining solvent countries are facing a rising α(F): Put differently, the ratio of the debts that the solvent must now guarantee over their aggregate GDP increases even if the eurozone’s aggregate debt and aggregate GDP remain the same (indeed, even if the eurozone’s aggregate debt-to-GDP ratio is constant or falling!).

Bottom left diagram: The new axis added here (that runs from the cross diagram’s centre leftward) is the average of the interest rate spreads (i.e. the average difference of member-state interest rates from the lowest interest rate in the eurozone, i.e. Germany’s) facing eurozone’s still solvent states. What happens when α(F) rises in response to the ‘fall’ of a member state that has recently made the awful transition from being an EFSF donor to an EFSF recipient? The simple answer is: Interest rate spreads rise throughout the eurozone. This simple truth is captured here by the blue curve s(α): E.g. When Ireland ‘fell’, α rose and the markets got more jittery about the capacity of Portugal, the new marginal member-state, to shoulder not only its own debt burden but also the added burden of its contribution to the Irish bail out. Markets, in these circumstances, react (naturally) by pushing up the spreads of still solvent nations with a high-ish debt-to-GDP ratio and relatively sluggish growth. Thus, the positive relationship between a(F) and s in this part of our cross diagram.

Top left diagram: Each member-state has a limit beyond which it cannot refinance its existing debt when the interest rates it is called upon to pay reaches a certain threshold level. This is what happened to Greece in May 2010, to Ireland a few months later, to Portugal in the Spring of 2011 and, soon, to Spain and Italy (which will run out of money in September 2011 and February 2012 respectively). In this, final, part of the diagram, the assumption is that pre-crisis average spreads equalled s0. The other values of s, si, depict the level of average spreads facing still solvent member-state i above which it too ‘falls’ and joins the EFSF list of recipient states.

Let us now use this diagram to answer the original questions: Why Italy and Spain? And why is the actual size of the EFSF immaterial? Let us begin our account at the two points that the diagram marks as starting points: In the top right diagram it is point N on the horizontal axis (corresponding to the initial condition when no member-states had yet ‘fallen’) while in the top left diagram it is the average interest rate eurozone spreads level s0 (on the horizontal axis). For reasons that I shall not discuss here, at some point average spreads began to rise sometime toward the end of 2009. When they reached level s1, this triggered the Greek crisis and, after many trials and tribulations, the Greek bail out of May 2010. Once Greece had fallen, the average contribution of each of the remaining member-states, which hitherto equalled zero, rose to level α1. The result was a further increase in average spreads until s reached s2, thus causing Ireland to ‘fall’. [The reader ought to trace the continuous arrow that begins at s0 (see top left diagram), shifts leftwards to s1, then jumps up until F rises from 1 to 2 (i.e. Ireland joins Greece – see top right diagram), then proceeds to the bottom right diagram pushing α to α2 before migrating again to the bottom right diagram where it pushes average spreads to s3, a level that throws Portugal off the cliff etc. etc.

There are two points to note here, before moving to my concluding remarks:

First, the best we can say about our European leaders is that maybe they had hoped that the gradient of curve s(α) would prove less steep and, thus, might have prevented the cobweb-like explosion from occurring. If so, they ought to have known better. For the slope of this curve is not cast in stone but is predicated upon the psychology of the markets. In view of the gross uncertainty at a global level, to bury a toxic ratio, like α(F), in the foundations of your anti-Crisis apparatus (the EFSF) is to ask for trouble.

Secondly, Germany and the rest of the surplus countries were hoping that the loan guarantees that they were offering to the EFSF would never need to turn into actual cash transactions. This would, indeed, be so if the EFSF had a coherent structure: its very institution would have averted speculative games by market traders and German taxpayers would never have had to cough up the euros associated with the loan guarantees to the EFSF. But, with the toxic α(F) inside the EFSF’s foundations, markets recognise the shape of the cross diagram above. And nothing pleases them more than an opportunity to bet against an official’s incredible threat, promise or prediction. If only for this reason, it was insanity personified to imagine that the α(F) curve might turn out slight enough to help contain the contagion. In short, our leaders ought to have known better.


In its attempt to preserve the PSD principle (the idea that all eurozone debts must be separable and attributable to a single member-state) Europe has conjured up a toxic monster by which to resolve an existentialist Crisis. The monster is of course no other than the EFSF and the Crisis is the negative dynamic that threatens credibly to deconstruct the eurozone. Why is the EFSF a monster that is more likely to destroy the eurozone than save it? Because it is an institution that, remarkably, manages, in the middle of a debt crisis, to boost the ratio of the debts that the solvent member-states must guarantee over their aggregate GDP increases even if the eurozone’s aggregate debt and aggregate GDP remain the same (indeed, even if the eurozone’s aggregate debt-to-GDP ratio is constant or falling!).

In this light, the only surprise that Italy and Spain now find themselves inches from an EFSF program is that many were… surprised by this turn of events. The first reason why their surprise is misplaced is that the EFSF’s toxic cobweb-like structure, which is the root cause of the inexorable contagion, remains intact. The second reason is that the latest Greek bail out (see here for my earlier assessment) puts the existing EFSF under an even greater strain therefore increasing its toxicity (increasing further the gradient of the α(F) curve in the preceding cross diagram). In effect, a flimsy, struggling structure has been assigned an even heavier load. Is it any wonder that the Crisis’ poisonous web is spreading its reach further as if in a bid to catch first Spain and then Italy? 

Most commentators on the second Greek bail out have commented positively on the easier terms granted to the first and hardest of the ‘fallen. They have also made polite noises about the extension of the EFSF’s remit to include a flexible IMF-like credit line for member-states not yet officially ‘fallen’. “If only”, they add woefully, “the EFSF were extended from the current €440 billion to nearer €2 trillion, the Crisis would end.” By golly are they deluded! What they do not seem to grasp is that, in the EFSF’s case, every new task accelerates the process of the eurozone’s unravelling depicted in the preceding diagram. Speculators will not be deterred by a well funded EFSF as long as the explosive cobweb-like structure of the cross diagram is preserved. While it remains in place, more funds for the EFSF is like more rope for the hangman. Italy and Spain, followed soon by Belgium, will be twisting in the wind however well endowed our leaders decree the EFSF should be.

What could undo the EFSF’s toxicity and puncture a hole through its cobweb-like dynamic? The answer is: the removal of the toxic ratio buried inside. Remove that and all will go swimmingly. But to remove it, Germany and the rest of the surplus nations must give up on the PSD principle (the ‘perfectly separable debts’ dictum) and adopt a genuine eurobond backed up by no guarantees from member states. You see, these guarantees are what create the cobweb-like shape of the current EFSF’s dynamic. The fact that the strongest promises to bail out the second strongest who, in turn, promises to bail out the third strongest, and so on, creates the domino (or, to be more precise, the mountaineering) effect.

To stop this negative dynamic on its tracks Europe needs a common eurobond which represents debt taken out on behalf of the eurozone as a whole with no separate assignments of parts of this debt (at differential interest rates and in the face of differential default probabilities) to different member-states. “But then who will guarantee these eurobonds?” I hear the bond vigilantes ask in earnest. Our suggestion, in the Modest Proposal, is simple: If the ECB issues these eurobonds in order to fund the servicing of tranches of member-states’ existing bonds and, at the same time, opens debit accounts for member-states where the latter will make their long term repayments to the ECB (at interest rates reflecting the ECB-issued eurobonds), then the ECB’s sterling reputation in the global money markets (aided by the common knowledge that, in the final analysis, the ECB has the capacity to monetise debts) will ensure that no further guarantees will be necessary: Investors will flock to buy the ECB’s eurobonds and to fund Europe’s debt relief and recovery (especially under Policy 3 of the Modest Proposal).

The next question that, usually, enters the reader’s mind is: If what you are saying is right, why are Europe’s leaders so committed to the current structure of the EFSF? You may, dear reader, logically conclude that one of two explanations hold: Either my argument here is false or our leaders are irrational. Yet the truth is a little more complicated than that and, therefore, a third explanation may be best: My argument is right and our leaders are rational, albeit in a narrow sense of the word. Put differently, their commitment to the awful EFSF reflects a most peculiar form of rational idiocy. My next post will show what this means and how it is possible that idiocy is reinforced, at a pan-European level, by this narrow form of rationality.


  • Your visualisation is quite a masterpiece and shows how an accurate analysis can open up towards a better understanding of the difficulties they have created for themselves. Just like a sound feedback loop; it gets worse as the inputs increase, layer upon layer.

    Only one immediate thought; if the underlying problem is the use of bonds; why not return to the concept that re-set the European economy after WW2; a Marshall Plan using equity capital, rather than loans?

    • Great article. To avoid either a Eurobond or break up of the Euro, don’t you think we may just see more of today – ECB can step in in an unconstrained way as it has started and has no theoretical limits to its capacity to do this (and will attempt to sterlise these purchases)…wouldn’t this be the lesser of evils?

  • All these mechanisms, socialist approaches etc. will not work. People born long before us would agree:

    “It is not wise to defend what one has to give up eventually.” – Niccolò di Bernardo dei Machiavelli, born 1469

    “Political power is never able to suspend eceonomic law.” – Eugen Böhm Ritter von Bawerk, born 1861

    • Dear Knut34,

      I can understand, that you want to have a dispute going, which is fine, but consider, that this blog is one, that discusses Prof.Varoufakis public comments on the current financial crisis.
      So if you don’t like to be considered a “Troll” (http://en.wikipedia.org/wiki/Troll_%28Internet%29) (read this)
      than please care to relate your messages to the blog-entry you are commenting. Your last comment brings you near the notion of an internet troll.
      We are not here to exchange ideologies and world views. This crisis creates a lot of frustration in me and obviously also in you. But let’s try to keep this place free from our emotions. Just try to bring an argument against Prof.Varoufakis article. I would be grateful to you, if you can find a logical fraud in his arguments. That would bring us all further.

    • (A) What else than “socialist approach” could be Eurobonds called?

      (1) Why is this off topic?
      (2) It is exactly the socialist approach that exposes the flaw of the modest proposal: It sounds good in theory, but it never works (moral hazard). On top of that it assumes infinite capacity and stability of countries that actually contribute. This is an exclusive small club: AT, DE, NL & FI. Like in socialism this club will dissolve or go bankrupt if the poor farmers start to rob it.

      (B) The crisis creates zero emotions in me. Getting robbed by others creates emotions.

  • Domino effect in progress, for very different reasons, to all the ‘fallen’ euro zone member-states so far (Greece, Ireland and Portugal) and it is the predicament currently felt in Spain and Italy, with Belgium and France not far behind. It becomes evident that your “Modest Proposal” is the only solution to save eurozone from disaster. Hoping eurozone survives the coming typhoon.

  • It’s really annoying to see that a clear and simple explanation like yours, even a cobweb can be simple, seems like a fringe idea. The mainstream policy in EU cannot be understood under any circumstances. I believe that when some time will have passed, we’ll be able to understand why the european bereaucracy moves along this path today.
    I have a question for you, if you’d be kind to give us some light on this: Are the “periphery” countries really members of the Euro currency after their bonds yields are priced with a huge premium? Could one say that a country ,that has to pay a huge spread over the German rate in order to finance itself, is effectively out of the euro and is just a user of a (foreign) currency just because it has no currency of their own? Are Greece, Ireland, Porugal and the others members of a newly founded zone like the CFA franc?

    • Welcome to reality. Before the Euro the club med countries paid up to 15% interest. Why should this be different if they use the same currency as the NL, AT, DE & FI?

      Individuals with steady revenues streams and frugal spending habits also pay less interest than people with erratic earnings and irresponsible spending. Yes, even if they live in the same country.

      Interest rate should reflect risk. Finally the market has recognized that giving the same currency to moderate irresponsible governments and extremely irresponsible governments does not mean that they have the same level of risk.

  • Excellent illustration of the contagion mechanism, and the debt dynamics in Europe. However, the conclusions about the eventual collapse of the euro and the EU should be mitigated by the fact that Europe is not alone in the world. Speculators target also the US and other markets.

    If such a toxic background existed for the euro, to the extend you describe it, then how to explain its relative strength, or at least its stability, towards the dollar?

    Obviously, there is a “terror equilibrium” between Europe’s and the US’s debt problems, similar to the cold war political equivalent. And we can reasonably expect that, given the universality of the problems, some form of solution will be found for the world debt problem that will not involve the collapse of any particular major currency or market.

    • Chisto:

      As you very astutely pointed out, this is German terror on Europe’s south. And terror begets anti-terror activities. So it is time that the same implements of terror are deployed on the guilty only this time with highly punitive measures to underscore that such terror tactics are highly unacceptable and will be dealth with in the most severe way.

  • This crisis is turning to a complete repudiation of all German positions. It also makes clear that Germany should not have a leadership position in finacial matters because basically it finds herself out of depth on many issues of modern finance. Finally, the Germans have cause considerable damage to more than one eurozone countries and they now need to repay treble damages with punitive interests so that they learn their lesson once and for all. Germany has acted as a monopoly and needs to pay damages as a monopoly.

    • I fully agree: Greece & Portugal should have a leadership position in financial matters. They have shown that they understand modern finance: (a) manipulate balance sheet using off balance sheet vehicles (b) get funding without a business model (c) lie repeatedly to investors (d) when hitting the wall exit with a golden parachute.

  • I mentally have been thinking of this as the inbuilt ‘gamma’ in the European debt problem, so it’s great to see a more formal analysis of it though. nice one

  • “Our suggestion, in the Modest Proposal, is simple: If the ECB issues these eurobonds in order to fund the servicing of tranches of member-states’ existing bonds and, at the same time, opens debit accounts for member-states where the latter will make their long term repayments to the ECB (at interest rates reflecting the ECB-issued eurobonds), then the ECB’s sterling reputation in the global money markets (aided by the common knowledge that, in the final analysis, the ECB has the capacity to monetise debts) will ensure that no further guarantees will be necessary: Investors will flock to buy the ECB’s eurobonds and to fund Europe’s debt relief and recovery (especially under Policy 3 of the Modest Proposal).”

    The above, did not make sense to me when I originally saw it described in the “modest proposal” and does not make sense still as I read it now. If dear Yanis or anybody else can explain this in some relevant context I’d be delighted to read the explanation. Not clear also where ECB’s “sterling reputation” in a new role as eurozone’s proxy bond issuer, comes from. The fact alone that neither the ECB nor any other central bank, has performed that role in the past, should make people pause and provide at least some extra supporting arguments that this will be the case now and how this might be achieved.
    Furthermore, I claim no financial market guru ‘ness or expertise other than just from the point of view of pure self interest in order to defend myself and capital and working from various posts in the field. But when I read allusions that the ECB’s supposed reputation as debt issuer is supported by “the common knowledge that it can monetize debts”, then only the coin clinging sounds of uncontrolled money printing resonates in my head. I can hardly see how this can lure investors to flock into buying this newly printed wallpaper…

    • Dear Mano, let me offer you a simple deal: You will tell me which part of the Modest Proposal does not make sense to you and I promise to try to show that it does. Deal? As for your question regarding the ECB, two simple points: Yes, it is utterly true that the Modest Proposal is asking of the ECB to perform a role that no other Central Bank has ever undertaken. You, rightly, argue that this “should make people pause and provide at least some extra supporting arguments that this will be the case now and how this might be achieved”. Believe me we have taken pause and have written/spoken countless words to offer supporting arguments. The main ones are two: First, the ECB is a unique Central Bank in the history of humanity. It is the only Central Bank that has undertaken to keep a currency going without a counter-part Treasury with jurisdiction over the same currency area. If the ECB is to be (as it has been) exceptional and unique in this sense, we claim that it must also be exceptional and unique as the sole Central Bank that issues eurobonds. Secondly, the ECB does have a sterling reputation in the international markets, as we speak. Question:Will ECB-issues of eurobonds undermine that reputation? Not on your Nelly as long as: (i) the ECB credibly commits to making these issues intertemporally revenue neutral (by charging member-states the cost of long term servicing of these eurobonds), and (b) markets recognise (as they will) that the ECB’s eurobonds are helping stabilise the euro area and constitute no new debt but a form of sound management of existing debt (i.e. a much more convincing debt management method than the current debacle of a European System of Central Banks which covertly finance, with no rhyme or reason, the insatiable debt mountain of eurozone member countries).

      Furthermore, I claim no financial market guru ‘ness or expertise other than just from the point of view of pure self interest in order to defethe nd myself and capital and working from various posts in the field. But when I read allusions that the ECB’s supposed reputation as debt issuer is supported by “the common knowledge that it can monetize debts”, then only the coin clinging sounds of uncontrolled money printing resonates in my head. I can hardly see how this can lure investors to flock into buying this newly printed wallpaper…

    • Dear Yani, you have a deal. Here it goes:
      The most important part that still does not make sense to me is exactly the role you are asking ECB to take in your proposal. Exactly the part as you describe it in the paragraph I quoted in my comment above. I have asked again in this blog here.
      You offer two arguments here that in my view are very weak as presented, in supporting the assertion that the ECB *alone* will be succesful in convincing the markets that it can command low interest rates if it were to issue eurobonds under the scheme that the modest proposal describes.
      I hope we can agree on one thing. The ECB has zero reputation in managing eurozone members’ debt. The sterling reputation that you claim it has in the capital markets may have to do with the degree its role as a central bank that implements eurozone’s monetary policy has been succesful so far. Even if we were to agree that this has been really exceptional, this has nothing to do with its hypothetical reputation in the bond markets as a debt issuer. As far as I know, when the investment public reffers to a government’s reputation in the bond markets, they allude to its ability to be fiscally responsible and its ability to generate revenue through its economy to pay back the bondholders. The ECB has no such track record and in your modest proposal it does not appear to have those elements that would convince the investment public that something new is happening here and that the ECB will be the comander of it. You are presenting the ECB in a role of a facade for the existing and future debt requirements of each member state with no power to enforce fiscal policy upon them(which in turn would assure that member states do not borrow what they cannot repay). You do not present some revenue generating mechanism that could service these eurbonds other than that of the individual borrowers paying back the ECB on time on their bonds. You do not suggest what will happen if a member state in that scheme cannot pay back its debt to the ECB on its bonds. Where will this money come from? Printing money? I don’t thing that this will run along well with the public. You don’t want to now have somebody who borrows money and they have a “money printer” to pay you back right? I would assume that this will destroy the reputation of the whole central banking system as we know it. This is not monetary policy. This is debt servicing we are talking about.
      In your second point, it sounds like you then need to give the ECB all the tools that it will require to really enforce the “sound debt” management you want it to implement. But you haven’t done so yet. I actually agree with that part. But in your proposal, and of course correct me if I am wrong, there is no such mechanism proposed. What you are referring to which I think is the missing link to make your proposal achieve the desired effect is exactly what is missing. A common european treasury assuming fiscal policy over local eurozone member economies.

  • Hey Guys, you have to get serious here with statements about German Terror.
    You cannot even blame them for being reluctant to support profligate countries.
    You cannot blame them for being restrained and considerate the last 10 years,
    while Greece had another corruption party. Well the party is over.

    Although Yannis comes with more interresting and possible viable solutions have you though that what is happening is actually “by design”. Given that the numbers are increasingly non-viable for Italy, and simply put Germany cannot a) bail-out the entire europe or b)lead europe to a new level of integration…. everything that is happening to me points that the days of eurozone are numbered and this is a decision already taken by Germany.
    Instead of providing solution, they are just kicking the can and give some extra time to see if south europe can sort their problems out. If not either them or us are out.

    But this is not necessary a bad thing… as I cannot possible see how can we recover,
    with a currency overvalued by 50-100% for our economy and with ..omg.. rising interrest
    rates in the middle for the worst crisis we’ve ever seen

  • I think the whole illustration is missing a point. Not all countries are insolvent and in the same time. I remember that you also pointed out the difference of liquidity problems with solvency ones. I think, with appropriate definitions (measures) the mechanism will work more like this:

    “N solvent States – M illiquid states – F insolvent states” …..

    as long as as the solvent states can support the illiquid states or as long as the illiquid ones take appropriate measures (which of course, and as always for the euro zone members, here there are of two components: the EU driven and the country level ones) then we can have a perpetual cycling of debt flows, since the illiquid ones can recover more easily and become again solvent. So, basically the illustrated example will work like injecting a new “N” player, with fluctuations, if i am guessing correctly, in between the “endgame” and the “start”.

    Let alone if we add a time dimension which also plays a great role and produces different perplexities.

    Now the process of getting back to solvency condition is different subject matter by itself.

    So, pardon me but let me somehow disagree with this analysis. And for reasons that i cannot explain right now, let me disagree with the PSD as well. My personal view about the this crisis is not if euro will be sustained with its current member states, but the costs of keeping it.

    Yesterday night a debate with moderator and a UK,Italian,German participants debated about current turmoil in Eurozone.
    Prof. Bofinger present Economic advisor to the German Government surely aquinted with Yanis work suggested EUROBONDS as the most adequate solution to avoid the Euro abyss.
    Mentioned a German stance on this subject within a few month meaning implementation
    of the Yanis Modest Proposal with Euro Bonds.It was pityfull German”Peinlich” to hear the
    ugly almost abusive comments from the British participant in favour of desintegration of the
    Fact from Bofinger Europe 4% deficit while in US ca 10% a much worse situation.
    With Modest Proposal Europe comes out ahead of the US Economy.
    Now this seems doomed to happen in light of current Global Financial Turmoil causing
    widening spreads for Italy&Spain as shown in Yanis graph. The final empowerment
    to the Eurozone waits around the corner meaning showdown for abusive speculators and
    harassing Rating Institutes leading the ongoing currency WAR that will strengthen Euro and
    aweaken USD further as crisis diminish.A sort of Kick in the ass on Speculators that default themselfs.This coming German Initiative seals a favour to Europe outstanding since
    WW2.THX Germany.Now paving the way to enforce UNITED FORTRESS EUROPE in the
    GLOBAL scene for years to come.
    The European

  • May i suggest that a typo managed to creep in the footnote? It seems that the last word of the last sentence should be solvent and not insolvent.
    (obviously there is no need to publish this, unless i am wrong)

  • you know, it’s really hard to have any solution when your union requires unanimity, it’s formed of 17 members and every year at least some of it’s decision makers are fretting about elections in their own countries, so they can’t even make up their mind where the glass of water should be without reading 10 polls before…

    and trichet’s right – it’s a political issue. Leadership(if any) should make up it’s mind. And that’s that.

    Your solution doesn’t solve much – if a country has messy finances, it’ll keep on having messy finances, eurobonds or not. Either it can monetize it’s debt/debase it’s currency(kinda hard in a union), either the rest of the union pays up or it has to default. And with eurobonds, case of a default, well… the rest of the union pays up. It’s just stealth pay up, but still pay up. Really, it’s not rocket science…

    With eurobonds, all you’ll achieve is a less than sterling reputation for ecb pretty fast.

    sure, that doesn’t make the efsf less stupid and obviously it just serves to deepen the crisis. But that doesn’t make eurobonds better.

    Even without esfs(and really, it’s not even in place yet, so it’s definitely not because of the future debt it’ll incur – and no, markets are stupid, they definitely don’t think that far – I make money from this on a constant basis) all the countries with problems have messy finances. Either the rest pays up for them or they have to default(or at least… how was that… “selective default”, the modern term for haircut), since they can’t debase. And those without messy finances(Ireland, Spain up to a point) got there by propping up their messy banks… so now they have messy finances.

    The modest proposal is abit disappointing for someone who shifted from economics to maths. I guess you’re fully aware that with the current levels of debt/gdp in all the “pressured” countries, a default might BARELY be avoided with a decent dose of inflation, if not downright hyperinflation(and add France here). The bar is obviously much lower without that option. Either transfer union or break up… rest is can kicking.

    I think union would be better, but that’s a… “political decision”. Not an accountability gimmick. And eurobonds are just a glorified accountability gimmick; ok, at least one that doesn’t deepen the crisis, but that’s about it. Eventually they kick the can further… uhh, guess that’s good?

    • O.K. The first down to earth comment on this economics gimmick!!! Well done!

  • Agree with you all that this is an excellent analysis why shifting debt to other EU countries creates a contagion problem.
    But can Greece and other countries in trouble afford to be dependent of (or wait for) a proper EU level solution?
    Can these countries not initiate steps to stay in control by transforming current national debt and annual deficits into lower risk debt with stable, low interest rates?
    Given their situation these countries might have the key since they really need a fundamental change that creates a much more stable solution for controlling and funding debts.
    Part of that answer might be not shifting debt up but shifting debt down. By pushing debt down to the tax payers fiscally, the private and business assets of all tax payers become a strong collatoral and next to that makes debt transparant to the tax payers. This could become a strong foundation backed up by eurobonds offering additional securities and guaranteeing an interest rate ceiling. This could provide a stable funding structure that leverages nation’s assets and uses EU funding as a safeguard but not as a primary fund. This would be more in line with PSD principle and still leverage EU funding to control capital market interest games.
    Modern financial systems make such shift down feasible and would make tax payers directly accountable in a transparant manner improving democratic oversight over the debt discipline of governments.

  • That the contagion from one country to the other is a viscious circle is undeniable. But how to break out of it?

    If we want to get the private sector involved:

    1) Ban ‘Naked’ Credit Default Swaps immediately in Europe(CDS which do not have to need an undelying bond) – that would end the crisis straight away, as everybody who has CDS now has to buy bonds to cover them

    if that is not enough

    2) Force private sector banks in Europe to buy EU sovereign debt at a fixed interest rate.

    EU secondary market intervention also clearly works – so agree where we want yields for each country, and then get the ECB/EFSF to buy bonds until yields are at that level.

    That takes the pricing power off the market and gives it back to the provider of the product, the EU.

    It has the added advantage that not all the bonds would be priced the same, Greece could perhaps pay a premium of 0.5% over the German bonds, so it would allow the the pricing to reflect the higher risk. But 0.5% is a lot more manageable than current spreads of 15 to 20%

    The huge financial meltdown in 2008 mostly caused by sofisticated WALL STREET
    Engineering still in unwinding mode?”Recomend movie INSIDE JOB with Matt Damon+ YANIS new BOOK”
    Are this just a continuation of the 2008 CRASH? You bet it is!!
    All this debt now surfacing to visibility was prime trigger of the 2008 SUB PRIME meltdown.
    Quick fixes like QE1&2 short to resolve underlying just piling further DEBT.After all
    economic expansion during BOOM years 2005-2007 now a major contraction is halting
    progress in LABOR Markets giving persistant headache to leaders of western hemisphere.
    AUSTERITY word of the DAY! Is this the way out to achieve the NEW NORMAL??
    REFLECTION: West directed huge production to CHINA with WEST raising DEBT to
    enable CONSUMPTION now causing GLOBAL TURMOIL
    Real democracy is claimed in streets of LONDON;MADRID etc.
    The NEW GLOBAL PLAN must include better POLITICAL management of
    the FINANCIAL SYSTEM to elude excessive speculative abuse.
    People want order restored away from CHAOS caused by GREEDY MARKET
    HEDGE FUNDS;BANKS etc.COMMON sense seems huge lacking.
    A Concerned WORLD CITIZEN

  • Dear Yani,

    this is an excellent visualization, indeed. However, to sustain this self-destructive “positive-feedback loop”, the gradient of s(α) needs to exceed a certain critical value in every iteration of the loop. And this critical value is pivotal for the sake of your argument, i.e. that the very structure of the EFSF leads to instability. Therefore, it would be helpful if you could share with us the methodology, data and assumptions you used to estimate the gradient of the s(α) function.

    • It is true that the s(a) function must relatively elastic to the overall dynamic wrt the function linking spreads with s(a). But this is much more likely than not. If you are asking for the data underpinning this diagram, and take an engineer’ approach to it, you have misunderstood both its usefulness and the essence of economic processes. For more on this, you may consult our recent book: Modern Political Economics: Making sense of the post-2008 world, London: Routledge, 2011 (jointly authored with J. Halevi and N. Theocarakis)

    • Working in the field of Computational Economics I’m bound to look at the hard data. However, you are right that the inherent instability of the EFSF structure is still highlighted, even with an elastically quantitative approach.

    • There is no hard data. For unlike engineering and physics, in our diagrams our curves do not correspond to some experimentally reproducible reality. They are mere hypotheses. Take a demand curve. It is a figmment of our imagination – and an unstable figment at that. All that actually exists is a single point (a combination of a price and quantity). The rest depend on untenable ceteris paribus assumptions. In short, our curves are not just difficult to estimate. They are also theoretically impossilble to define. Thus, inestimable!

    Upcoming tuesday Merkel_Sarkozy meeting in Paris seems to be a kick off for
    establishing a preview how to implement the Modest Proposal concept in EUROZONE
    political mindset. A lot of strings attached facing first hand hit countries like GREECE etc
    to be approved by German Government.Now finaly MERKEL fully aware of risks in
    expanding the EFSF rescue fund ending in a last pin fall game with Germany as last Brick.
    Price for taking a no stance piles up to 20-30% or more if EURO cracks.
    Reality catched up with the impossible BIG SWITZERLAND dream.
    In a not to distant past GERMANY tried to expand their REICH twice by MILITARY FORCE
    ending in disaster.NOW EUROZONE hope is with GERMANYS help avoid the financial
    abyss at next corner. A New EUROZONE caractericed by GERMAN design in
    First Financial WAR i Europe won by GERMANYS HELP.
    No question they now all for a UNITED REICH EUROPE
    AAA Rating!

  • Dear Yanis Varoufakis,

    thanks for the article – as you mention yourself in the comments, you are presenting mere hypotheses. Which is pretty much everything that can be said about economics in a day and age where those holding chairs are desperately trying to stuff a reality informed more by mimetic psychology and people trying to drive wedhes into the political system than rational decision making into familiar models. So, saying that all that is pretty much made up (except for a hypothetical logical structure) is a pretty decent approach to the subject, and certainly a step in the right direction.

    There’s two things going on in my opinion: One is “secondary market effects” turning into “primary effects” and driving all actors. I think this is what we’re mostly seeing these days. Attempts to turn rumours into money. So, yes, limiting the amount of potential breakup-points would certainly limited the markets’ ability to make money off of that.

    As for the second thing – if you wonder why there’s no Eurobonds, look no further than at the Greek political behaviour in the run up to the Euro and the time thereafter. Lower interest rates weren’t considered an enormous opportunity but essentially a free lunch. You may remember the statement that there’s no such thing as a free lunch… The implicit guarantee was exploited over time and now Greece is asking again for money they were given from 1995 in form of implicit guarantees. But this time, it’s not only about an implicit guarantee, which we’re dealing with in form of the EFSF right now, but about direct guarantees in form of common debt.

    German economists like Peter Bofinger, one of the main consultants to the German government, argued in a 1994 paper arguing for the introduction of the Euro that a credibility transfer should be carried out as quickly as possible due to the opportunities that opened up through lower interest rates.

    What he didn’t get, apparently, was that, apparently, that the political pressures on the rational actors inside the political economies suddenly being able to borrow much cheaper, would not be able to adjust and deal with the lower borrowing costs responsibly.

    And that’s the problem: after what happened before, and seeing that, indeed, only market pressures, however unfair and overburdening the country, and certainly the wrong poeple within the country, seem to be able to drive the political system into action, what could be a reasonable argument to undertake such an adventure? Given that very palpable record – why should these governments be trusted to adhere to their political obligations now?

    I’m not denying other structural imbalances in the Euro area, let’s call them Lagarde-effect. Or the problem that too much money from the core has created bubbles in the periphery. Or competitiveness effects of currencies, although I believe people arguing that beggar thy neighbour policies would help the European south to an extent that they could grow out of the crisis or that this may help the political system to ease the pain of adjustments, are simply wrong. People will notice the lack of ability to buy smartphones in local currency just as they will notice the reduction on their paychecks in Euros. Beggar thy neighbour has always been a bad policy, and as Germany has demonstrated in the 2000s, internal devaluations are certainly possible.

    In my opinion, all the *actual* imbalance questions need answers, and they should be addressed. But with respect to the question of using Eurobonds to reduce/end irrational market speculations against the internal fault lines, there’s really only one main question that needs to be answered. It’s not technical, it’s not some kind of theoretical delta. It’s not a blue curve.

    It’s the question of how the political economies of countries now under “unfair” market pressures can be trusted to deal responsibly with the effects of a restored larger checkbook that is *only politically controlled*. Red and blue bonds will create similar fault lines, so with Eurobonds, it’s all or nothing. And that requires trusting that those being supported will indeed live up to what’s asked of them.

    If you could answer that question positively, I don’t think there’d be as much opposition in the “donor states”. But right now, no one believes that this can be ensured – which, on the other hand, implies that Eurobonds aren’t primarily instruments to reduce fault lines and unfair, overshooting market pressures, but basically transfers of money to cover the effects of previous transfers of money.

    This is a tricky situation, and everyone interested in a strong, common Europe should work towards solving it. In my opinion, Eurobonds won’t help with economic imbalances. As for their use as a means to reduce the effects of the current financial crisis, I think everyone in favour of Eurobonds – and I’m not saying I’m against them under all circumstances – should focus on answering *that* question, yet, sadly, I haven’t seen anyone doing so. And that includes this article.

  • Dear Yanni, it looks like (as per to date) your prediction of a spiral avalanche breakdown was very accurate in its dynamics.

    However, can you explain why Spain is next in the list, with one of the lowest public-debt-to-GDP ratio in the Eurozone and a fiscal deficit in the order of 0.5%?

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