What the Modest Proposal asks of the ECB: Responses to a reader’s criticisms

06/08/2011 by

Manos Makrakis, a reader of this blog, has expressed strong reservations about the newfangled role that our Modest Proposal assigns to the European Central Bank (see Policy 1). His text appears below in full. Here are, in numbered points, my reply:

1. The Modest Proposal is a Second Best Solution to the eurozone’s problems:

Second Best solutions are proposed when the equivalent First Best solution is unavailable, infeasible or downright impossible. Naturally, European federation and a eurozone Federal Treasury, with the powers to tax, spend and borrow (i.e. issue eurobonds), would be the First Best. But, it is utterly infeasible within the timeframe that would be necessary to avert the eurozone’s disintegration. Thus, the Modest Proposal is recommended as the next best (or Second Best) policy initiative; the only policy mix which is: (a) readily implementable by means of existing institutions (the ECB, the EIB and the EFSF) and (b) capable of ending the process of eurozone disintegration.

2. The ECB’s exceptionalism was a fait accomplis from its inception. The Modest Proposal simply extends its exceptionalism in a manner that is essential for the ECB to perform its, already exceptional, mission

Your empirical point is absolutely correct: Bonds  have never in the past been issued by a Central Bank. Equally, however, no Central Bank has ever been called upon to keep a currency union going without a counterparty Treasury with jurisdiction over the same currency area. Yet, this is precisely what the EU has asked of the ECB: to perform the unique, exceptional, never-tried-out-in-the-past role of safeguarding the euro without a Treasury opposite number. In this light, my response to your criticism that we are asking of the ECB to do what no other Central Bank has ever done before is that Europe has been asking precisely this of the ECBC from its very inception. All we are suggesting is that, since it is, in any case, doing things differently to all other Central Banks in the history of capitalism, then it should do one more thing that will help stabilise the currency union over which it the ECB turns out to be the uniquely responsible EU institution (along with the non-credible Growth and Stability Pact).

To recap, the ECB’s exceptionalism is part of its very existence. Alas, as it stands it renders the currency unstable. To stabilise it it needs to do one more thing: Issue bonds in its own name.

3. The ECB’s reputation vis-a-vis bond issuance

You write: “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 successful so far.” Correct. But this is the beauty of a strong reputation. If Apple all of a sudden markets a new video projector, a device over which Apple has no track record (and thus no reputation per se), its overall reputation will put it in good stead with video projector buyers. The question, therefore, is not whether ECB-issued bonds will find buyers but whether they will, in the long run, prove a good investment (just as in the case of Apple’s hypothetical video projectors the issue is whether they will prove to be decent projectors that preserve, as opposed to jeopardise, Apple’s good name.

 4. How well will the new ECB eurobonds fare once issued?

The reputation of the ECB as a bond issuers will depend on two factors, only one of which you mention: The extent to which (a) a liquid, buoyant market will ensure that the ECB-bonds will create a self-maintained momentum that is comparable to that of US Treasury Bills, and (b) the ECB will be able to enforce repayments to itself by the eurozone’s member-states whose Maastricht-compliant debt has been transferred onto the ECB’s books.

Starting with point (a), which you skipped, there is little doubt in my mind that were the ECB to issue bonds of a face value that, ultimately, tends to 60% of the eurozone’s GDP, the new bond market’s liquidity will be precisely that which is necessary in order to create a self-perpetuating market and one, to boot, which helps the euro turn into more of an international reserve currency (albeit without challenging the dollar’s position) than it already is.

Moving on to point (b), which is troubling you, the following point needs to be made: While nothing stops any country, in theory, from defaulting on its international obligations, it is impossible to imagine that any eurozone member-state will choose to default on its long-term debt to the ECB (for this is the spectre that you raise as an argument against the Modest Proposal). The reason is simple: Doing so would, in effect, cut it off from eurobond financing of its investment programs via the EIB (see Policy 3 of our Modest Proposal). It would constitute an act of economic suicide. “What if a member-state, like Greece, finds it impossible to service its debts?”, I hear you ask. Well, even in that case, debts to the ECB (accrued because of the tranche transfer we propose) will be repaid even if a member-state defaults on its obligations to others. For you must not forget that the Modest Proposal decrees that only the Maastricht compliant debt is transferred to the ECB (and financed through ECB-issued eurobonds). The rest is the responsibility of the member-state. If a default occurs, it will not affect the member-state’s obligations to the ECB.

At this point, it is helpful to note the following: First, the last point amounts to super-seniority for the member-state’s debts toward the ECB. Secondly, this is no different to how the IMF, or indeed the EFSF, currently binds borrowers to a commitment that their monies will be returned first, in case of a default. Thirdly, under the Modest Proposal a default to third parties will be highly manageable (unlike now).

To recap, you chastised the Modest Proposal for not specifying the mechanism by which the ECB will ensure that member-states will repay their debts to it, thus ensuring that the eurobond issue is revenue neutral from the ECB’s perspective. My response is twofold: First, there is an inbuilt incentive mechanism within the Modest Proposal (Policy 3) and, secondly, these are solved problems (for if the EFSF can enforce its terms and conditions on member-states under EFSF programs then the ECB can do so far more powerfully).

5. The limits between monetary and fiscal policy and the former’s credibility under the Modest Proposal

At some point you write that the role we assign the ECB goes beyond monetary policy and spills over into ‘debt servicing’. Here we must agree to disagree on what a Central Bank really does (besides the rhetoric). As Mr Bernanke, and even Mr Trichet, have so vividly demonstrated, the limits between monetary policy and debt management are bound to be blurred, especially so during a Crisis (like the present one). When Central Banks buy bonds on the secondary market, as they have been doing with aplomb, what exactly are they doing? Is it monetary policy? Is it debt management? I submit to you that carrying out their monetary policy task is impossible without indulging in a degree of debt management. For if they were to abstain from the bond market at a time of crisis, the very currency that they are the guardians of will be put under great strain. Monetising debt is, and has always been, part of what Central Banks do at poignant historical moments.

From this perspective, the Modest Proposal is proposing a path that is more, rather than less, ‘conservative’, from a monetarist perspective. Without the ECB-issued eurobonds the Crisis continues to progress, the eurozone unravels, and the ECB is forced, kicking and screaming, to use its own meagre resources (backed up bby the prospect of printing money) to buy bonds as if there is no tomorrow. And since this is ineffective as a means of combating the crisis, this unfunded ‘debt management’ continues without rhyme, reason or limit. Compare and contrast this to our proposal: The crisis is arrested by an ECB that performs the same ‘debt management’ task within strict limits (up to but no more than 60% of eurozone GDP) and in a fully funded manner (as it presses into the service of debt management the capital of Chinese/Norwegian Sovereign Wealth Funds, private investors globally etc.)

In short, it is illusory to think that Central Banks do not delve in debt management. They do. What distinguishes monetary from fiscal policy is not that the Central Bank never touches the ‘filthy’ debt of the sovereign but that it does so  only in the secondary markets. The beauty of the Modest Proposal is that it allows the ECB to do what it is already doing in a fully funded manner (thus averting the inevitable money printing which is now the order of the day) and in a way that actually helps arrest the Crisis (which the current open ended, unfunded money printing has singularly failed to do).


Manos Makrakis comments, which gave rise to the text above, follow:

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.

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