To the Finland Station: The undoing of the Menshevik Approach to the Euro Crisis

27/08/2011 by

When Lenin alighted on 3rd April 1917 at Petrograd’s Finland Station, a train was set in motion that upstaged, and eventually overturned, the Mensheviks’ plan for an ‘evolutionary’ path from absolute Tsarism to some form of social democracy. Ironically, it took a Finnish social democrat (newly elected finance minister Jutta Urpilainen) to derail once and for all the eurozone’s ‘Menshevik Plan’ for a gradual adaptation to the new realities that the Crisis is spewing out. In what follows I shall lay bare what I term, cheekily, the ‘Menshevik Approach to the Euro Crisis’, its reliance on the Principle of Perfectly Separable Debts (of PSDs), and explain how this Principle turns into an impossibility the dream of turning the EFSF into a European Debt Agency (issuing jointly and mutually guaranteed eurobonds). Lastly, I shall address why the shoddy and unworkable Finnish-Greek side-deal has put paid to this dangerous illusion.

The Menshevik Approach to the Euro Crisis

The original Mensheviks’ mantra was gradualism. Similarly, during our current Euro Crisis, the EU’s ruling elites have been hinting at a gradualist slide into a quite different Europe. They often tell us, in defence of their penchant for stuttering on-the-huff decision making, that this is how Europe progresses: Slowly, it creates new institutions, frequently with the wrong remit, which sooner or later fall into place within Europe’s grand design.

What they really want to say is that, in this Crisis, they began with loans to Greece, then created an EFSF too meek to meet the Crisis’ challenge but, finally, when the going gets really tough, they will not only fund the EFSF properly but they will, to boot, give it a complete makeover turning it into a European Debt Agency that will, in good time, evolve into an eventual EU Federal Treasury (with the capacity to tax, spend, borrow and, crucially, distribute)…

One thing the Euro-Mensheviks do not like to discuss is the centrepiece of their ‘gradualism’, the cornerstone of their peculiar Meshevism: what I term the Principle of Perfectly Separable Debts, or PSDs: Each euro of debt guarantees or loans to the fiscally-stricken member-states must be assigned to one and only one single member-state, so as to preserve the surplus countries’ inaliable opportunity to exit the eurozone at will. The Menshevik approach is about doing all that can be done to save the euro without violating the PSDs Principle. But let us take stock of how Euro-Meshevism reached the point it is at before projecting into the future.

Euro-Mensheviks in Action

  1. At the beginning there was the May 2010 Greek bailout loan: a mixture of (i) an €80 billion high interest EU loan that was split up in tranches, with each tranche carrying its own default rate and corresponding to a single member-state (the PDSs Principle in action); (ii) a much lower interest rate €30 billion IMF loan; and (iii) a swinging austerity program that would, undoubtedly, cause Greek GDP to shrink by at least 10% intertemporally.
  2. A few days later, the EFSF (European Financial Stability Fund) was put together in the form of a ‘special vehicle’ which would offer identical loans (to the Greek one) to member-states that would need them next; in the hope that the very availability such loans would remove the need to extend them. Despite the fact that the Irish and Portuguese loans that did follow [following the twin failures to stop contagion of (a) the EFSF’s creation and (b) the ECB’s €74 billion secondary market Irish/Portuguese bond purchases] had the same structure as those of the Greek bailout that preceded, the EFSF’s activation introduced a highly toxic new ingredient to the crisis: the EFSF bonds, structured as they were in the image of pre-2008 CDOs. Why structure them in a manner that history proved so unrelenting in enhancing existing crises? Why incorporate negative engineering into the very (EFSF) bonds whose purpose was to raise funding to end the debt Crisis? The answer is, naturally, the imperative to preserve the PSDs Principle which, once instilled into the EFSF-bonds, translated into a chain reaction that is currently leading us, with mathematical precision, to the euro’s end. See here for the complete analysis.
  3. Unsurprisingly, the EFSF’s creation and activation (with the Irish and Portuguese loans) did nothing to stop either the chain reaction or the implosion of the original weakest link, Greece. Once it became lavishly clear that the austerity imposed on Greece, in exchange for the May 2010 bailout, unleashed unprecedented recessionary forces that guaranteed a spectacular Greek default of a magnitude worse than that avoided in May 2010, the markets began to extrapolate, with the well known effects on eurozone banks and Spanish spreads. The Eurogroup reacted with the second bailout for Greece, in July 2011, which effectively restructured significantly Greece’s official €110 billion loan (mainly those from the EU), promised a new low interest rate loan from the toxic EFSF, shored up the PSDs Principle (by ingraining in the new deal clauses that created made all new loans in the image of bilateral agreements) and attempted to cover it all up behind the fig leaf of an hypothetical debt roll over for pre-May 2010 debts to the eurozone’s banks. The problem was that, given the EFSF’s toxicity, placing an even greater burden on the EFSF sparked off legitimate fears that Italy and Spain (whose growth had, meanwhile, stalled) would not be able to shoulder their share of the aforementioned PSDs. At that point, Italy and Spain fell through the cracks…
  4. Can Spain and, more poignantly, Italy be propped up without violating the PSDs Principle while, all along, allowing France the extraordinary privilege off remaining the last AAA-basket case economy? I have no doubt that the answer is negative but, equally, I stand convinced that the Euro-Mensheviks will, without doubt, keep trying to square this particular circle by means of three additional moves.

The Euro-Menshevik Master Plan for the Fall of 2011 and beyond

  • Enlarge the EFSF from its current puny size of €440 billion to up to between €1.5 and €2 trillion. The idea here is that such a boost will push Italian and Spanish spreads down long enough. With some luck, growth in these two Mediterranean countries will pick up and the Crisis will have been seen through.

Tragically, this will not happen for a terribly simple reason: The EFSF’s problem, as I keep suggesting, is not its size but its toxic structure that reflects the PSDs Principle. The larger its funding, from the heterogeneous bonds that it floats in the money markets, the faster the chain reaction will reach France’s AAA-rating. And when that happens, Germany will refuse to back the EFSF by committing up to 50% of German GDP to it in the form of loan guarantees.

Are the Euro-Mensheviks deterred by this thought? Do they not foresee this? I think that many of them not only foresee this development but, indeed, they may very well welcome it. Why? Because this will be the moment to make the final move along their gradualist path:2.

  • Empower the EFSF to issue bonds that are homogeneous (i.e. joint eurobonds mutually and severally guaranteed by all member-states at once) thus converting the EFSF into a European Debt Agency.

In exchange for this gross violation of the PSDs Principle, which will be portrayed when the time comes as a last resort policy for salvaging the euro, create (within the newly refurbished EFSF) an Adjustment Board or Directorate which determines which member-state is to receive which slice of the funds drawn from the international markets through this new eurobond. In this sense, the PSDs Principle will have been allowed to die a quiet death only to the replaced by another: The Central Distribution of Refinancing Principle, to be honed and implemented by an unelected body that determines which member-state deserves central refinancing, under what conditions and to what extent.

  • Being true descendants of the original Mensheviks, if pushed to defend the violation of the Bostonian Principle (of No Taxation without Representation), the Euro-Mensheviks will almost certainly argue that the creation of the new Adjustment Board or Directorate will, eventually, become democratically accountable (more likely than not by receiving some approval stamp from the cacophonous European Parliament).

To recap, the Euro-Menshevik gradualist mindset visualises a resolution to the euro crisis that emerges from an evolutionary transformation of the EFSF into a proto-federal EU Treasury that (a) issues eurobonds guaranteed jointly by all eurozone member-states, and (b) passes on the funds thus gathered to member-states in exchange for centralised control of its fiscal policy.

In effect, the Euro-Mensheviks are planning to hold on to the PSDs Principle until they can trade it for centralised control of each member-state’s fiscal policy, labour market regulation etc.

The Finnish spanner in the Euro-Menshevik works

Opposition to the EFSF, to the bailouts it funds, to the very notion of fiscal consolidation and, above all, a staunch defence of the PSDs Principle, have all been hallmarks of conservative forces within the EU. Not so the Finnish demand that Greece auto-insures its fresh loan to Finland (by purchasing AAA-rated securities before it can get a penny from Helsinki). This demand came from the social democratic end of the political spectrum, the party that put Mr Jutta Urpilainen into the Finance Ministry.

Though I have no doubt that the rest of the EU, reflecting Mr Schauble’s strong views on the matter, will prevail upon Finland to rescind its collateral deal with Greece, the damage to the Euro-Menshevik best laid plans has been done. Permanently. The reason is three-fold:

  • First, because the Finns have a point: Given the structure of the EFSF, who will rescue Greece’s, Spain’s, Italy’s etc. rescuers? It is one thing to ask from a small affluent country like Finland to show solidarity toward its fiscally stricken eurozone partners. But it is quite another to ask of it to fall off a cliff; an act that will, in any case, will not help the already fallen.
  • Secondly, Europe cannot have it both ways. We cannot on the one hand stick valiantly to the PSDs Principle while hoping to evolve out of it via an evolutionary path (see my diagram) that will destroy the euro before it converges onto a new federalist principle.
  • Thirdly, Greece’s second bailout is shoddy. No one believes that (a) the Greek state’s bankers will sign up to the dotted line (providing up to 90% of rolled over funds), (b) the Greek state will be able to avoid a default over the next thirty years, and (c) the eurozone’s banks will (given a parlous state that no one is talking about in Brussels) avoid a major new credit crunch that will, inevitably, lead to the derailment of not only the second Greek rescue plan but, indeed, of the whole EFSF bandwagon.

For these three reasons, among others, it is perfectly sensible of the Finnish social democrats to utilise the provisions of the 21st July Greek deal that give them the right to demand not so much collateral from Greece but some legitimate analysis from the Euro-Mensheviks who are running the policy debate with other peoples’ money that the latter will not go to waste.

Summary: The deep flaw in the Euro-Menshevik Plan exposed

While the PSDs Principle remains at the heart of the eurozone’s reaction, gradualism faces a sharp impossibility: The degree of fiscal consolidation that will prevent the eurozone from collapsing is inconsistent with anything that can come out of the EFSF’s gradual transformation into some European Debt Agency. This impossibility may well prove to be the euro’s death knell, as long as the Euro-Mensheviks remain the only serious opponents of the conservatives (e.g. the Bundesbank, Otmar Issig et al) who resist the gradual replacement of the PSDs Principle by some centralised fiscal union. The Finnish social democrats’ gift to us all, perhaps unwittingly, is to illustrate how deeply ingrained the PSDs Principle is within the logic of bilateral deals from which nothing can evolve that is remotely capable of ending the chain reaction whose inescapable outcome is the eurozone’s collapse. In this sense, the Finns are supra-intentionally pointing to the only pressing dilemma in town: Organise the euro’s dismantling or opt for radical yet implementable policies like the ones in the Modest Proposal:

  • Fiscal consolidation by means of ECB-issued eurobonds which will fund a revenue-neutral transfer of the Maastricht-compliant debt of the entire eurozone sovereign debt
  • Forced recapitalisation of the eurozone’s banking sector by the EFSF
  • A pan-European investment-led Recovery Program to be implemented by the European Investment Bank, and co-financed (again in a revenue-neutral manner) by net ECB-eurobond issues.
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