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

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.

22 Comments

  • Well done mate, another clear-headed, cracking assessment. The markets are still not fully discounting the dangers EMU, as a whole, now faces. Personly I don’t see how EMU lasts beyond the end of 2011. Also what are the optics of an Italian President of the ECB buying Italian government bonds, as Draghi will likely have to do from the start of his term on November 1st? Can’t imagine that will do down too well with Germans.

  • Hi Yannis. I have a question about the ECB taking on them self the sovereign dept of the member states.

    Does the ECB have the money to pay the maturing donds, before it issues its own bond?

    Thank you

    • The ECB can issue eurobonds in short shrift so as to ensure that its bond servicing needs coincide with the eurobond auctions. Technically it is a mole hill. Politically it is a nighty mountain…

  • WAKE UP CALL LAST MINUTE
    Enlightening Yanis article on Menshevik plan and the PSD principle approach run by our
    EuroZone Elite as a Master Plan. doomed to fail with sole benefit allowing surplus countries to exit the Euro.Lately in German press articles I think “inspired of the supposed Finnish-Greece separate deal” talks about neutralising the DEBT poisioning with
    REAL INSURANCE in order to extend further loans.This as a means to diminish insecurity
    in Financial Markets etc.They suggest best way forward would be EURO BONDS
    secured by REAL INSURANCE like GOLD or other STATE assets.It´s like introducing
    a sort of CDO instrument with asset packages.This would lower short term interest rates
    and lower debt burden for the most affected EuroZone members like GREECE.
    As EuroZone will not voluntarily devalue it´s currency that road to increased GROWTH
    is closed.The Finnish supposed deal point to the lack of insurance to avoid falling in the
    facing abyss crashing the EURO as stated by Yanis.
    COULD the MODEST PROPOSAL concept be integrated with some kind of REAL INSURANCE to further strenghten it´s value and entail a POLITICAL Majority to decide
    implementing a EURO BOND concept instead of continuing along the EFSF path
    ending in ABYSS of EURO.On any condition CDS”Credit default swaps” on this type of
    CDO forbidden in European law! Those CDS caused the final 2008 crash when introduced in NAKED format.In order to enlighten all population I think this Documentary Film
    INSIDE JOB should be broadcasted to the entire population as a WAKE UP CALL!
    OPINION of the many not the few SOLUTION achieved.

  • They try to chew water.
    When they do that wake me up.

    Everybody is asking too much except simplicity and peace.
    If so ,let the euro and the global economy blow the hell up.

  • Yani:

    I think you are way too kind in describing euro-nonsense, mixed with euro-idiocy and wrapped in euro-impotence as a phenomenon worth talking about.

    The Greek crisis started 2-3 years ago when Greek sovereign debt started deviating from its reasonable peg to the German Bundes. Any reasonable attempt by Greece to seek euro-assistance has been met with euphemisms in the form of euro-bank bailouts masked as Greek bailouts.

    The original problem, which was highly and easily containable has spiraled into an issue 20 times or more as potent and thus requiring tons of medicine with huge uncertainty outcome.

    Having completely failed in the “an ounce of prevention is worth a pound of cure” approach, the EU has now only one solution left: namely Eurobonds.

    What we are witnessing now is how a group of certifiable idiots are to gradually come to their eventual senses after they have exhausted any conceivable trick in the book.

    • “when Greek sovereign debt started deviating from its reasonable peg to the German Bundes.”

      What is reasonable? Historically it would be a difference of about 10%+

    • Ten percent interest rate spreads on sovereign debt can be reasonable when the sovereigns have their own currencies and the one currency can ‘slide’, or depreciate, gradually vis-a-vis the other one. But when they are locked together into a single currency, a spread of more than 2% to 3% becomes unsustainable (and therefore unreasonable). The reason, of course, is that when the spreads reach that point, a run on the bonds of the deficit country means that its debt is impossible to refinance. You may argue that the problem is the currency union, and that we should never have had one. But there is no sense is disputing my claim that, within a currency union, reasonable spreads lie within a certain narrow band.

    • I do not understand why the same currency is the key factor when investors decide what to pay for a bond.

      If company A and B issue bonds in the same currency, A is free cash flow rich and B is almost broke. The spready will be 20% or even 50%.

      It is not for politics to decide what the spread is. Afterall we do not live in communist times in Europe, yet.

    • According to your logic, sovereigns are governed by the same rules as companies. Alas, this is not and cannot be so. The reason is simple: A company’s revenues are unaffected if its cost cutting does not affect the appeal (e.g. quality) of its products. This allows companies to recover during periods of slumps by cutting their costs. In sharp contrast, macroeconomies that have sovereign debt which cannot be monetised do not have this luxury when they develop a deficit. A slump will cause a run on its bonds and will push the rate of interest through the roof however savagely they cut their spending – until the common currency breaks down. As proof, compare and contrast Spain and the UK. Spain has a lower deficit and a lower debt-to-GDP ratio than the UK. And yet Spain pays 3.5% more to borrow than the UK (and must, for thins reason, turn to the EU for funds). Why? Because Spain and the UK are not governed by the same economic laws that govern Company A and Company B. In short, unless you grasp the subtelties of macroeconomics, you are bound to minunderstand this Crisis.

    • From the supply side this makes some sense. But somene needs to buy the bonds. Why on earth would an invstor buy a Greek bon for 2% more interest than a German or Dutch bond? He must be crazy or filantropic!

      So the balance must be somewhere in between. Not white, not black. Not like a 40% premium as for broke companies and not 2%.

    • At the moment the bonds are backed by each government and not by the ECB —> the premium is high –> high barrier to borrow more –> good way to control high spender governments

    • I can see why you would want debt separability to be maintained while the euro continues to facilitate the surpluses of Germany et al. The only problem is if debt separability is maintained, then the euro will collapse and with it Germany et al will fall into a hole. In short, you cannot have your cake and eat it…

    • A German collaps it is not my problem. I would rather not have my cake and not eat it then have other people eat it.

  • In the end of the day the tragedy in all this issue is that no matter what solution is (hopefully) found, it will require a deeper (in essence) political integration for which nobody is ready or asked…

    The long term negative implications of a forced economic -political integration might be proved as dangerous as the short term problems which arise from its nonexistence…

  • You attempt to argue that the surplus countries have an “inalienable opportunity,” whatever that is, “to exit the Euro at will.”

    Why did you write that?

    What treaty establishes the right of a country to exit the Eurozone under any conditions, much less “at will”?

    Thank you

    • You are asking an important question. It is the case that the relevant Treaties underpinning the euro’s creation make no provision for a member-state exiting the eurozone. This was an intentional ‘ommission’ in order to shore up the claim that the euro was a permanent fixture. Having said that, if Germany’s Federal Parliament (or indeed Greece’s) were to vote in favour of an immediate exit, there is no Treaty to stop it from doing so. Berlin, to continue with my example, could honour all its liabilities to the ECB and to the EFSF and make a quick exit. The fact that every euro of debt in the eurozone is assigned to a single member state means that Germany knows exactly what it owes and to whom courtesy of being a member of the euro. It can thus pay it back and leave. Of course the same appplies to Greece. So, why am I saying that the surplus countries, e.g. Germany, can leave at a moment’s notice while the deficit ones, like Greece, cannot? For the obvious reason that an exit announcement would cause a capital rush INTO a surplus country and a capital flight FROM a deficit country. While this does not mean that Germany wants (or should want) to exit the euro, it does mean that it can, when the deficit countries cannot. The result is the extraordinary bargaining power of Germany and the rest of the surplus countries. The euro’s tragedy therefore is that, while it is crumbling, the only thing that can stop its disintegration is a large degree of debt homogenisation – the type of homogenisation that will annul the surplus’ countries exit option (by making it impossible to assign every euro of debt to each member state).

  • So it appears that the only way out to a terrible crisis that will leave Europe on the knees is a “jump forward” (The Maoist reference is purely intentional :o).
    We should all be wise enough to do in months what we should have done in the past fifteen years, before and after the Euro adoption.
    Set up a constitutional parliamentary assembly.
    One European government, elected by the people, together with an eu parliament, with full authority on economics and foreign policy. In other words, the United States of Europe.
    No use to say, it won’t happen, and we all end up on our knees.

  • Perhaps the most interesting aspect is that they seem unable to see their own fault lines.

    The only question left is when, not if; their entire edifice will collapse.

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