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A reply to Kantoos Economics on the merits of the Modest Proposal

28/05/2012

Kantoos Economics recently honoured me with an invocation to its readers to read my musings on the Euro Debacle, and to judge them critically. I thank Kantoos Economics for a simple reason: The one precious lesson that 1929 ought to have taught us is that after a Wall Street catastrophe, which is followed by a world recession, two things tend to ensue – first, the painful fragmentation of common currencies (the Gold Standard then, the euro now) and, secondly, a Hobbesian war of all against all. Already we notice (even in the pages of my personal blog), that our economic woes are turning one proud people against another. Germans point the finger at Greeks, Greeks dig deep into the memory bank to portray Mr Schauble as a Nazi (when the Nazis are in our Athens Parliament!); soon the Greeks will turn against the Greeks and, yes, the Germans against the Germans. A well meaning dialogue between Europeans whose top priority is to arrest this Crisis is the only, and best, solvent of this debilitating tension.

Let me now turn to Kantoos Economics’ (KE hereafter) critique of our Modest Proposal. First, I note with considerable satisfaction that KE is in agreement with our Policy 1 regarding bank recapitalisation. However, regarding Policy 2, KE is unimpressed by our suggestion that the ECB acts as a go-between member-states and international money markets (through the issue of ECB-bonds). I shall quote verbatim KE’s objections and try to address them directly:

In essence, Yanis says that jointly and severally guaranteed Eurobonds are not the answer because they involve transfers from core to periphery taxpayers.

My point is a little more… pointed than this. It is that not only does it involve transfers but, to boot, that these transfers are inefficient. Jointly and severally guaranteed eurobonds are a little like an inefficient water mains that spills a lot of water before it gets it to our homes. The reason is that, given the markets’ tumult, when a bond is guaranteed jointly by, say, Germany and Portugal (to give a simple example) market players will be more put off by the mention of Portugal than they will be attracted by the ‘news’ of Germany’s backing. As a result, the interest rate that such a bond will fetch will be, for a given degree of true ‘risk’, too high for Germany and not low enough for Portugal.

[Yanis] claims that he has found a way around this, by having the ECB issue bonds on the member states’ behalf, have the states pay off their debt at the ECB, and have the EFSF/ESM guarantee the losses of the ECB “in the remote case that some members do not redeem its bonds in the distant future”.

Permit me to put this a little more accurately. First, we do not propose a blanket servicing of the member-state’s debt by the ECB. Our proposal concerns only what we call the Maastricht-compliant part of the member-state’s debt. This is important because it answers the moral hazard concerns of many and puts an upper bound to the ECB’s obligations under our scheme. In short, member-states only receive the ECB’s assistance regarding the debt that they were ‘allowed’ to have by the original Maastricht Treaty. All other debt is excluded from the ECB-debt conversion that we are proposing.

Secondly, the ECB services the Maastricht-compliant part of each maturing bond of member-states by issuing its own ECB-bonds and, simultaneously, opening debit accounts for the participating member-state into which the latter must repay, in the fullness of time, the money necessary for the ECB-bonds to be redeemed. Member-states that opt to participate in this ECB-debt conversion scheme do so under certain conditions. Not willy-nilly. One condition is that the member-state signs a binding contract with the ECB that their debt to the ECB (to the debit account mentioned above) will have super-seniority status over all other liabilities. Other conditions may be added so as to maximise the debt conversion’s credibility; e.g. member-states may be asked to make annual, or even quarterly, payments into their debit accounts over the 10 or 20 year period that leads to the maturation of the ECB-bonds issued on their behalf. That way, the repayments are smoothed out, amortised even, and the probability of default by the member-state to its ECB debit account tends to zero.

In other words, even if Italy or Spain were to default in 10 or 20 years time (when an ECB-bond issued on their behalf matures), they would have to default on all other creditors (e.g. holder of government bonds that were not converted by the ECB, since they were part of the ‘red’ debt that was not eligible for the ECB’s debt conversion) before failing to pay their debt back to the ECB. And even then, the shortfall will only be a small fraction of the monies owed since they will have being repaying the ECB in small doses over the years. The benefit of this is twofold:

  1. It ensures that the ECB’s bonds are almost default-proof, thus ensuring that the interest rates of the ECB bonds will be tiny (and, ergo, the interest due by the whole of the Eurozone on its aggregate Maastricht-compliant debt) while,
  2. It increases the pressure on the member-states to put their house in order since investors, knowing that the member-states’ debt to the ECB enjoys super-seniority status, will demand high interest rates to lend them over and above the Maastricht level.

In short, super-seniority and provisions for smooth, amortised, repayment by member-states to their ECB debit accounts offer an ironclad guarantee that no member-state would default against the ECB – just like almost no country has ever defaulted against the IMF (which makes sure that the super-seniority clause is active in regard to its loans).

But to make our ECB-administered debt conversion plan even more ironclad, we have added the provision of the EFSF-ESM providing the ECB with insurance in case even one euro owed the ECB by a member-state goes ‘missing’. After all, was this idea not part of the December 2011 EU Summit agreement (that the ESM would be offering insurance on 20% of member states’ government bonds)? The principle of the EFSF-ESM offering insurance protection to member-state creditors has thus been established. All we are suggesting is that the said principle is incorporated into a scheme that makes rational sense. Indeed, I submit it to you, dear reader, that our suggestion (that the EFSF-ESM insures the ECB against the minuscule risk that, despite super-seniority and amortisation, some of the member-state’s debt to their ECB debit accounts will not be repaid) stands head and shoulders above the ludicrous December 2011 EU Summit agreement on ESM-provided insurance of Italian and Spanish bonds.

How is this different from a jointly and severally guaranteed Eurobond? 

I think that the above has already answered this question. The answer is: Stupendously different! Indeed, the two (our suggestion from jointly and severally guaranteed eurobonds) are like chalk and cheese. Here are two eye-glaring differences.

  1. Jointly and severally issued eurobonds will be backed, partly, by weak member-states without any of the security that our scheme provides via (a) smooth amortised repayments, (b) super-seniority status over other weak member-states’ debts to the Centre (for if they did have that status then all of a sudden bunds and other surplus countries’ bonds would, suddenly, become inferior to the eurobonds, thus becoming far less attractive to investors), and (c) the EFSF-ESM insurance scheme which cannot work with jointly and severally guaranteed eurobonds
  2. Jointly and severally issued eurobonds require both a Treaty Change and a new federal-like institution that will issue them. They may also require a change in the German Constitution. In short, jointly and severally issued eurobonds cannot happen. Period. But is this different with ECB-bonds? Is there no legal impediment? Yes and no, respectively. If the ECB were to issue its own bonds, without any backing whatsoever from Germany, Holland, or any other member-state, then there is no violation whatsoever of any Treaty of Constitution. And, indeed, there would be no reason to create a new institution to issue them (since the ECB already… exists). The crucial difference here, that KE must note, is that whereas jointly and severally issued bonds must be backed in law by the German taxpayer (thus requiring changes in Treaties and the Constitution), our ECB-bond scheme is backed by contracts between (fiscally-stricken) member-states wishing to make use of this facility and the ECB. No one else (i.e. countries like Germany that may feel no need to make use of this scheme) needs to make any commitment.

The ECB’s role ensures that interest rates on these bonds are very low. This lowers the debt burden of, say, Italy. However, there is no guarantee that Italy will be able to service its debt in the future. Who is standing behind these ECB bonds?

I have already answered this above: It is the Italian taxpayer that stands behind the ECB-bonds issued on Italy’s behalf, the Portuguese taxpayer for the ECB-bonds issued on Portugal’s behalf etc. What makes this ‘backstop” credible? As I have explained above: super-seniority, amortisation and, as a last, last resort, the EFSF-ESM insurance policy.

Either the ECB itself, which means that it needs to be recapitalized (= will transfer lower profits to the governments). Or the insurance by the EFSF/ESM will cover losses. Either way, the other European governments pay. So there is not a big difference here: ECB bonds transfer risks

I think that KE is being far too negative here. Our proposal does precisely the opposite of pushing the ECB into paying for the member-state’s debt. It tries to reduce the ECB’s liabilities by giving it an opportunity to manage the Crisis rationally. As things stand, the ECB system, under Target 2 and ELA provisions, is ending up with countless billions of liabilities that are never to be repaid – especially now that the Crisis is running amok (and if Greece exits, willingly or otherwise). Our scheme will arrest the Crisis and give the ECB a sporting chance at putting the lid on what, presently, amounts to a galloping exposure on unsustainable debts on its balance sheet. (Imagine what will happen to the ECB’s balance sheet if Spain blows up?)

Similarly, with the core countries’ governments. At the moment they are pouring money down into a black hole – e.g. the bankrupt Greek government which was made by the troika to borrow  4.2 billion from the EFSF in order to repay the ECB for bonds the later purchased, at a large discount. How sustainable is this (independently of which government we Greeks elect in June)? Compared to our proposal that the EFSF-ESM bear a very, very small risk (insuring the ECB’s debit accounts in the manner described above), what is happening now is plundering the German taxpayer not to give to the Greeks and to the Irish but, instead, to throw it all away into the black hole also known as our current ‘fiscal consolidation’ plan.

Where I can see a difference is in interest rates: Eurobonds will have yields above German rates (some weighted average of all Eurozone yields), whereas ECB bonds will probably have German rates, so Germany won’t pay more than before. Fair enough. But the problem here is that ECB bonds might increase the yield on other bonds. Sounds silly? It is not. If the states have to recapitalize or insure the ECB, these countries’ risks increase.

If states had to re-capitalise the ECB, that would be so. But this is not so. Indeed, under the Modest Proposal they would be spared of any need to recapitalise anyone – unlike what is going on now, i.e. a process that guarantees that the German, Dutch and Finnish governments will have to re-capitalise everything in sight (banks, ECB, EFSF-ESM) without even any success in stopping the fragmentation of the Eurozone. Markets know this. So, the very announcement of a scheme like the one we are suggesting will reduce significantly the fear of hefty recapitalisations.

The ECB bond is just a Eurobond with a higher seniority, if you want: the loss-absorbing capacity of the ECB is around 2,000 – 3,000 billion euros, but this capacity is directly related to government revenues. ECB bonds will therefore be repaid first, at the expense of the government revenues that are available for other bonds. This leads de facto to a lower seniority of the normal bonds, which as we all know leads to a higher yield on these junior bonds. So by giving out ECB bonds, the yields on other bonds are likely to increase.

I have already said so myself – see above. The difference is that this is a strength, not a weakness, of our proposal. Since we divide each member-state’s debt between Maastricht-compliant and the rest, and suggest that the ECB manages the former but not the latter, it would be rather helpful if a ‘healthy’ interest rate spread emerges between the two classes of debt making sure that, while the Maastricht-compliant debt of fiscally-stricken member-states is cheap to refinance, there is a market determined premium to pay for excessive public debt. Moreover, this spread will differ depending on the member-state. In Germany’s case, for instance, (which also has a debt overhand, in relation to Maastricht limits) the interest rate spread between ECB-bonds and bunds may even be negative at first, until markets begin to believe that the Crisis is over and the chances that the Eurozone will break up have receded to zero. In the case of other countries, the spread will be positive and analogous to the efforts of the government to rein in its debt. What is wrong with that?

Yanis would have to make a more convincing case that by having the ECB issue bonds, some risk is taken out of the market, and are not just redistributed like in the case of Eurobonds. But where? There might be a safety and liquidity premium for ECB bonds that lowers yields overall, which the Eurobonds do not have to the same extent (as they are by no means perfectly safe). There might be other reasons, but in my view ECB bonds are not a silver bullet, and very close to the commonly proposed Eurobonds.

I have already explained why our ECB-debt conversion scheme has a structure that puts clear blue water between ECB-bonds and jointly and severally guaranteed eurobonds (not to mention again their merits from a legal perspective). All I want to add here is that the creation of ECB-bonds will have an extremely positive effect in international money markets – one that we should not ignore. Sovereign wealth funds, private investors in, say, Japan etc. know and respect the ECB trademark. This gives ECB-bonds a drawing card that is crucial. Of course smart investors look beyond logos, and like to delve into the details. But if the details are as outlined above, investors far and wide will find these ECB-bonds extremely attractive. Capital will flow back into the Eurozone; capital that has fled over the past two years of Crisis mismanagement. ECB-bonds will thus play an additional role: that of shoring up the euro’s claims to reserve currency status (in addition to the US dollar). In summary, while silver bullets do not exist, this is a very promising scheme which deserves serious consideration by politicians and bureaucrats who have not covered themselves in glory over the past two years…

[Yanis] conclusion is that Germany refuses his proposal…

… [f]irst, because Germany does not really want interest rate relief for the struggling Periphery. For some reason, which I shall not elaborate on here, Mrs Merkel feels that fiscal waterboarding is what the Periphery needs more of these days.

Secondly, because such a scheme would mean that Germany would lose its capacity to leave the eurozone as a common debt external to the European System of Central Banks will be born by the ECB, thus making it impossible for any member-state to up stumps and leave the euro. Such a loss of its ‘exit card’ (that only Germany truly owns) will reduce the German chancellor’s bargaining power, within the eurozone, inordinately 

I think both are incorrect. The pressure on the countries in the periphery has certainly helped to change their domestic policies, and I am sure Yanis agrees. More pressure is surely not in Germany’s interest, as it threatens to break up the Eurozone, which would be very costly by almost any calculation I have seen. The second aspect sounds very weird to me: a German exit is surely not the main reason why Germany has bargaining power. A German exit would be extremely complex, legally nigh impossible, and threatening Germany’s industry that just recovered from several negative shocks (reunification, globalization, EU enlargement, higher financing costs).

On the first point: Mrs Merkel told us only the other day that her objection to eurobonds is that they will reduce interest rates; something she said is counterproductive because it takes countries like Italy and Spain off the hook. So, my explanation is correct. KE may agree with Mrs Merkel (that high interest rates must be maintained as an incentive) – but this only means that KE agrees with the first reason I gave as to why Germany is resisting proposals such as ours. Where KE may legitimately disagree with me is with my term ‘fiscal waterboarding’. I stand by it for the following reason: In my estimation, waterboarding by the CIA and its operatives was both a violation of common human decency and ineffective (in that torture provides a lot more misleading ‘information’ than useful tips). It is my considered opinion that what is happening today in places like Greece and Spain is, just like waterboarding, both inhuman and inefficient. From experience, I can tell you dear reader that the severity of the cutbacks in Greece have reduced our society’s capacity to reform. How come? In two ways.

First, reform requires investment. Any CEO will tell you that to improve management structures one needs to invest in them. Greece, Italy, Spain et al are so busy cutting that no investment goes into genuine reforms.

Secondly, the cruelty of the austerity packages (that is evident for all who have eyes to see, and want to use them) destroys the common will to effect reforms. This we can only neglect to our peril. In short, if Europe were to adopt a sensible, humane, pan-European Recovery Plan (like the one we are outlining in the Modest Proposal), the chances of genuine reform would be boosted. At present, fiscal waterboarding is stealing the thunder of reforms and identifying the concept of reform with misanthropy – not unlike the way in which democracy was given a bad name under Yeltsin’s rule in Russia or after the US invasion of Iraq.

On the second point: KE is correct to give all the reasons why Germany does not want to get out of the Eurozone. These are legal (it would have to renege on its Treaty obligations with the EU), economic (serious hardship looms if a new DM is created, is revalued massively and, thus, leads to the loss of export markets) and, not to be scoffed at, political-cum-psychological (being part of Europe is crucial to Germany’s postwar perception of itself, its raison d’ etre). But this is not my point. My point is not that Germany plans to exit the Eurozone. No, my point is that, courtesy of being a surplus country within a common currency that is in Crisis, the fact that it can leave the Eurozone (i.e. an announcement that it will leave will cause a capital flight into Germany, independently of the fact that it does not want to leave, and of the other costs it involves) gives it an enormous bargaining advantage in relation to, for example, France or Italy which cannot leave whether they want to or not (courtesy of being in deficit, a fact that ensures a capital flight from them if they announce such a move). To put it bluntly, Germany possesses an exit card that others do not possess. It neither wants nor intends to use it. But by merely holding onto it, Berlin can silence the rest in the EU Council meetings. Adopting policies like those in our Modest Proposal is equivalent to giving up this precious exit card and the huge bargaining power it affords the Chancellor. Mrs does not feel she has the political, even the moral, authority to give this much bargaining power up (at least not lightheartedly). In a way, I understand this. Alas, by keeping this exit card, the Eurozone is sinking and, soon, it will be worth precious little!

Yanis writings on the Euro Crisis are important for me because they challenge my thinking, and I like that. But except for the banking aspect, I am having trouble with some of his views. Besides the above on ECB bonds, I disagree with…

  • … his tendency to blame Germany for economically exploiting Europe. That is a very one-sided view of what Germany’s economic development is about, and why it developed the way it did. So far, Germany has not gained from being in the euro (contrary to what is written again and again), and it is likely to foot a massive bill when this whole mess is over (partly self-inflicted, I know, but almost surely not the major part of it).

I must protest. My top priority has been, from day one, to fight against the ‘blame game’. Indeed, wherever I speak and whomever I am addressing, I repeat ad nauseum that we must do our utmost to stop blaming one another. I even go so far as to say that there is no such thing as ‘the Germans’ or ‘the Greeks’. See for instance this piece and this, related, video documentary of mine. 

Having said this, I disagree that Germany has not benefitted from the euro. Of course it is all a matter of how one defines ‘Germany’. I have no doubt that large numbers of German hard-working workers have not benefitted from the euro, judging by the rise in the proportion of working-poor Germans. But that Germany has benefitted in aggregate, there is no doubt. Where I agree with KE is that, if the Eurozone collapses, Germany will pay perhaps the heftiest price. Come to think of it, my criticism of the German government’s attitude toward Greece’s fiscal woes, in an article I wrote back in 2010, was that it had a tendency to impose upon it a new form of ‘Versailles Treaty’, a ‘bailout’ agreement which would, eventually, end up doing more harm to Germany than to anyone else. In fact, I concluded that article with the following words which I hope will not prove prophetic (even though I fear they will):

In this context, turning countries like Greece into sundrenched wastelands, and forcing the rest of the Eurozone into an even faster debt-deflationary downward spiral, is a most efficient way of undermining Germany’s own economy. Assuming, for argument’s sake, that Greece is getting its just deserts, do the hard working Germans deserve a political elite that quickmarches them straight into economic catastrophe? [A New Versailles Treaty is Haunting Europe, 2010]

  • … his tendency to make this Euro Crisis look like an easy-to-solve problem which is not backed-up by any theory or evidence from the past, as far as I know. It is a full-blown mess (on a continent with legally mandated free capital movement) that is and always was very difficult to solve – including the question what a “fair” distribution of the burden looks like, irrespective of the usual moralizations.

Here I shall disagree profusely once more. This Crisis was extremely easy to prevent and, once it started, quite easy to arrest. It constitutes a spectacular failure of our politicians. Technically, it was no big deal. We needed to deal swiftly with the banks (by creating a Euro-TARP, and leaving national governments out of the equation), with debt (by having the ECB manage it rationally – as opposed to dumping it, eventually, onto the ECB without any plan and after it had grown inordinately) and with investment (by energising early on the European Investment Bank). Yes, it is true, there is no evidence of that. Why? Because the Eurozone happens to be the first such experiment in human history. It is like arguing that Apollo 11 ought to have left Earth for the Moon only after we had proof from past experience that we can land men on the Moon.

Now, don’t get me wrong. I am not suggesting that planning for a common European future is straightforward. Of course it is not. It is damned hard and complicated. But to arrest this Crisis was dead easy. By accepting, as KE does, that it was too hard and complex, we are simply giving undeserved absolution to our awful, idiotic politicians. They do not deserve it.

  • …  his diagnosis that Europe suffers from an under-investment crisis. That is a strange view given that Greece, Ireland and Spain received massive EU and capital market help to over-invest in infrastructure and real estate in the past. Europe suffers from a lack of smart investment and even more importantly, from a lack of efficient, growth-promoting institutions. If he meant to say that the periphery (and the Eurozone as a whole) suffers from a lack of aggregate demand (AD), I fully agree with him. But again, there are problems withdividing up AD in the Eurozone, and above all, a problem with getting the ECB to stabilize aggregate demand, and not headline inflation.

I am stunned! Every Crisis is preceded by an investment spree. The Great Depression was preceded by the investment flourish of the 1920s. This does not mean that, post-1929, there was not a dearth of investment! The fact that a tsunami of capital flowed into Europe’s Periphery prior to 2008, does not contradict the observation that, today, we have negative investment in the Periphery – and extremely low aggregate investment in the Eurozone. Of course we need smart investment (unlike the silly investments of pre-2008 in real estate and white elephants). But none of this challenges my point that Europe is now suffering from serious under-investment. 

Anyhow, let me finish by re-iterating that debates like this one are the only solvent of the alliance of nationalism and idiocy which are currently eating away at Europe’s foundations. I thank Kantoos Economics for the opportunity.

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