On the transition to a viable Eurozone and the Modigliani-Miller Theorem: Continuing the dialogue with Kantoos Economics on the Modest Proposal (response YV3 to KE3)

06/06/2012 by

Continuing our exchange with Kantoos Economics (KE) on the Modest Proposal, today we turn to the question of the lead-up to a new Eurozone architecture. What kind of transition period will be necessary?  Also, KE asked me to respond on the relevance of the Modigliani-Theorem to our ECB-mediated debt conversion scheme that we are proposing.

[Readers unfamiliar with this debate should read preceding posts in the following order: KE1, which was the original critique of the Modest Proposal, YV1 (my response to KE1), KE2, YV2 and now this post – which will be known as KE3]

Kantoos Economics asked: How is the transition period (to a Modest Proposal type of Eurozone) supposed to look like? Will each bondholder get two new bonds: one which is backed by the ECB, the other by the national government? Or will countries, as I assumed, just replace bonds that run out with ECB bonds? The latter will run into legal problems, as new debt will be senior to existing bonds which, as far as I know, would be a default event on existing bonds that often have a pari passu clause. On the other hand, it would give countries a grace period in which they don’t have to turn to the market, which could be helpful in current circumstances.

Yanis Varoufakis: What I had in mind was something much, much simpler. In fact, it is so simple that there is no need whatsoever for a transition period. And it certainly does not require a bondholder to get two bonds. This is how it will work: Tomorrow morning the ECB announces that, forthwith, it will be servicing the Maastrich-compliant portion of any maturing member-state government bond (assuming that the said member-state signs its contract with the ECB that commits it to the terms and conditions of participating in this debt-conversion scheme that is to be run by the ECB).

E.g. take a Spanish government bond that matures on 1st September 2012 with a face value equal to  1 billion. The ECB does nothing till the 31st of August. Tomorrow’s announcement is all that is necessary. What it tells the bondholders is that, come the 1st of September, they will receive around  670 million from the ECB and the remaining  230 million from the Spanish government. (Note that these sums reflect the Spanish government’s Maastricht-compliant debt; that is, I am assuming that 23% of Spanish debt exceeds its Maastricht limits). On the same day, or perhaps on 31st August, the ECB will have issued ECB-bonds equal to  670 billion in, say, 20-year bonds (or more depending on the coupon value) and, simultaneously, open a debit account for Spain into which Spain is now obliged to make periodic deposits to cover the capital plus the coupon.

So, to answer KE’s question: Holders of the original Spanish debt simply get their money back – partly from the ECB and partly from Spain. Two types of bonds are issued in the money markets in order to effect this debt conversion: ECB bonds and Spanish government bonds. Investors chose which they want to buy (the ECB ones at a low interest rate with greater security or the riskier, but higher yielding, Spanish government ones). Note that there are no legal problems here and no need to have a transition period. Policy 2 of the Modest Proposal will be up and running the moment the ECB makes its announcement tomorrow morning. With all the benefits (i.e. the calming effect on the market and the alleviation of fiscal stress for countries like Spain) applying immediately.

Kantoos Economics: [A] very famous theorem, Modigliani-Miller, tells us that the structure of how a company finances itself – under lots of idealizing conditions – is irrelevant for how much it is worth. For the Modest Proposal and other suggestions of how to structure European sovereign debt, this means that when the “blue” part of the debt has higher seniority and thus, lower rates, the yields on the “red” debt will be so high that the interest rate cost will be the same in total. In theory, that is, without panic or disintegration or mutualization of debt. 

Yanis Varoufakis: I suppose that KE mentioned the Modigliani-Miller theorem (MMT) because of what it may bring to bear on the debate regarding the structure of the Eurozone’s aggregate debt, and my claim that re-structuring it (along the lines of Policy 2 of the Modest Proposal), would return the Eurozone to structural robustness. MMT shows that, all other things being equal, and under a set of assumptions that I mention below, a corporation’s expected net worth (and thus solvency) is independent of the extent to which its finances are predicated upon debt, equity or any conceivable mixture of debt and equity. In other words, no corporation can be aided back into solvency by altering the mix of debt and equity of its finances. 

As KE understands well (and says so in his post), MMT is irrelevant to us (i.e. to a debate on re-structuring the Eurozone’s public debt) for two reasons. First, because the assumptions underpinning MMT do not hold. In particular, MMT assumes that bankruptcy is not an issue, that price formation falls Brownian motion (i.e. is fundamentally random) and that all relevant decision makers share the same information set. None of these apply in the case of the Eurozone. Secondly, and much, much more importantly, the Eurozone’s member-states are not corporations. This is important for two reasons: (a) Their financing is not based on equity at all but, rather, only on different debt instruments. The Modest Proposal simply argues that ECB-bonds are a better debt instrument than the existing government bonds or the touted severally and jointly guaranteed bonds. (b) The other reason, naturally, is that the member-states’ revenues (i.e. tax take) cannot be deemed independent of their expenditures (unlike a corporation’s that can be; and are).

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