What Mr Draghi should be aiming at: Or how to move from Ponzi Austerity to Rational Crisis Management by a stepwise implementation of the Modest Proposal

Ponzi growth happens when unsustainable capital flows, wilfully predicated upon funding schemes that Reason knows to be fraudulent, give rise to large spurts of economic activity.

Ponzi austerity, in contrast, is what happens when unsustainable spending cuts, wilfully predicated upon funding schemes that Reason knows to be fraudulent, cause significant drops in economic activity. (Click here for my original piece on Ponzi Growth and how it led to Ponzi Austerity.)

It is an incontestable fact that Europe’s Periphery shifted from Ponzi growth to Ponzi austerity some time after the Crash of 2008. Before the Crash, tsunamis of toxic money, minted and multiplied by US, UK and German banks, flooded the Periphery, causing bubbles in the real estate and public sectors. When that toxic money fizzled out, and capital receded from the Periphery like a vicious tide going out on a grim shore, the Periphery’s states and banks sunk deeply in the mud of irreversible insolvency. So as to delay the inevitable defaults that would strike huge blows on the tittering northern banks, so-called bailouts were arranged on condition of austerity policies that were as unsustainable as the growth whose collapse led to them.

The European Central Bank (ECB) is the only serious institution that the Eurozone has. It was meant to be the guardian of the euro’s credibility but, alas, during both periods (Ponzi growth and Ponzi austerity), the ECB proved incapable of playing this role. When toxic capital flowed disastrously into the Periphery, the ECB whistled in the wind. When it flowed out, causing the collapse that then gave rise to the Ponzi austerity, the ECB was part and parcel of this crime against the peoples and the spirit of Europe. Now that the chickens are coming home to roost, the ECB is pledging to do “all it takes” to save the euro, but fails to back up such strong words with deeds.

The reason for the ECB’s failure is that its most powerful constituent part, the Bundesbank, is refusing to contemplate the two ‘normal’ operations that would stabilise the euro: (a) capping Peripheral spreads via unlimited bond purchases, and (b) a banking license for the EFSF-ESM in conjunction with a commitment to recapitalising banks directly. German opposition to (a) is predicated upon moral hazard arguments (i.e. the fear that, if Italy’s spreads are capped at a sustainable interest rate level, the Italian governments of the future will have no incentive to ‘pull itself together’). As for Germany’s opposition to (b), it is due to private German banks’ point-blank refusal to submit themselves to ECB (or non-German government) scrutiny; a development that is inevitable if an ECB-leveraged EFSF-ESM steps in to re-capitalise the banks.

The ECB’s short-term part in perpetuating Ponzi Austerity

In the short-term, Mr Draghi’s ECB is an active participant in Ponzi austerity. Here is a typical example. In July the ECB deemed that Greek banks are insolvent and that the ECB will, therefore, not accept collateral from them. It directed them to the ELA program which has the Central Bank of Greece provide liquidity to the Greek banks (at a higher interest rate than the ECB would) in the context of the ECB system’s ELA. To facilitate this, the ECB permits the Central Bank of Greece to… treble the amount of euros that its lends the Greek banks and to accept worthless collateral from them in return; collateral that the ECB itself would not touch with a bargepole. In effect, the ECB pretends that it is cutting off the Greek banks when, in reality, it is simply increasing these insolvent banks’ costs of borrowing without limiting the quantity of money that they borrow from the ECB’s broader system. In effect, it is causing, wilfully, the Greek banks to plunge deeper into insolvency.

Why is Mr Draghi allowing this to happen? Because the ECB wants its money back from the Greek state on 20th August! Some of you may recall that, in the heady days of the summer of 2010, the ECB stepped into the secondary bond market to purchase Greek, Portuguese and Irish bonds in a failed bid to shore them up. Now, some of these bonds are maturing. While the tranches held by individuals and banks were haircut ruthlessly (54% in face value and 75% in present value terms) last March, the ECB insisted that its Greek bonds will not be touched by the haircut (or PSI as it was called euphemistically). To maintain this façade of super-seniority, with a view to imposing it on Italy and Spain later (now that Mr Draghi has promised to step in and buy Italian and Spanish bonds), the ECB presently demands from the Greek government full repayment. Last May, the Greek state borrowed 4.2 billion from the EFSF and passed every cent to the ECB. The same was meant to happen on 20th August. However, Berlin insisted that the bailout tranches for the months of July and August be withheld from Greece until the Greek government dances to the prescribed tune. But if the Greek government was to be denied the new EFSF instalments, how could it pay the 3.2 billion due to the ECB on 20th August?

Here is where the ECB chose to become a central player in the saddest and meanest form of Ponzi austerity: While Berlin is pushing Athens to implement a huge cut in the government’s budget (given the shrinking rate of the social economy) of 11.5 billion euros, at the same time, the ECB makes three related moves: First, it declines the Greek government’s request for a one month delay in the repayment of the 3.2 billion it owes the ECB. Secondly, as mentioned above, it cuts Greek banks off ECB liquidity and turns them toward the Greek Central Bank’s ELA program; thus increasing their borrowing costs. Third, it permits the Greek Central Bank to provide to the Greek banks liquidity that the latter then pass to the Greek state so that the Greek state can, in theory, repay the ECB the 3.2 billion due. Indeed, on 14th August, while most Europeans, and Greeks, were on holiday, the insolvent Greek government issued around 4 billion euros of T-bills for the purpose of pretending to pay off a debt of 3.2 billion to the ECB. Why pretending? Because these T-bills were snapped up by the insolvent Greek banks for the purpose of posting them as collateral with the European System of Central Banks (via Central Bank of Greece and in the context of the ELA) so as to gain access to much needed liquidity. In a full and ridiculous circle, the ECB system financed the Greek state’s repayment to the… ECB guaranteeing, in the process, that the insolvent Greek state’s debt and the insolvent Greek banks’ debt grew.

While this is an extreme example of the ECB’s complicity in a macro-financial debacle (if not scandal), it is not unique. At the very same time, the Central Banks of Italy and Spain are forced to make use of precisely the same provisions to their insolvent banks so that they can purchase expensive short-term T-bills in order to finance their governments, to the tune of tens of billions of euros. It is a ‘trick’ that was first tried and tested in Ireland, as part of the operations that caused the Emerald Isle to slip into Greece’s wake, on the way to Bailoutistan.

To recap, in the short-run, Mr Draghi’s ECB is participating, knowingly, in a huge game of deception that, to all intents and purposes, constitutes a vicious system that can only be described adequately as Ponzi austerity. Mr Draghi surely knows this and is keen to break out of this deadlock. He has, in fact, promised to do precisely this in the medium term. But what exactly are the options that he is considering?

The ECB’s medium term plans

Mr Draghi has signalled a readiness to sidestep the Bundesbank’s objections, with the tacit support of the German chancellor, and re-start the program of ECB-purchases of Italian and Spanish debt (bonds, that is) in the secondary market as long as (i) the EFSF-ESM does likewise and (ii) Rome and Madrid agree, explicitly or implicitly, with a deepening of austerity policies and a broadening of so-called reforms (for which one should read: attacks on any regulation that shores up labour’s bargaining power over capital). The trouble with this plan is that it is bound to fail. The reasons are not hard to imagine:

The fact is that the ECB Board, even if it overrules the Bundesbank’s objections to this plan, will never authorise Mr Draghi to announce unlimited bond purchases. Consider the bond purchases of the past (i.e. the purchases of Italian, Portuguese and Irish bonds in the summer of 2010 and winter of 2011). They failed miserably because it was common knowledge that the ECB had only a couple of hundred billion euros to play with. This gave a splendid opportunity to speculators to bet that this (commonly known) sum would not be enough to shore up these bonds and lower their spreads in the medium term. They placed their bets against the ECB and won. Similarly now, given that the EFSF-ESM’s available sums are a pittance (and, to boot, it is still unclear whether they can be released in a flexible manner for this kind of use in the secondary markets) if the firepower available to Mr Draghi (stemming from the ECB’s printing presses), to fight the war on behalf of Italy and Spain, is also circumscribed, the markets will bet against him and will win hands down. This is the reason why everyone keeps proposing that either the ECB should declare (like the Central Bank of Switzerland in its fight to cap the franc) that it will print and allocate unlimited euros to cap Italian and Spanish spreads or, equivalently, that the EFSF-ESM should be given a banking licence; i.e. the right to use the ECB’s printing presses and asset book as a lever that accomplishes the same purpose.

To sum up, what would buy the Eurozone a good five years during which to redesign the Eurozone and avert the euro’s long term disintegration is either an unlimited power to print (so as to cap spreads) or a banking licence for the EFSF-ESM, coupled with a proper delinking of bank recapitalisations from the national governments (i.e. taking the capital injected into the banks off the national accounts of governments). Trouble is that Berlin is not willing to countenance either of these measures. Thus, the hapless Mr Draghi is forced to choose between a walk-on part in the unfolding tragi-comedy of Ponzi austerity and a bond purchasing scheme whose failure is foretold.

Is there an alternative? How Mr Draghi could adopt part of our Modest Proposal to break the vicious circle vis-à-vis Italy and Spain tomorrow morning

Imagine a press conference tomorrow morning in which Mr Draghi makes the following announcement:

“Henceforth the ECB will undertake a Debt Conversion Program for Italy and Spain. It will service (as opposed to purchase) a portion of every maturing Italo-Spanish government bond corresponding to the percentage of each country’s public debt that is allowed by the Maastricht Treaty.”

[In effect, it will be servicing 100[(D-E)/D% of each maturing bond, where D is the national government’s debt-to-GDP ratio (in %) and E is the difference between D and 60% (the Maastricht-compliant level). Assuming Italian and Spanish debt-toGDP ratios to equal 120% and 90% respectively, then the ECB would be servicing 50% of each Italian government maturing bond and 66.7% of each Spanish government maturing bond.]

“To fund these redemptions on behalf of Italy and Spain”, Mr Draghi will go on to say,” the ECB will issue bonds in its own name, guaranteed solely by the ECB but repaid, in full, by the respective member-state: Upon the issue of ECB bonds, the ECB will simultaneously open debit accounts for Italy and Spain into which the two countries will be legally bound to make deposits to cover the ECB-bonds’ coupons and principal. These new debts of Italy and Spain to the ECB shall enjoy super-seniority status and shall be insured by the EFSF-ESM against the risk of a hard default. Since the cost to the EFSF-ESM of offering this insurance will be minuscule (compared to the cost of purchasing, in association with the ECB, hundreds of billions of Italo-Spanish bonds), the EFSF-ESM will now have significant funds to devote to the task of directly recapitalising Italian and Spanish banks.”

Is there any doubt that such an announcement would spell the current crisis’ end? Moreover, do note dear reader that there is nothing in this Debt Conversion Program that violates the principle of no monetisation of the Periphery’s debt, no issues of moral hazard (since Italy and Spain will still have to service, on their own, the past of their debt that exceeded Maastricht limits) and no increase whatsoever in German, Dutch, Finnish or Austrian liabilities. Italy and Spain will enjoy large interest rate reductions without any concomitant rise in the long term interest rates that Germany pays (since Germany is not guaranteeing the Program), without any bond purchases by the ECB (funded by money printing), without a banking licence for the EFSF-ESM. And if this Program succeeds, it can be quickly extended to the rest of the Eurozone, thus creating a new, liquid market for proper Eurobonds (ECB-bonds) that will both stabilise the Eurozone and draw idle savings into it from the rest of the world.

Concluding remark

I submit it to you, dear reader, that this plan would work. So, why is Mr Draghi not announcing it, insisting instead on measures that will ultimately fail? Because of a combination of reasons. Some of them have to do with the inability of our central bankers (and politicians) to embrace original thinking (i.e. thinking that does not just replicate the practices of Goldman Sachs and the various outfits in which they cut their teeth before moving to their current jobs). However the most telling reason is that Berlin, and the other capitals of the surplus nations (Finland, Austria and the Netherlands), will not approve of any move or policy that binds them irreversibly to the euro. The Debt Conversion Program suggested here, while it requires no loan guarantees from German and Dutch taxpayers, creates a new type of bond that makes it impossible for the surplus nations to leave the Eurozone. It is not that they want to leave that causes them to veto ideas like this one. It is that they do not want to give up the relative bargaining power (vis-à-vis France and other member-states) that is afforded to them courtesy of the capacity to leave the euro. Alas, the preservation of that capacity may force all of us to bid adieu to the common currency; with tragic consequences for all.


  • Yanis, you should take advantage of your position in Valve and create a (TF2?) cartoon explaining with animation the current situation in eurozone and the modest proposal of yours. I imagine buckets, money transfers, interest rates, etc. The idea came to me because I find it difficult to comprehend some aspects of your proposal. This difficulty is not result of your explaining, but of my inexperience to understand how the money creation/lending scheme actually works.

  • All I can do is repeat the comment I had placed on The Times, London, web site against their report titled: Euro Rescue Plan fails to impress. August 3rd. http://www.thetimes.co.uk/tto/business/economics/article3495473.ece

    “The European Central Bank, now under the strong leadership of Mario Draghi, may at last have started to recognise that they have been trying to deal with the wrong problem. Up to this moment, everyone, (dare I say, carried along by the doomsday laden PR of the banking industry), has been led to believe that the underlying problem is excessive borrowing by the national governments that has, in turn, de-stabilised the banks.

    Now Draghi can see that each affected nation has the same problem; their income, (to repay debt), always stems from taxation derived from normal personal and business related transactions. Ergo, adding to the debt burden; while at one and the same moment adding to austerity in such a way as to decrease such tax income; has shot all of the European national economies in the foot.

    Now, at last, the real problem is emerging; the excessive leverage of the savings of the peoples of the various nations; by the banks. The banks took a single Euro and printed another fifty or more for each one they received. They then lent those 1/50th Euros to governments, at full value, expecting to receive a full value Euro back with added interest; in turn again, creating a vast ocean of grossly over-leveraged debt that is now clogging up the entire Western European banking system.

    The ECB will only add to the problem by creating more imaginary debt. They must have a mechanism to enable the transfer of the leveraged debt back into productive investment; which in turn, leads to increased employment by businesses and thus increased taxation to enable the return to long term stability.

    A courageous leader will see the need to change direction; and Draghi has, quite rightly; hesitated; to give him the time to think through his new strategy.

    The only way out is to exchange the excessively leveraged debt clogging up the system, for a mechanism that will re-invest it back into productive employment.

    The Editor of The Times was very prescient when he allowed this otherwise penniless inventor to constantly write here on The Times web site about a new way to look at such investment. Mervyn King was equally prescient when in 2010, he asked the same inventor to present his thoughts to the UK government, that in turn again inspired a Green Paper, Financing a Private Sector Recovery.

    Draghi now knows why they both supported him. His proposals for the use of vanishing bonds, carefully set out in The Capital Spillway Trust response to the Green Paper, Financing a Private Sector Recovery, has opened a clear road out of the ECB’s dilemma.

    Europe has learnt that debt is not productive investment; that the European Investment Bank is a lender of debt, not an investor of equity capital; that without a rapid transfer of leveraged debt back into productive, free enterprise based equity capital investment; they will not succeed with their own venture;


    I ask Europe to remember that I am a European Citizen too.”

    (I made this last point as I am well aware that being a British citizen, my input may not be welcomed by those that see the British government as an impediment to their own wish for a more integrated Europe).

  • Europe needs a “deus ex machina” in order to find a solution. This should not be a war.

    • How about the USA left you to the soviets?or better yet imposed austerity measures to pay back the trillions Germany owed after the warfor rebuilding and war reparations ?

  • Just a little sidenote about our media reporting about all of this.

    I can just say that indeed “Berlin” is reacting exactly the way you describe it. We read now that Rösler, who leads the ministry for economics, and Merkel and others “lost patience with Greece”.
    It is almost bizarre to look back just a few weeks. Before the elections the same politicians and 99% of our media reported that those elections in June were a fight between “good and evil”. Everything would be nice if Greece would vote like Germany and others wanted it to vote.

    Now they got exactly what they wanted in June. So that was their “good”. You’d have expected that they had thought a bit about what they had told people before…
    Any modest proposal would, of course, be put under “bad”.

    It is downright bizarre that not even a few % of our most valued german citizens at least recognize what nonsense our market-radical politicians and most of our media told us about good and evil *before* the elections. It is just 2 months ago…

    It is a dreadful thing to realize that people swallow everything, even the most bizarre contradictions, ideas that did not work (austerity politics a la Merkel), prejudice about “the” greek people and more, and do not even compare what they were told in 2008, 2010, a few weeks ago, and now…Downright bizarre.

    • Nobody said everything would be nice if the old partys come to power again! Germany couldn’t care less than about who is acting as government in Greece.

      It was and is all about the gazillion broken promises by Greek officials, about the total failure to deliver the inevitable changes in structures, mindsets and society (talk
      about nepotism, cortuption, efficient public services

  • Yanis, we had Ewald Nowotny of the OeNB (a friend of the family) at the house the other day and he shared a few of his wisdoms with me. My sense is that he would entirely agree with your proposal (which I have forwarded to him). Interestingly, he said – at his initiative and not at my prompting – that this alone wouldn’t solve Greece’s problems. It could only set the stage for Greece’s reforming its economy and public administration. Sounds familiar?

  • I think you are absolutely right that the surplus nations wants the back door open to leave the euro due to their I believe well founded fear that the problem countries will not make the needed reforms of their economies. After all many of them have a history of decades or even longer of not being able to do this.
    When the euro was introduced it was taken as a forgone conclusion that this would happen but that thrust is now gone.
    While your modest proposal would surely work (have read the book) it could, I think not be implemented without much tighter pan European budget control. Would all the problem countries be willing to submit to this?

  • The only way to solve the crisis is to immediately downgrade Germany’s rating to a D-.

    We can then sit down and talk as to what steps Germany needs to undertake in order to improve its rating (on a very long and gradual basis).

  • In effect, your proposal is for ECB to “re-forbid” EUs public debts over 60%.
    What about the much needed for the current public sector and social welfare survival over-60% debt? You are not clear about it, but you seem to imply that PIIGS could still go out in the markets and ask for it and they will achive lower spreads; or sharply adjust their public sector and social welfare payments to the servise-guaranteed 60%-debth. But, please enlighten me, in the last case, where in effect is that any different than Mrs Merckel’s “obsessions”?

  • It seems to me that the current debate surrounding these bail out mechansisms miss the point. Consumerism and exponential debt growth on ever more imaginary collateral is hittting the wall and Greece is now the first case where the drama unfolds. It will get much worse and will reach the core including the US and Japan, possibly much faster than generally expected. This Yanis talk is just an up-beefed double talk of this whole class of so-called economists who were the most apologetic myistifiers of this vulgar and stupid built up of credit bubbles and the ensuing asset bubbles. I still think Yanis is looking for becoming part of this bureaucracy that wishes to revive the old days, just a bit better and efficient…no chance!
    Paul, Montevideo

    • Paul, you are being unfair. My life choices ought to tell you that I seek no greater office than that of radical, outsider, commentator. The energy I am putting into saving this wretched eurozone, which I always loathed, is due to the prior experience with the 1930s and the early 1980s which proves, beyond doubt, that a collapse of capitalism brought about by capitalism’s own centrifugal forces does not beget revolutionary, progressive change. The only beneficiaries of the eurozone collapse will be the Nazis and the bigots.

  • You mention UK, US and German banks but supress the French ones.

    Who have held the largest amounts of ClubMed bonds before the crisis and deleveraged most since then, on taxpayer’s costs. I have shown proof for this repeatedly.

    Yanis, how come you constantly ignore the French contribution to the desaster?

    • If you read my book you will see that I do not let the French off the hook at all. However, when it comes to the capital flows that flooded the Periphery pre-2008, I am very much afraid that the German banks played the major role in that.

4 Trackbacks