Latest Q&A on our Modest Proposal:

Mindful Money has just published an interview in which I answer three of their questions on the Modest Proposal and its differences from the plan to bolster the Eurozone by granting a banking licence to the EFSF-ESM. Click here for the complete article or read on for the barebones Q&A…

1.       Is the model you suggest for the EFSF similar to the proposal to grant a banking license to the ESM? Do you see the fundamental problem with the bailouts to date that they were limited in scale – that is unlimited liquidity provided by the central bank acts as a guarantor of future funding but might actually end up costing less?

No, our proposal regarding the EFSF is substantially different to the suggestion that the EFSF be granted a banking licence. We propose that the EFSF (and the ESM, its permanent successor) be converted into, effectively, a Euro-TARP institution. That is, a fund from which insolvent banks are recapitalised centrally (as opposed via national governments) while the ECB and a massively re-vamped EBA (European Banking Authority) undertake the task of supervising and, potentially, winding down insolvent banks.

The fundamental problem with the current EFSF, as I see it, is not so much its limited firepower (which is, of course, beyond doubt) but, rather, its toxic (CDO-like) architecture. Think about it: When Ireland went bankrupt and drew funds from the EFSF, Portugal guaranteed part of these loans. When Portugal went under, Spain guaranteed bits of the EFSF bonds that were issued on behalf of Portugal. And now that Spain is buckling, Italy will have to guarantee the new Spanish loans. And so on. In essence, the EFSF bonds, which finance the bailouts, have precisely the structure of a toxic CDO. Thus, we are caught in between a rock and a hard place: If the EFSF is not given enough firepower (i.e. rights to issue at least a trillion of bonds), it is irrelevant. And if it is given enough firepower, its toxicity threatens to bring down the whole of the Eurozone.

To end this conundrum, the EFSF’s funding on bank recapitalisations must be separated full from funding of national governments, with the latter task taken over by the ECB. Our proposal (see The Modest Proposal for Resolving the Euro Crisis) is that the ECB issues its own bonds in order to service the Maastricht compliant part of the Eurozone member-states’ debt while the EFSF turns itself into a Euro TARP. Failing this, a banking licence for the EFSF coupled with an explicit aim to recapitalize centrally the Eurozone’s banks would detoxify the EFSF and put, at least, a temporary end to the deadly embrace between insolvent banks and insolvent states.

2.       If the ECB issues debt does this entail the same joint-liability problem that Germany has so far steadfastly refused to countenance? That is, is agreement on Policy 1 necessary for Policy 2 to function?

 No, it does not. What Germany is currently refusing to countenance, with good reason, is jointly and severally guaranteed eurobonds; i.e. joint debt that needs to be backed up by the German taxpayers to be credible. If, in contrast, the ECB issues its own bonds, the German taxpayer will not be directly responsible for these bonds. One may, of course, argue that if the ECB fails, then it is German taxpayer that will be called upon to pay the bill. Yet this is not true. Consider what is happening today with Target 2; the system of liabilities and assets within the ECB system which allows for the common currency to continue in the face of gross capital movement imbalances. As the crisis deepens, Target 2 imbalances are rising exponentially. Yet this is not a problem, and no one really has to pay these liabilities, as long as the probability of a Eurozone breakup is negligible. If the Eurozone is broken up, these balance sheet liabilities will simply be erased; with the German banks ending up the beneficiaries at the expense of the Bundesbank (something that the latter can take in its stride following the mass capital flight into Germany following a potential euro break up). Similarly with the ECB bonds. The German taxpayer will not be liable for these debts in the extremely unlikely event that the Eurozone breaks up even after the ECB has stepped in and issued bonds on behalf of Eurozone member-states. Finally, yes, agreement on Policy 1 is a prerequisite for Policy 2 to work. In other words, it is imperative that the banking crisis is separated from the public debt crisis. As long as the two are joined at the hip, so to speak, the Eurozone is doomed.

3.       What sort of scale would EIB action need to be in order to offer a meaningful stimulus? Moreover, will there have to be a balance between the beneficial impact of each investment to the EIB and the degree to which it benefits the underlying economy of a nation state?

Given the advanced stage of the Depression in the Periphery and the second dip of the Recession in the surplus countries, the EIB-EIF’s investment must rise up to 10% of Eurozone GDP. Mind you, it is misleading to think of this as a stimulus. By stimulus, we mean a standard pseudo-Keynesian policy of the state printing money and pumping it, through state channels, into the economy; pretty much what the Obama administration purported to do. Our proposal is that the EIB-EIF are simply allowed to borrow on banking principles (i.e. predicated upon the quality of their business plans) in order to energise idle savings and turn them into productive and profitable investments. In effect, there is nothing new here. The EIB has been doing it for decades. Our simple suggestion is that the EIB is allowed, possibly in collaboration with the ECB and the EU, to finance 100% of projects that it deems potentially profitable. 

11 Comments

  • I would add one more question: Will Greece have to have special treatment under the modest proposal?

    • Yes. As will some other member-states (e.g. Ireland). The Moest Proposal sets the scene for what needs to be one at Eurozone level. Some country by country calibration will be necessary.

  • κ. Βαρουφάκη, από τα κείμενά σας έχω καταλάβει πόσο θεμελιώδους σημασίας είναι ένας μηχανισμός ανακύκλωσης των πλεονασμάτων από τις πλεονασματικές προς τις ελλειμματικές χώρες (ιδίως στα πλαίσια μιας νομισματικής ένωσης). Για τις ελλειμματικές χώρες ωστόσο, θα πρέπει να υπάρχει κάποιο όριο στο πόσο μεγάλο εμπορικό έλλειμμα θα μπορούν να έχουν; Ρωτάω προφανώς για την Ελλάδα η οποία με ισοζύγιο τρεχουσών συναλλαγών στο -9% του ΑΕΠ έχει ξεφύγει από τις υπόλοιπες χώρες της ευρωζώνης…

  • Yanis is correct to say that the entire monetary system in Europe is deeply flawed and this is going to have to be a long post. It is imperative that the people surrounding Draghi understand that they are on the wrong path; that continuing to try and make the governments’ of small nations take responsibility for what has occurred is just plain wrong. They need to read up on what the real problem is and as such I am going to place a substantial part of a Mervyn King speech here.

    There are two underlying issues; the first is leverage. As Mervyn King tells us in his “Banking: From Bagehot to Basel, and Back Again”, Monday 25 October 2010, http://www.bankofengland.co.uk/publications/Documents/speeches/2010/speech455.pdf

    “At the heart of this crisis was the expansion and subsequent contraction of the balance
    sheet of the banking system. Other parts of the financial system in general functioned
    normally. And we saw in 1987 and again in the early 2000s, that a sharp fall in equity
    values did not cause the same damage as did the banking crisis. Equity markets provide a
    natural safety valve, and when they suffer sharp falls, economic policy can respond. But
    when the banking system failed in September 2008, not even massive injections of both
    liquidity and capital by the state could prevent a devastating collapse of confidence and
    output around the world. So it is imperative that we find an answer to the question of
    how to make our banking system more stable.

    As Bagehot knew only too well, banking crises are endemic to the market economy that
    has evolved since the Industrial Revolution. The words “banking” and “crises” are
    natural bedfellows. If love and marriage go together like a horse and carriage, then
    banking and crisis go together like Oxford and the Isis, intertwined for as long as anyone
    can remember. Unfortunately, such crises are occurring more frequently and on an ever
    larger scale. Why?

    2. The practice of banking:
    For almost a century after Bagehot wrote Lombard Street, the size of the banking sector
    in the UK, relative to GDP, was broadly stable at around 50%. But, over the past fifty
    years, bank balance sheets have grown so fast that today they are over five times annual
    GDP. The size of the US banking industry has grown from around 20% in Bagehot’s
    time to around 100% of GDP today. And, until recently, the true scale of balance sheets
    was understated by these figures because banks were allowed to put exposures to entities
    such as special purpose vehicles off balance sheet.

    Surprisingly, such an extraordinary rate of expansion has been accompanied by
    increasing concentration: the largest institutions have expanded the most. Table 1 shows
    that the asset holdings of the top ten banks in the UK amount to over 450% of GDP, with
    RBS, Barclays and HSBC each individually having assets in excess of UK GDP. Table 2
    shows that in the US, the top ten banks amount to over 60% of GDP, six times larger than
    the top ten fifty years ago. Bank of America today accounts for the same proportion of
    the US banking system as all of the top 10 banks put together in 1960.

    While banks’ balance sheets have exploded, so have the risks associated with those
    balance sheets. Bagehot would have been used to banks with leverage ratios (total assets,
    or liabilities, to capital) of around six to one. But capital ratios have declined and
    leverage has risen. Immediately prior to the crisis, leverage in the banking system of the
    industrialised world had increased to astronomical levels. Simple leverage ratios of close to 50 or more could be found in the US, UK, and the continent of Europe, driven in part
    by the expansion of trading books (Brennan, Haldane and Madouros, 2010).
    And banks resorted to using more short-term, wholesale funding. The average maturity
    of wholesale funding issued by banks has declined by two thirds in the UK and by around
    three quarters in the US over the past thirty years – at the same time as reliance on
    wholesale funding has increased. As a result, they have run a higher degree of maturity
    mismatch between their long-dated assets and short-term funding. To cap it all, they held
    a lower proportion of liquid assets on their balance sheets, so they were more exposed if
    some of the short-term funding dried up. In less than fifty years, the share of highly
    liquid assets that UK banks hold has declined from around a third of their assets to less
    than 2% last year (Bank of England, 2009). Banks tested the limits of where the
    risk-return trade-off was located, in all parts of their operations. As John Kay wrote
    about his experience on the board of HBoS, the problems began “on the day it was
    decided that treasury should be a profit centre in its own right rather than an ancillary
    activity” (Kay, 2008).

    Moreover, the size of the balance sheet is no longer limited by the scale of opportunities
    to lend to companies or individuals in the real economy. So-called ‘financial
    engineering’ allows banks to manufacture additional assets without limit. And in the
    run-up to the crisis, they were aided and abetted in this endeavour by a host of vehicles
    and funds in the so-called shadow banking system, which in the US grew in gross terms
    to be larger than the traditional banking sector. This shadow banking system, as well as
    holding securitised debt and a host of manufactured – or ‘synthetic’ – exposures was also
    a significant source of funding for the conventional banking system. Money market
    funds and other similar entities had call liabilities totalling over $7 trillion. And they on
    lent very significant amounts to banks, both directly and indirectly via chains of
    transactions.”

    —— The above is from the horse’s mouth. Europe MUST listen to Mervyn King..

    The second issue, (as I see it), is well known to readers of these pages; in that I believe that the present structures, such as the EIB, do not have the correct mindset to address the underlying problem of there not being ANY mechanism to capitalise free enterprise business, (and thus job), creation. Grand gestures via the existing EIB way of thinking; lending vast sums of money through EXISTING government and large corporates; is NOT investment. We must have new investment right down at the grass roots of every nation.

    That leverage and a lack of a simple, but well thought out system, widely accepted set of rules; to permit normal free enterprise job creation right down at the grass roots of every nation; are the deeply embedded flaws that must be addressed.

    Europe has to change direction. Yes, it will take great courage to accept that previous thinking was wrong; but they have no choice. They must address the real problems. Grossly excessive leverage and lack of free enterprise equity capital investment right down at the grass roots of every Western economy.

  • Yanis is correct to say that the entire monetary system in Europe is deeply flawed and this is going to have to be a long post. It is imperative that the people surrounding Draghi understand that they are on the wrong path; that continuing to try and make the governments’ of small nations take responsibility for what has occurred is just plain wrong. They need to read up on what the real problem is and as such I am going to place a substantial part of a Mervyn King speech here.

    There are two underlying issues; the first is leverage. As Mervyn King tells us in his “Banking: From Bagehot to Basel, and Back Again”, Monday 25 October 2010, http://www.bankofengland.co.uk/publications/Documents/speeches/2010/speech455.pdf

    “At the heart of this crisis was the expansion and subsequent contraction of the balance sheet of the banking system. Other parts of the financial system in general functioned normally. And we saw in 1987 and again in the early 2000s, that a sharp fall in equity values did not cause the same damage as did the banking crisis. Equity markets provide a natural safety valve, and when they suffer sharp falls, economic policy can respond. But when the banking system failed in September 2008, not even massive injections of both liquidity and capital by the state could prevent a devastating collapse of confidence and output around the world. So it is imperative that we find an answer to the question of how to make our banking system more stable.

    As Bagehot knew only too well, banking crises are endemic to the market economy that has evolved since the Industrial Revolution. The words “banking” and “crises” are natural bedfellows. If love and marriage go together like a horse and carriage, then banking and crisis go together like Oxford and the Isis, intertwined for as long as anyone can remember. Unfortunately, such crises are occurring more frequently and on an ever larger scale. Why?

    2. The practice of banking:
    For almost a century after Bagehot wrote Lombard Street, the size of the banking sector in the UK, relative to GDP, was broadly stable at around 50%. But, over the past fifty years, bank balance sheets have grown so fast that today they are over five times annual GDP. The size of the US banking industry has grown from around 20% in Bagehot’s time to around 100% of GDP today. And, until recently, the true scale of balance sheets was understated by these figures because banks were allowed to put exposures to entities such as special purpose vehicles off balance sheet.

    Surprisingly, such an extraordinary rate of expansion has been accompanied by increasing concentration: the largest institutions have expanded the most. Table 1 shows that the asset holdings of the top ten banks in the UK amount to over 450% of GDP, with RBS, Barclays and HSBC each individually having assets in excess of UK GDP. Table 2 shows that in the US, the top ten banks amount to over 60% of GDP, six times larger than the top ten fifty years ago. Bank of America today accounts for the same proportion of the US banking system as all of the top 10 banks put together in 1960.

    While banks’ balance sheets have exploded, so have the risks associated with those balance sheets. Bagehot would have been used to banks with leverage ratios (total assets, or liabilities, to capital) of around six to one. But capital ratios have declined and leverage has risen. Immediately prior to the crisis, leverage in the banking system of the industrialised world had increased to astronomical levels. Simple leverage ratios of close to 50 or more could be found in the US, UK, and the continent of Europe, driven in part by the expansion of trading books (Brennan, Haldane and Madouros, 2010). And banks resorted to using more short-term, wholesale funding. The average maturity of wholesale funding issued by banks has declined by two thirds in the UK and by around three quarters in the US over the past thirty years – at the same time as reliance on wholesale funding has increased. As a result, they have run a higher degree of maturity mismatch between their long-dated assets and short-term funding. To cap it all, they held a lower proportion of liquid assets on their balance sheets, so they were more exposed if some of the short-term funding dried up. In less than fifty years, the share of highly liquid assets that UK banks hold has declined from around a third of their assets to less than 2% last year (Bank of England, 2009). Banks tested the limits of where the risk-return trade-off was located, in all parts of their operations. As John Kay wrote about his experience on the board of HBoS, the problems began “on the day it was decided that treasury should be a profit centre in its own right rather than an ancillary activity” (Kay, 2008).

    Moreover, the size of the balance sheet is no longer limited by the scale of opportunities to lend to companies or individuals in the real economy. So-called ‘financial engineering’ allows banks to manufacture additional assets without limit. And in the run-up to the crisis, they were aided and abetted in this endeavour by a host of vehicles and funds in the so-called shadow banking system, which in the US grew in gross terms to be larger than the traditional banking sector. This shadow banking system, as well as holding securitised debt and a host of manufactured – or ‘synthetic’ – exposures was also a significant source of funding for the conventional banking system. Money market funds and other similar entities had call liabilities totalling over $7 trillion. And they on lent very significant amounts to banks, both directly and indirectly via chains of transactions.”

    —— The above is from the horse’s mouth. Europe MUST listen to Mervyn King..

    The second issue, (as I see it), is well known to readers of these pages; in that I believe that the present structures, such as the EIB, do not have the correct mindset to address the underlying problem of there not being ANY mechanism to capitalise free enterprise business, (and thus job), creation. Grand gestures via the existing EIB way of thinking; lending vast sums of money through EXISTING government and large corporates; is NOT investment. We must have new investment right down at the grass roots of every nation.

    That leverage and a lack of a simple, but well thought out system, widely accepted set of rules; to permit normal free enterprise job creation right down at the grass roots of every nation; are the deeply embedded flaws that must be addressed.

    Europe has to change direction. Yes, it will take great courage to accept that previous thinking was wrong; but they have no choice. They must address the real problems. Grossly excessive leverage and lack of free enterprise equity capital investment right down at the grass roots of every Western economy.

    • Thanks for the Mervin King piece, Chris – a good reminder of what needs to be addressed in UK as well as Europe. I’ve been rather amazed that King has made so much sense for so long as the HEAD (for Christ’s sake) of the Bank of England, then to be completely ignored by the powers that be, not only in England, but everywhere.

    • David,

      thanks for the support; very much appreciated.

      You are correct, Mervyn King seems to be the only head of a central bank that has openly addressed the underlying facts; yet, he seems to have been ignored. Perhaps one reason is that the Bank of England is in the process of becoming the “Prudential Authority” within the United Kingdom. And by that meaning; that it will also become responsible for the shadow banking system as well.

      What most do not understand is that the shadow banking system is in fact what we once called the savings institutions; particularly the insurance companies. So an associated implication is that these “others” were also taking advantage of the “blind eye” of the authorities’, (apparent, sic!, lack of understanding of the entire workings of the financial system), to openly act as though they were themselves banks to “Leverage” their inputs. So we are NOT dealing with a banking crisis; we are dealing with a systematic creation of almost unbelievable volumes of what one might call “Vapourware” (grossly leveraged income), by institutions totally OUTSIDE of the banking system.

      Again, I believe that Mervyn King has been very conservative with the proposal that it was fifty, when I have read of examples where others thought it might have reached several hundred or more), and then, to make matters much worse, re-distributing the leveraged paper amongst themselves.

      Let me give you an example. Think; if you wanted to open a business, you must be able to supply sufficient assets, equity capital, to underpin your trade and then, you can only trade to the limit of those assets. So how did the many “Hedge Funds” come up with their sometimes hundreds of billions? Where did the money come from? I say it came from a friend saying to another, Hey Fred, why not open a Hedge Fund and I will send you billions for which all I will ask for in return is, say, 5% return, and with the software I am going to also send you, (also of course for a small consideration), you can deal electronically via a computer on the “Markets” and make at least 12% return. (And of course, also, as a hedge fund, you too can lend to others……..). Pass it on Fred….

      So Fred does not have any real capital; instead, he has a friend who will also benefit by being able to offload his “LEVERAGED” paper to another that will not ask too many questions of how he got started…….. That is how we suddenly have so many hedge funds trading on computers and earning so much money….. except that it is entirely money that is vapourware; perhaps as little as one three hundredth of a Euro for each supposed Euro…. …

      Now we can see why the authorities have been so reluctant to widen the discussion; it leads to the recognition that this is not just a banking crisis, it is the entire financial system that is broken. Imagine being faced with many loose bricks in the walls of your home and knowing that if you pull any single one of them out, the whole house might fall down. What do you do? ….. you try and forget and just carry on living there in the hope that nothing will happen that brings the house down around you.

      Sooner or later, we must have a leader that has the courage to face the facts and acts accordingly. All we can and must do is keep the facts out in the open so that they are not swept under the house carpet.

      Mervyn King is not receiving any political support so we have to assume his hands are tied; that he cannot act. So the question is; is Draghi that leader?

      We will know that answer within a couple of months.

  • Yanis, I am not going to pull any punches here. There are some huge problems with your modest proposal.

    1.You say “EFSF’s funding on bank recapitalisations must be separated full from funding of national governments” – This money will ultimately come from the taxpayer and savers. Do you acknowledge that your proposal is reallocating the assets of citizens without democratic involvement?

    2. But continuing on to your second point it seems you do not see the connection, you say “. If, in contrast, the ECB issues its own bonds, the German taxpayer will not be directly responsible for these bonds. ” – Any increase in the money supply reduces the buying power of ALL European taxpayers and savers and anyone that has Euro’s. To say the German taxpayer will not pay for the increase in the number of Euros in existence is totally incorrect. (You talk about Target 2 but I do not believe this involves the creation of Euros in any way, please correct me if I am wrong)

    3. You say “Our proposal is that the EIB-EIF are simply allowed to borrow on banking principles (i.e. predicated upon the quality of their business plans) in order to energise idle savings and turn them into productive and profitable investments.” – Yanis, you must be impression that banks do not want to make money. If there is an opportunity for banks to make a profit, trust me, they will take it, the last thing they want is government involvement in their money making adventures, I am sure you will agree with this? Banks must be being presented with good business plans, even now, so you have to ask, why are they not lending? Is it because they do not have the cash available? Or are they acting in a coordinated fashion to choke the credit supply in order for politicians to enact a plan along the lines of what you are proposing?

    In summary, do believe the answer to the Euro crisis is to try to restore the balance sheets of the major European banks? Is this the goal of the modest proposal?

    • Let me take each point separately:

      1. Taxpayers are already paying through the nose and without consultation. If the EFSF capitalises banks directly, takes equity in them and the ECB-EBA supervise their return to health (i.e. appoint new boards, wind down the basket cases amongst them etc.), the equity can be sold back to the private sector in a year so as to ensure that the taxpayers receive their money back with interest (as happened in the US with TARP). Currently, we have no democratic accountability and taxpayer money being poured down the drain. With our proposal, the democratic deficit remains but, at least, there will be no wasted taxpayer money.

      2. There is fundamental error here. Issuing ECB bonds will NOT increase the money supply. Not in the slightest. We are, you must recall, not suggesting that the ECB prints the money. We are suggesting that it plays the role of go-between markets and member-states so as to ensure that the total interest the Eurozone member-states will repay in the next 200 years is reduced by up to 30%. If anything, this will allow the ECB to reduce the rate of money supply expansion – which today is large and worrying.

      3. What you say about banks’ profit-seeking leading to the funding of profitable investment projects applies in normal times. But these are not normal times. All of the Eurozone’s banks have negative equity. They are, technically, insolvent. This means that they do not and they will not lend to anyone any amount of money, concerned as they are to hoard as much cash as possible. Under these extraordinary circumstances only a public and solvent bank like the EIB can break the vicious circle.

  • Prof. Varoufakis,

    I would be very interested in your take on the proposal to change the ECB’s mandate to NGDP level targeting.

    The main message of your “Global Minotaur” is that we need a new Surplus Recycling Mechanism. Labour and money markets don’t return to equilibrium (sticky prices, liquidity trap), that’s why markets need a helping hand. I asked myself, why can’t monetary policy (if needed in combination with fiscal policy, think of helicopter drops) be this helping hand? You never talk about monetary policy.

    We agree, that in our current situation we need some mechanism which brings back aggregate demand, but with no politics involved since we don’t have a fiscal union. Monetary policy fits perfect. (Even if -as a transmission mechanism in a liquidity trap- a helicopter drop is needed, it’s not fiscal in the sense of discretionary spending. There’s no politics involved.)

    I will even make a stronger assertion: only monetary policy can solve our problem. Your proposal will rescue us from utter catastrophe, but there is still the danger of turning Japanese. Japan did a lot of fiscal spending and is still in stagnation. Why? I believe what they really neeed but never did: creating inflation expectations! This would make money into a hot potatoe, stimulating demand and easing the debt burden. Without higher inflation no amount of fiscal policy can work, the left hand (fiscal policy) will be neutralised by the right hand (monetary policy).
    So, where does your plan differ from what the Japanese did? Why should it work better? (What would the EIB do but building bridges to nowwhere?)

    My propoals would be: let the ECB level target NGDP by giving each and every Euro-citizen a transfer payment until NGDP is on target. Rising NGDP will reflate prices, helping business and banks, easing the burden of government debt. Even Merkel’s austerity could be neutralised, the more states are forced to cut spending which depresses NDGP, the more the ECB would have to print money to rise NGDP again.

    By the way, if my parents didn’t lie to me I’m German and I know, what I’m proposing here is the ultimate nightmare of most Germans, but the inflationphobe Germans carry the biggest danger of turning Japanese, they are in lots of ways the Japanese of Europe. So NGDP level targeting would help most of all the Germans, even if they won’t welcome it or especially if they won’t welcome it.

    So, what do you think?