Debt Redemption, PSI&OSI versus our Modest Proposal: Q&A with Portuguese readers

20/07/2013 by

The debate on the Modest Proposal 4.0 is hotting up. Here are comprehensive answers to queries from Portuguese readers of Exrpesso magazine concerning debt haircuts, the European Stability Mechanism, the differences between a Debt Redemption Fund and our Modest Proposal etc. My answers were later incorporated into this comprehensive story by Jorge Nascimento Rodrigues.

Portuguese socialists suggested that: “The share of sovereign debt exceeding 60% of GDP should be managed at European level, each country assuming responsibility for payment of interest. This solution lowered the interest payable and the budget deficit. Notwithstanding this overall solution, based on a “Redemption Fund,” our country must defend the intervention of the ESM in protecting the debt issues of countries with difficulties.”

This is the German Council of Economic Advisers’ recommendation, known as the Redemption Fund. It is misconstrued for two reasons.

First, it plays to the critics of any central management of public debt because it appears to reward member-states in proportion to the extent to which they violated the Maastricht Treaty’s limit regarding public debt. By offering to convert (at lower rates) debt that exceeds the member-state’s Maastricht Compliant Debt (MDC – 60% of GDP) it sounds like a policy tailor-made to rewarding member-states that violated the Eurozone’s basic rules. In contrast, the Modest Proposal proposes a debt conversion plan that concerns only the (under the Treaties) ‘legitimate’ MDC of each member state, leaving the ‘illegitimate’ debt (which exceeds MCD) to the member-states. As such our recommendations answer decisively criticisms based on the notion of moral hazard.

Secondly, the Redemption Fund proposal is based on the dangerous idea that its adoption be made conditional on a massive reduction of public debt down to MDC levels. This means that the public debt of, say, Italy, must be cut by 50% within twenty years or so. It would be suicidal for any Italian government to commit to such an idea as it would lock in expectations of massive deflation, courtesy of the gargantuan primary surpluses that it would involve.

Lastly, the idea that Portugal “must defend the intervention of the ESM in protecting the debt issues of countries with difficulties” is seriously misguided in the sense that it shows no understanding that, in view of the CDO-like structure of the ESM’s own bonds (by which it finances ‘rescues’), having the ESM assist the bond yields of Portugal or Spain will accelerate the crisis. This is why the Modest Proposal suggests that the ESM should not be giving any assistance to member-states (leaving the limited public debt conversion programme to the ECB) and instead concentrate: (a) on direct bank recapitalisations and (b) providing insurance to the ECB’ limited public debt conversion programme.

Is your ICRP (adding the ESSP) is preferable to a full type Marshall Plan from the Eurozone surplus countries? What are the strong points of your ICRP?

A Marshall Plan requires a great power that is ready and willing to give away a very large sum of money to deficit countries or regions; just as the US did after the war. No one is prepared to do this now. Nor should they, really. It is a great error to believe that Germany should pay either for the debt or for the investments that our countries so desperately need. No, what we need is closer to a European New Deal than a Marshall Plan for Europe’s periphery. And this is precisely the essence and the strength of our proposed Investment-led Convergence and Recovery Program (ICRP). ICRP is all about mobilising idle private savings, through the European Investment Bank and its sister organisation the European Investment Fund, and helping them find their way into productive investments that will both yield good returns for investors and, of course, help Europe recover. In short, the strong points of our ICRP are: (1) No need for governments to finance it, and thus no need to ask the taxpayers of the surplus countries to guarantee them, (2) No new institutions are necessary (since the EIB and the EIF are ready to take on this task, and (3) it helps Europe escape the false dilemmas of stability-vs-growth and austerity-vs-stimulus.

How to convince German voters of any solution instead of punitive austerity if they have no historical memory of the Austerity Bruning period in the 1930s and of the details of the debate in Bretton Woods between the Americans and Maynard Keynes?

Through rational arguments. By pointing out to them that the current policies are (a) costing them dearly (e.g. the forthcoming Greek OSI) and (b) are failing. By explaining to them that policies like those in the Modest Proposal would solve the crisis without German taxpayers paying a cent, without any debt buybacks, without rewarding the profligate or causing inflationary pressures, without bending the rules of the Union.

Why not a PSI or/and OSI debt hair cut? A Leftist party in Portugal proposed this month a haircut of 50% of official and private debt (overall €203 billion end of May) with a debt swap with a new maturity of 30 years.

Over the past few years, especially in 2010 when the Greek loan and associated memorandum were being hatched, my position was clear: Our governments should propose a rational Eurozone-wide solution like the one in our Modest Proposal. And use the threat of default (along the lines suggested by the Portuguese leftist party that you mentioned) as leverage. If Germany and other surplus countries reject proposals like ours, that would solve the crisis without making the surplus nations pay for our debts, then we have no alternative than to say No too. No to huge loans in order to repay un-payable debts on condition of reducing our GDP massively (which is what austerity does). This remains my line. Faced with such a determined position, I believe that Berlin and Frankfurt would see reason and avoid our unilateral defaults. For we should make no mistake. While default is preferable to the current situation (of accepting huge new loans plus harsh austerity that destroys our economies), it would pose great problems for the Eurozone – and for our countries too. A large scale PSI would leave the Portuguese banks deeply insolvent whereas an OSI to our debts to the EFSF-ESM would probably bring down the EFSF-ESM. Then again, if Berlin-Frankfurt refuse to listen to rational voices, insisting that our countries are reduced to dust, so be it. The task of the Modest Proposal is, at the very least, to silence those who argue that there is no alternative to the current policies.

The Eurogroup and the Germans already accepted, although late as IMF recognized recently, a restructuring of Greek debt. Why not to “extend” that proceedure to Portugal for instance (that has now a debt to GDP ratio of 123.3%)?

They will probably have to do this. However, what is the logic of accepting a haircut for Greek and Portuguese debt but not for Ireland’s or Spain’s or, indeed, Italy’s? There is no logic in dealing with this issue on a case by case basis. This is why the Modest Proposal offers a universal solution to the debt crisis that applies equally to any member-state that chooses to participate in our proposed debt conversion of the Maastricht Compliant Debt (MDC).

In Greece the situation is presently different. Over 75pc of the overall debt is in the hands of troika; in Portugal for example is 32%. An OSI is unavoidable with the Greek debt ratio to GDP over 168%? Are Merkel and Schauble opposing an OSI because of the German September elections or because it would be a huge precedent?

For both reasons. First, the German government is going to the polls by telling German voters that it has managed to defeat the Euro Crisis without any serious concessions on Eurobonds, OSI etc. Mrs Merkel does not want to agree to anything that will upset this electoral strategy. But there is another reason too. The ESM cannot handle an OSI. At least not without a large cost. Think about it. The monies the ESM has provided to Greece, Ireland, Portugal and Spain are borrowed by the ESM which issues, for this purpose, its own bonds using guarantees by the rest of the member-states – including Italy and, yes, Spain. A large OSI would mean that the ESM’s own bonds will suddenly see their yields rise and, at the same time, so will Italy and Spain because (a) the chances of being helped in their hour of need, by the ESM, will have diminished (as the ESM’s borrowing costs increase) and (b) they stand to lose some of the money that they have guaranteed to the Greek bailout. I think it is now becoming increasingly clear that the ESM should never have got into the business of lending member-states. It is why we insist that the debt crisis should be dealt with by the ECB (as part of our limited debt conversion programme) while the ESM should be redeployed as, mainly, a bank recapitalisation fund.

The Troika imposed on the Greek government public sector workers’ layoffs (permanent and temporary – through a so-called ‘mobility scheme’) so as to provide Greece with the next tranche of €6.8 billion. In Portugal, the Public Expenditure Review imposed a permanent public expenditure cut of €4.7 billion (or 2.8% of GDP) for 2013 and 2014 as a pre condition to the follow-up of the bailout program until June 2014. What are the alternatives to these mandatory cuts?

The alternative is to wake up to the reality that these further cutbacks are like petrol thrown onto a fire; that, at a time of rapidly diminishing private sector expenditure, to introduce further cuts to public expenditure (especially through layoffs that cause the greatest negative multiplier possible) is to eat massively into our countries’ national income and, therefore, to enhance, idiotically, our debt-to-GDP ratio. So, the simple answer to your question is that the alternative to these policies is to… cease and desist. To embrace policies that escape the toxic dilemma of austerity-vs-stimulus. How can this be done? Our answer is in the Modest Proposal 4.0

Are precautionary lines for Portugal and Ireland inevitable? Because those precautionary lines from European sources or IMF are temporary by nature, eventually to cover 2014-2015, what do you expect after 2015 for Portugal and Ireland?

Support is inevitable since neither Portugal nor Ireland is viable. But, there are many ways in which our leaders can provide more funding. One alternative would be for Ireland and Portugal to be placed formally under the umbrella of the ECB’s OMT. That way Europe can claim, disingenuously, that the two countries have “returned to the markets” when, in reality, only the ECB’s threat to bond dealers will have allowed that. Of course, such a development would not change anything on the ground since a new Memorandum and fresh austerity will be part and parcel of the strategy.

Spain has already €60bl from the €100bl package for Banks recapitalization. Do you think will they need to use these billions?

The greatest danger for Europe presently is that we shall end up with zombie, undercapitalised banks for ever and ever; that, so as to limit the states’ borrowing from ESM, on behalf of their banks, they will pretend that the banks have been adequately capitalised when that is as far from the truth as possible. Spanish banks need more than €100 billion. Settling for less sounds good in Madrid but Spain will pay for that with a never ending credit crunch.

In more general terms what do you mean by the proposal for a direct recapitalization from ESM?

We propose that banks in need of recapitalisation from the ESM be turned over to the ESM directly – instead of having the national government borrow on the bank’s behalf. Banks from Cyprus, Greece and Spain would likely fall under this proposal. The ESM, and not the national government, would then restructure, recapitalize and resolve the failing banks dedicating the bulk of its funding capacity to this purpose. Thus the umbilical cord between the banking crisis and the debt crisis will be severed.

More precisely, our proposal is that a national government should have the option of waiving its right to supervise and resolve a failing bank. Shares equivalent to the needed capital injection will then pass to the ESM, and the ECB and ESM will appoint a new Board of Directors. The new board will conduct a full review of the bank’s position and will recommend to the ECB-ESM a course for reform of the bank.

Reform may entail a merger, downsizing, even a full resolution of the bank, with the understanding that steps will be taken to avoid, above all, a haircut of deposits. Once the bank has been restructured and recapitalised, the ESM will sell its shares and recoup its costs.

All this can be implemented today, without a Banking Union or any treaty changes. The experience that the ECB and the ESM will acquire from this case-by-case process will help hone the formation of a proper banking union once the present crisis recedes.

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