by James Galbraith, Stuart Holland and Yanis Varoufakis (*)
Peter Bofinger’s proposal for Euro-bundles (see here for an introduction) serves the noble purpose of rekindling the debate on the Eurozone’s fiscal and monetary incoherence. The idea behind Euro-bundles is to issue a common bond without joint liability that the ECB can then purchase in the context of a monetary policy that uses quantitative easing to fend off deflation, with the welcome side effect of lessening the Eurozone’s borrowing costs. While we shall be arguing that Professor Bofinger’s Euro-bundles are ill- conceived, we applaud his idea of a common bond involving, in some capacity, the ECB. This idea points in the direction of a genuine solution to the Eurozone’s fiscal and monetary fragility.The problem with Professor Bofinger’s Euro-bundles
Euro-bundles are not new. Indeed, they are virtually indistinguishable FROM the bonds issued by the EFSF (an SPV hastily conceived in May 2010 to raise the funds necessary for the Periphery’s ‘bailouts’) and by its permanent successor, the ESM. They are bundles of sliced up sovereign bonds, with each slice corresponding to one member-state debt (in proportion to their GDP), complete with separate interest rates and different default probabilities. In short, they are a CDO-like toxic debt instrument that contains (as we have explained here, here and here long ago), the domino dynamic; which led to the sequential bankruptcy of several Eurozone member-states after the creation of these EFSF-bonds.
In short, Europe has produced such Euro-bundles before, with dire consequences. So, what is new in Professor Bofinger’s proposal? The novelty is that the ESM (or a new Special Purpose Vehicle, an EFSF Mk2) would be issuing a lot more of these bonds on behalf of member-states on the understanding that the ECB will be purchasing them through quantitative easing (i.e. of its monetary policy) aimed at combating deflation. This seems both unlikely and unwise to us on two counts: First, the ECB could buy, if it decides to adopt quantitative easing, existing sovereign bonds from each member-state in proportion to their GDP. No need for Euro-bundles here. Second, Professor Bofinger’s argument that Euro-bundles will help ease the Periphery’s borrowing costs, as well as slow down the flight from Peripheral to Core bonds (in a time of crisis), seems weak for the following reasons.
The weakness of Euro-bundles is revealed when we examine how the financial sector will respond to their creation. For if Euro-bundles were to be sold on to private investors, what would stop financial engineers in Goldman Sachs and its competitors from constructing derivatives that effectively ‘unbundle’ the Euro-bundles, selling those new derivatives to investors, with different risk preferences and speculative ambitions? Capital could then flee the Periphery’s debt in favour of bunds and other core bonds just as easily as if no bundle had been issued. For as long as the Euro-bundles, like the EFSF-ESM bonds, are CDO-like in construction, their inner fragmentation can allow markets to unbundle them at the drop of a hat. This is, indeed, what we observed over that past few years with EFSF-bonds, at least until the ECB stepped in with the game-changing announcement of OMT; i.e. with the threat of massive debt monetisation.
Salvaging Professor Bofinger’s underlying idea: The case for ECB-bonds
Professor Bofinger proposed Euro-bundles to solve two problems afflicting the Eurozone: First, to create a common Eurozone debt instrument that the ECB could purchase as part of quantitative easing, the purpose of which is to stave deflation off once interest rates have reached their zero lower bound. Secony, to find a roundabout way to ease the Periphery’s borrowing costs without, however, having Germany or the Netherlands guarantee the bonds (or part of the bonds) of Greece, Portugal or Spain.
We fully support the notion of a new, Eurozone-wide debt instrument that is not jointly guaranteed by member-states (i.e. with no joint liability) but which helps consolidate both fiscal and monetary policy within the common currency area, with the ECB playing a major role in its creation and management. But, if the ECB is to play a major role (as it ought to), why confine this role to that of the new bond’s (quasi-guaranteed) buyer? Why create a new SPV to (or have the EFSF) issue Euro-bundles to be purchased by the ECB, or have the ESM do something similar, when the ECB could itself be the issuer of a solid, homogenous ECB-bond that would be immediately marketed to the joy of investors everywhere?
This has long been a central policy recommendation of our Modest Proposal for Resolving the Euro Crisis: ECB-bonds! (See Policy 2: An ECB-mediated Limited Debt Conversion Program.) Our recommendation is that the proceeds from ECB-bonds would be used to service, not to buy, Eurozone member- states’ debt up to a ceiling, the Maastricht ceiling of Debt to GDP, which is fixed at 60%. Obviously, the servicing stops when each ECB-bond matures and is redeemed by the member-state debited with its servicing, not the ECB. During the ECB servicing period the member-state pays the ECB its own servicing cost plus a small fee, so the ECB does not monetise any country’s debt; nor is there German liability for the ECB-bonds issued on behalf of Greece or Portugal.
The merit of our ECB-bonds proposal is that it kills three birds with one stone:
(A) The BONDS bring into being a solid, homogeneous common Eurozone bond (unlike the current EFSF-ESM CDO-like bonds or Professor Bofinger’s Euro- bundles) that will attract idle savings from far and wide.
(B) They offer the ECB a way out of its monetary policy paralysis (as the ECB will be able buy back its own ECB-bonds from private sector banks; thus effecting quantitative easing)
(C) They offer the prospect of co-financing a European Investment Bank-led Recovery program, as per our Policy 3 recommendation in the Modest Proposal.
Professor Bofinger has correctly identified a dangerous GAP in the Eurozone. A GAP that requires that a new Eurozone-wide debt instrument BE created in order to allow the ECB to carry out its monetary duties, and TO escape its current paralysis in the face of powerful deflationary forces. His proposal for Euro-bundles, however, represents a step back to the EFSF- ESM toxic bonds.
However, the idea of a new debt instrument, in whose creation the ECB must play a central role, is spot on. The optimal debt instrument for these purposes must be solid and homogenous and must not require joint liability of core and peripheral member-states. The solution is the issue of ECB- bonds, as part of a Limited Debt Conversion Program that we outlined in the Modest Proposal.
(*) We owe a debt to George Krimpas for having spotted the gist of our argument even before we did, and having provided even part of the wording above.