Yanis Varoufakis: Why Reinhart and Rogoff are Wrong About the Eurozone’s Debt Structure and the Costs of Debt Mutualisation

Yves here. I don’t know whether to be relieved or annoyed to see Carmen Reinhart and Ken Rogoff retreat from their pro-austerity stance and endorse debt restructuring, since their prior view (that budget-cutting was necessary and productive) served to justify considerable and unnecessary pain being inflicted on periphery Eurozone countries to preserve the illusion of health of French and German banks.

But as Yanis Varoufakis points out, although Reinhart and Rogoff are retreating from much of their erroneous thinking, they haven’t renounced all of it.

By Yanis Varoufakis, a professor of economics at the University of Athens. Cross posted from his blog

Carmen Reinhart and Kenneth Rogoff recently published a notable IMF working paper (13/266) entitled ‘Financial and Sovereign Debt Crises: Some lessons learned and those forgotten’ (December 2013). Their overarching claim is that the advanced economies are wrong to pretend that the present levels of debt can be sustained by means of fiscal austerity and without debt restructuring, sustained inflation or a combination of the two. This is a sensible argument, well grounded on empirical and historical evidence, that governments would be wise to internalise. 

However, while the general thrust of the Reinhart and Rogoff paper is indeed reasonable and in principle useful, their discussion of Eurozone debt crisis is founded on a factual error that, since 2010, has been underpinning erroneous policy responses to the Euro Crisis.

Here is the contentious paragraph: “…the size of the problem suggests that restructurings will be needed, particularly, for example, in the periphery of Europe, far beyond anything discussed in public to this point. Of course, mutualization of euro country debt effectively uses northern country taxpayer resources to bail out the periphery and reduces the need for restructuring. But the size of the overall problem is such that mutualization could potentially result in continuing slow growth or even recession in the core countries, magnifying their own already challenging sustainability problems for debt and old-age benefit programs.” [p.10, emphasis added]

In the above paragraph, Reinhart and Rogoff are, in effect, restating the Merkel rationale for rejecting Eurobonds. When they speak of debt mutualisation, they take it for granted (mistakenly) that debt mutualisation can and must only come in the form of jointly and severally guaranteed Eurobonds; that is, bonds issued with the backing of all the Eurozone member-states jointly. Under such a scheme, Germany and… Greece, Holland and Portugal, Austria and Spain, etc., will be backing some form of common debt (or bond). Naturally, the interest rate that this common debt will incur will be some weighted average of the interest rates of the member-states’ government bonds. In short, Germany will be paying more to back this common bond than it now pays for its bunds, and Greece will be paying less than it would have had it been issuing its own bonds. In this sense, Reinhart, Rogoff and Merkel are correct: Germany, and the rest of the surplus Eurozone nations, will be subsidising the deficit member-states (in contravention of the Lisbon Treaty and Germany’s constitutional court strictures). Moreover, it is quite likely that, under such a scheme, not only will the joint interest rate prove too high for countries like Germany but, to boot, it may well turn out to be insufficiently low for countries like Greece!

Nevertheless, it is a serious mistake to identify debt mutualisation with jointly and severally guaranteed Eurobonds. For there is another mechanism by which to mutualise debt and substantially reduce the Periphery’s aggregate debt without incurring any costs upon countries like Germany. [t is the mechanism that we have included as Policy 2 (ECB-Mediated Debt Conversion) in our Modest Proposal for Resolving the Euro Crisis; and which can be shown to reduce the debt crisis’ burden not only on the Eurozone’s peripheral countries but also on Germany.

Key to this alternative, mutually beneficial, debt mutualisation scheme is that no government backs the new, common (or Union) bonds. Instead, part of the public debt of each Eurozone member-state (the part that it was allowed to have according to the original Maastricht Treaty – let’s call it ‘Maastricht Compliant Debt’ or MDC) is mutualised through the issue of bonds by the European Central Bank itself (ECB). Here is how this ECB-mediated debt conversion works:

The ECB announces forthwith that it will be undertaking a Debt Conversion Program for any member-state that wishes to participate: The ECB will service (as opposed to purchase) a portion of every maturing government bond corresponding to the percentage of the member-state’s public debt that is allowed by the Maastricht Treaty. To fund these partial redemptions on behalf of some member-state, the ECB will issue bonds in its own name, guaranteed solely by the ECB but repaid, in full, by the member-state. Upon the issue of ECB bonds, the ECB will simultaneously open a debit account per participating member-state into which the latter is legally bound to make deposits to cover the ECB-bonds’ coupons and principal. These debts of member-states to the ECB shall enjoy super-seniority status and be insured by the European Stability Mechanism against the risk of a hard default. This Debt Conversion Program, which involves no debt monetisation by the ECB, and no guarantees of part of the Periphery’s debt by Germany, will instantly engender large interest rate reductions for fiscally-stricken states without any concomitant rise in the long term interest rates that Germany pays (since Germany is not guaranteeing the Program). [For more details, see Policy 2 of the Modest Proposal here.]


Reinhart and Rogoff make a good point regarding the advanced economies’ current state of denial: Fiscal consolidation cannot address the debt crisis that has befallen them and debt restructuring will, eventually, prove unavoidable. However, when it comes to the special case that is the Eurozone, the almost complete lack of common debt within the Euro Area makes it possible to reduce the total amount of debt through a clever form of mutualisation that does not involve redistributing debt from the deficit to the surplus nations. Assuming that debt mutualisation can only come in the form of jointly and severally guaranteed Eurobonds is both incorrect and an impediment to the development of sensible public finance policies in Europe.

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  1. j gibbs

    This appear to be a clever idea, but it appears to leave all the country debt in place and, thus, would really only benefit the creditors who have already sucked out the greater part of European economic blood, right? IMHO, what is needed is are substantial haircuts on country debt as well as personal debt. Wonder how R&R feel about that?

  2. pebird

    I worry about this “restructuring” theme – probably code for a depositor bail-in, as the banks are large holders of Euro debt.

    As Martin Armstrong says, how can you have a common currency without a common debt? The Euro is an uncommon currency, indeed.

  3. Generalfeldmarschall von Hindenburg

    After these chumps were exposed as to say the least, inexpert users of Excel, why does anyone need to take them seriously?

    Once someone is anointed as a technocrat, I guess you can make colossal mistakes and still be treated as a sage. Just look at Greenspan.

    1. Xelcho

      Indeed. I can not agree more with you. After such a colossal failure and then the complete BS position they played afterward, they have ZERO credibility. Pathetic, if anything the only reasonable response to anything they post would be the question, “How are you two going to undo all of the damage you have wrought upon Europe?” There simply is no moving beyond it!


      1. Martin Finnucane

        I’d assumed that they’d crawled back under whatever rock they came out from under (Harvard, right?), never to be heard from again. Instead, here they are experting it up again. Perhaps they’re right or right-ish this time, but I’m at least right-ish most of the time, and unlike R&R I certainly never polluted the world with anything so stupid or corrupt as what neolib hack supremo Niall Ferguson termed the “law of finance.” And yet here I am languishing in obscurity.

        Ah, to belong to that Golden Caste. How does one get in?

  4. Fiver

    Five years have passed during which Germany has been charged by all and sundry with failure to backstop the entire Eurozone and now…we’ll just…pull…. the ole.. shuffle-roo and…. Presto! Germany isn’t needed to back the Eurozone because the ESM will? Not sure if “markets” predatory as ever, will accept the distinction.

    But even supposing the best outcome, I do not see how places like Greece, the Balkans, Portugal, Eastern Europe, the former ‘stans, all the smaller or weaker countries all over the world are going to have the wherewithal to improve their lot so long as they remain under the foot not of Germany, or some other local “bad guy” but of a criminally insane class of global corporate capitalists who’ve just “grown beyond us.”

  5. Ilya

    Imagine the moment euro was presented in Europe Union and countries debt and accumulations were converted correctly in euro. The total amount of euros was fixed. How this total amount of euros will be distributed in next 1, 3, 5, 10 years. It is clear that most money will be accumulated in countries which sells most, i.e. in Germany. Printing bonds and sending tranches to poor countries can helps or a moment but then capitals will be again accumulated at the same place. Then inflation will also deteriorate local economies. Conclusion: the idea of using a single currency in the form as it was presented euro was not a ‘perfect’ and standard manipulations that worked in multi-currency union could not improve new single currency union.
    Current economic situation is quite favorable for Germany and unfavorable for many others.

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