Revisiting the Modest Proposal: Q&A with a Skeptic – Fall 2014 version (*)

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

As Europe seems resigned to the perpetuation of the Euro Crisis, with its authorities in a state of permanent paralysis (with only the ECB trying, and failing, to stem the debt-deflationary vortex), it seems more pertinent than ever to keep the debate on the Modest Proposal going. If only as a reminder to the powers-that-be that there are immediately implementable policies whose implementation would stem the crisis without breaking any of the existing rules, without having the core countries pay one euro for the debts and losses of the periphery, and without any further diminution of national sovereignty. Can all this be possible? Is the Modest Proposal genuinely capable of delivering such much-needed relief at no cost and without bypassing any of the existing rules? We, the authors of the Modest Proposal, think so. Of course, sceptics have every right to pose questions and challenge our hypotheses. In this post, one such sceptic asks pertinent, probing questions about each of the Modest Proposal’s four policies. Which we do our best to answer. [(*)For earlier Q&As on the Modest Proposal, raising many of the same issues, click here and here.) Read on…

Banking Crisis (Policy 1)

Does the step-by-step bank recapitalisation (recommended by Policy 1) not contradict a basic tenet of existing Treaties, contrary to the Modest Proposal’s claim that it stays within existing rules and Treaties? Will the ESM not suffer losses?

Of course there will be losses. Resuscitating bankrupt bankers will always come at a loss. But not of the ESM. Indeed, judging by historical precedent, the ESM should have no difficulty returning a (small) profit to the European taxpayer.

Let us look at these historical precedents. Indeed, the Modest Proposal’s idea here is neither new nor untried. In effect, we are suggesting that the ESM should function like TARP did in the US (after 2009), like the Swedish, Finnish and Norwegian Banking Authorities in 1992, indeed like the Banking Authority of South Korea in 1998. In all these instances (that followed massive financial sector collapses), the public bank bailout fund stepped in, capitalised the banks, wiped out the banks’ bondholders and shareholders (ensuring that the losses would not fall on the fund itself) and restored, in association with the Central Bank, the banking system. In each of these occasions, the ex post market valuation of the banking system exceeded the ex ante capital injected by the public fund into it. There is no reason why the ESM could not do likewise. Even if there are net losses in the case of some banks, the net gains made from the rest of the ESM’s banking ‘portfolio’ should compensate adequately.

(Addendum: The ESM is most certainly going to take losses under the current regime anyway! The Greek state, for example, will never be able to meet its current repayment schedule, for the 40 to 50 billion we borrowed for the banks. The rescheduling of Greece’s repayments that Mrs Merkel and Dr Schaeuble have promised Prime Minister Samaras is a haircut, at least in present value terms.)

If the ESM’s bank recapitalisations could return a profit, why wouldn’t any private investor be willing to do it?

Three reasons: First, to succeed, this type of recapitalisation must come with economies of scale and substantial coordination that private investors cannot pull off. (Recapitalising one bank in an environment where many are zombiefied, does not generate the trust and optimism throughout the banking sector that would make this investment safe). Secondly, at a time of a general banking malaise, no private investor can (or wants to) raise the capital required (recall also Keynes’ characterisation of investors as “fair weather sailors who not only abandon their vessels in a storm but also destroy the lifeboats that can transport to dry land”). Third, TARP, the ESM etc. can/do work together with legislators and the Central Bank to make this happen. Private investors cannot do this.

Public Debt Crisis (Policy 2)

Turning now to the proposal that the ECB offers member-states the opportunity for a limited debt conversion (Policy 2), pertaining only to their Maastricht compliant debt (and thus limited), what happens to the remaining debt (exceeding the Maastricht limits of 60% of GDP)?

It is simple: The ‘bad’ or ‘red’ or Maastricht non-compliant’ part of maturing bonds will have to be repaid by the member-states – as is the case now for 100% of their debt. There are two possibilities here for over-indebted member-states:

One is that they will have to pay high interest rates for that part of newly issued debt (compared to the ultra low interest of the ‘good’ or ‘blue’ part that the ECB’s scheme makes possible). This is a major strength of our proposal, rather than a weakness, in that it addresses the (mostly German) fears of ‘moral hazard’, and giving governments a powerful incentive to stick within the Maastricht limits. It answers Mr Schaeuble’s concern that ECB action should not encourage member-states to allow their debt-to-GDP ratio to run riot.

A second possibility is that a member-state will not be able to repay its ‘bad’ or ‘red’ debt in full, in which case that part will have to be restructured using the CACs already included in all post Greek PSI bond issues. This is as it should be. Investors (banks in particular) should know that, if they lend to a heavily indebted member-state, the ‘red’ or ‘bad’ part of that sum might be ‘haircut’. Such discipline amongst investors would be a godsend and put an end to the preposterous presumption of assuming that a bankrupted member-state will invariably meet its obligations in full, come what may, by borrowing from the rest of Europe on the (absurd) condition of shrinking its national income (i.e. harsh austerity).

Your proposal includes giving super seniority status to the member-states obligations to the ECB for the servicing of the ECB-bonds issued on behalf of that member-state. But super seniority status has to have various attributes in order to have any substance. The first and foremost attribute is that it is paid BEFORE any other debt.

Quite right. This is the meaning of super-seniority, and it is what gives the Modest Proposal’s second policy, i.e. the proposed ECB-mediated public debt conversion facility, its credibility.

But does this not mean that the debt over and above the Maastricht compliant component (or the ‘red’ debt), which is to be refinanced by the member state itself, must mature after the ECB-mediated debt is repaid?

It is not a question of timing. It is a question of ranking debt obligations. The member-state’s agreement with the ECB should say, explicitly, that when a payment is due into its ECB debit account (in order to redeem an ECB-bond issued in the past on behalf of that member-state), it takes priority over all other debt repayments of the said member-state. Nothing different to the agreement each of our states has with the IMF.

Surely this will affect dramatically the interest to be paid on the ‘red’, non-Maastricht compliant, debt!

As it should! Remember: A large interest rate differential between the ‘good’ and the ‘bad’ (or the ‘blue’ and ‘red’) debts of our member-states is an essential part of our policy’s design, which we think makes it both (a) potentially appealing to fiscal ‘hawks’ and (b) an appropriate signal to governments and investors.

Still, I fail to see how the ECB-bonds will be sold at a low interest rate, if the repayment risk stays with the member-state without any form of guarantee by the ECB.

There is a misunderstanding here: The ECB-bonds will be issued and backed fully by the ECB. From the perspective of investors, they will be dealing only with the ECB, which will guarantee to them that they will get their money back, with interest. This is why the interest rate of these ECB-bonds will be tiny. Then, it is a matter for the ECB to recover these monies from the member-states. To ensure an almost 100% probability of full recovery, Policy 2 of the Modest Proposal includes not only the super-seniority clause (discussed above) but, also (and quite importantly), the provisions that:

• the ECB charges a small fee to all member-states for this ‘service’ (e.g. 20 basis points), and
• the ESM use a small part of its funding to buy additional insurance for the ECB, in case of an ultra-hard default by some member-state (thus, the ESM acts like an official CDS provider for the ECB)

Under these provisions, the ECB will be able to borrow (in today’s conditions) at no more than 1.1% and charge member-states, say, an ultra low 1.3% for servicing their ‘good’/blue’ debt. Overall, that would reduce the present value of aggregate Eurozone debt by at least 30%, bringing down with it the interest rates for the ‘bad’/’red’ debt (while preserving the large spread between the ‘good’ and ‘bad’ debts). In effect, the Eurozone’s debt crisis goes away!

Don’t’ you think that the 60% of GDP threshold, for the ‘blue’/’’red’ distinction, is arbitrary.

Of course it is arbitrary. But it is in the Maastricht Treaty and our Modest Proposal is about finding a solution within the existing (arbitrary and, in my view, idiotic) Treaties.

The Maastricht Treaty sets other economic targets that are interrelated, such as the Deficit-to-GDP ratio. In reality if the latter is higher or lower it will affect the perspective of the Debt-to-GDP ratio. In 2009 Greece, for example, had a Deficit-to-GDP ratio over 15%. No level of debt would have been acceptable (at least in the near term) under the circumstances.

Agreed. Your point about Greece, but also Ireland, proves that the Maastricht limits were meaningless, as no deficit member-state could be prevented from falling into a black hole after various bubbles burst (a public debt bubble in the case of Greece, a real estate and banking bubble in Ireland’s case). That we should have more flexible, and rational (i.e. less arbitrary), limits/rules is, of course, correct. That we should have had mechanisms from limiting the capital flow and current account imbalances prior to the crisis, is also correct. But the Modest Proposal takes these Treaties and the various mechanisms and rules in place as given, at least for now – until the current crisis is overcome. And here is another strength of the Modest Proposal: By ‘Europeanising’ (a) bank recaps (Policy 1), (b) the ‘blue’/’good’ debt (Policy 2) and (c) public investment (Policy 3), it makes it easier for governments (like Greece’s) to stay within the Maastricht limits, re. the budget deficit, in difficult times. Once the Eurozone is re-balanced, by the implementation of Policies 1,2&3, even Berlin will be more open to a serious discussion about overhauling Maastricht’s arbitrary rules.

Investment-Led Recovery Program (Policy 3)

Again here I fail to see how there will be a massive investment program (which I am in favour of) without this being supported by the other member states, hence violating the Modest Proposal’s commitment to finding solutions within the existing ‘rule’s and Treaties.

This is important. So, let’s look at this carefully.

The EIB and EIF are two profit making organizations. Why would they go along with your proposal?

The EIB-EIF operate on banking principles, and that is a good thing. But, there are not private profit-maximising banks, which is crucial. They are public institutions whose charter specifies that they exist to assist with the EU’s broader economic objectives. Rather than maximising profit, they operate on a basis of minimum profit targets (as most organisations, private ones too, do).

If the EIB/EIF are today willing to invest in any project, there is nothing precluding them to do so.

Alas there is: it is the convention that 50% of a project must be co-financed by the member-state. The fact that member-states are either insolvent (e.g. Greece) or illiquid (e.g. Austria) erects a huge constraint upon the EIB’s plans, say, to fund a super-fast railway linking Patra to Munich, via Vienna. The Modest Proposal’s Policy 3 suggests that the EIB is unshackled from this constraint and that the ECB comes to its assistance in order to bring into fruition projects that the EIB considers potentially profitable but cannot rely on Greek or Austrian (temporarily cash-strapped) partners.

We have, in fact, suggested two ways in which the ECB can offer the backing necessary.

One is through a form of non-toxic Quantitative Easing: Once the EIB approves some major project (on sound banking principles, at a time when the member-states that will benefit are illiquid), it issues EIB-bonds to cover 100% of the funding and the ECB stands by so that, if EIB-bond yields begin to rise (because the EIB is borrowing in its own name a lot more from the markets than in the past), the ECB steps in and purchases these bonds in the secondary market in quantities necessary to bring the yields down. In a deflationary Europe, where Mr Draghi is struggling to find ways of introducing some form of QE (but has no Eurobond to purchase, unlike the Fed that buys US Treasuries of the Bank of England that buys gilts), buying EIB bonds is the obvious thing to do. Moreover, unlike US or UK style QE, which inflates bubbles in the financial sector (when CDOs, mortgages, credit card debt and the like are purchased with Central Bank money), buying EIB bonds avoids this pitfall and allows the ECB to be more surgical and efficient in its anti-deflation intervention, partnering up with the EIB for this purpose.

A second method is the following: Once the EIB approves some major project, it issues EIB-bonds to cover 50% of the funding, as it currently does, but the ECB issues additional ECB-bonds (since, Policy 2 will have created the mechanism for such issues anyway) to cover the remaining 50%, which it then charges to the debit accounts of the member-states that will benefit directly from the EIB-funded project. Then, it is the member-state that takes on that risk (as now) but does this at very low interest rates that only the ECB can secure on its behalf.

These two methods Could, In Fact, Be Combined To Create An Investment Injection Into The Eurozone Of 8% Of Overall Gdp. Such An ‘Injection’ Would Then ‘Crowd In’ Private Investment That Will Blow New Wind Into The Eib’s Sails And Ward Off The Recession/Deflation/Depression Afflicting The Eurozone. Put Slightly Differently, It Is Erroneous To Think Of The Eib’s Expected Returns From Some Project As Exogenous To Eib Policies And Impervious To A Broad, Investment-Led Recovery Program Like The One Policy 3 Of The Modest Proposal Recommends.

Humanitarian CRISIS (Policy 4)

There are probably many sources, besides TARGET2, from where funds can be raised for Policy 4. Even direct financing from member states.

Of course there are. But, once again, the Modest Proposal is making recommendations that require no Treaty changes. Which means we sought funds that would not require fiscal transfers or “direct financing from member-states”. The beauty of tapping into TARGET2 accumulated interest is that these monies are not the result of fiscal transfers but merely accounting profits whose volume reflects nothing but the internal imbalances of the Eurozone – which are also responsible for the hardship of millions of Europeans.

I can only agree with such a policy assuming its implementation is less costly than the benefits to be distributed (and that it does not produce counter incentives to receivers).

Our suggestion is that these TARGET2 funds pay for a US food stamp type of program – an utterly low cost, superbly efficient system for countering hunger and fighting poverty (the evidence from the US is overwhelming) and, indeed, for propping up food producers, super-markets etc. As for your fear of “counter-incentives to receivers”, when the hungry get fed no incentives are distorted. Even if some less hungry people are fed, in this manner, that is fine too…