Options for Europe – Part 73

The title is my current working title for a book I am finalising over the next few months on the Eurozone. If all goes well (and it should) it will be published in both Italian and English by very well-known publishers. The publication date for the Italian edition is tentatively late April to early May 2014.

You can access the entire sequence of blogs in this series through the – Euro book Category.

I cannot guarantee the sequence of daily additions will make sense overall because at times I will go back and fill in bits (that I needed library access or whatever for). But you should be able to pick up the thread over time although the full edited version will only be available in the final book (obviously).

Part III – Options for Europe

Chapter 22 Establishing a European fiscal capacity to save the Eurozone

[PRIOR MATERIAL HERE]

[NEW MATERIAL TODAY]

Solutions that propose manipulating and massaging public debt

Here is a sample of proposals that all start with the observation that the Eurozone cannot progress while the Member States have high public debt ratios. They all claim that the crisis is now a sovereign debt crisis which can only be solved if there is some rapid reductions of the debt ratios. Paul De Grauwe suggests that a first step towards a fiscal union should address one of the basic flaw in the EMU, whereby “member governments issue debt in euros, a currency that they cannot control” (2013), by pooling government debts so as to better align the capacity to pay with the responsibility for the liability. As usual, any discussion of a ‘federal’ development opens up the ‘moral hazard’ debate. In this context the issue would be how to stop the Member States from running up too much ‘pooled’ debt. But De Grauwe also raises the issue of interest rate imbalances, whereby nations such as Germany would be forced to pay higher interest on its debt as a result of absorbing some of the risks associated with the weaker economies. This sort of concern highlights the reason why these nations should never have entered a monetary union in the first place.

De Grauwe’s solution is for a Eurozone debt mutualisation scheme that would: (a) limit how much debt could be pooled by each Member State; (b) penalise the weaker nations so that the stronger nations do not have to pay higher costs; and (c) create a federal surveillance body that would discipline government spending. Following the proposal from Enderlein et al. (2012) to reduce democratic rights as insolvency approaches, De Grauwe suggests that “rule-breaking governments should gradually lose control over their own national budgetary processes”. Of-course, what constitutes a ‘fiscally responsible’ position is not a matter of fact but a matter of opinion and heavily tainted by ideology. The rule-driven approach that De Grauwe and his colleagues favour is associated with an ideology that appears to only produce stagnation.

But debt-mutualisation schemes started jumping out of the woodwork as the crisis deepened. In this vein, Jacques Delpla and Jakob von Weizsäcker proposed what they called the ‘Blue Bond Proposal’ (BBP). Their 2010 BBP proposal claims to be an “incentive-driven and durable way out of” the debt dilemma (Delpla and von Weizsäcker, 2010: 1). There are a number of derivative plans in the literature, which share similar characteristics and shortcomings. The BBP would pool up to 60 per cent of each nation’s public debt (the allowable amount under the SGP) into a common ‘Blue Bonds’ fund, with “joint and several liability” (p.1), which would reduce “the borrowing cost for that part of the debt” (p.1). The remaining “Red Debt” would be subordinated to the Blue Bonds and its servicing costs would rise, thereby providing the incentive to reduce the debt to the Maastricht threshold. Further rules are proposed to tie down governments participating in the scheme all of which reduce the options available to Member States and reinforce the austerity straitjacket. For example, the proposal might allow nations such as Germany to add the full 60 per cent of its debt to the pool while nations such as Greece would be restricted to borrowing much lower proportions. Given the immediate problem is mainly one of default risk, the proposal’s perverse incentives (punish those most at risk) would not seem to be part of any viable short-term solution.

There is also a sense that the authors think all debt above the Maastricht threshold is due to the pursuit of unsustainable fiscal policies. The authors claim that the financial markets failed Greece by “continuing to provide cheap funding while fiscal policy was reckless” (p.2). How do they also assess the situations of Spain and Ireland, which were the models of fiscal rectitude leading up the crisis? But moreover, imagine that China continues to slow and the world is plunged into a further economic spending crisis. Under current arrangements, the public debt levels will rise sharply in Eurozone nations as a result and deficits would increase again, even though the governments are locked into the austerity mentality. It is likely that many nations would go beyond the 60 per cent debt threshold given the elevated debt levels already in place due to the GFC. The proponents of the BBP state that the 60 per cent threshold is the “debt level deemed sustainable for any EU member state according to the Maastricht Treaty” (p.6). But in the event of a sequence of slowdowns, exacerbated by the austerity bias, the BBP he proposal would punish many nations, even if they were following the mindless fiscal path specified by the Treaty. It is hard to see how that can represent a viable solution. There is once again an implicit denial of the exposure the Eurozone has to regular cycles. As we discussed earlier, the reference values in the SGP were considered to be ‘safe’ given the expected output gaps that might occur in a serious downturn. Those expectations were tied up with the ‘Great Moderation’, which was a short-hand way of saying that the business cycle was considered dead by many influential macroeconomists. The same arrogance underpins this approach. The GFC was the first major spending collapse that hit the Eurozone, it won’t be the last!

A variant of the BBP scheme was published by economists Yanis Varoufakis and Stuart Holland in November 2010 under their so-called Modest Proposal. One wonders whether the authors are familiar with Jonathan Swift’s satire of the same name published in 1729, where Irish parents were encouraged to ease their economic travails by selling their children as food to provide some culinary pleasure to the rich. Varoufakis and Holland have since updated their proposal a number of times since. The latest version (July 2013) was co-authored with American economist James Galbraith. The aim of the proposal is to ‘resolve the Eurozone crisis’, which they identify as being, in fact, four “interrelated” problems: a banking crisis, involving banks that are the responsibility lies of the national governments, who do not have the currency capacity to guarantee deposits; a debt crisis where nations cannot borrow from private bond markets; an investment crisis, where both the level of investment has fallen sharply and the imbalance between the trade surplus and deficit nations has widened; a social crisis, with high unemployment, rising homelessness and poverty, and falling incomes. Like all the ‘hybrid’ schemes, they are motivating by the assertion is that “a Eurozone breakup would destroy the European Union, except perhaps in name” which would pose a “global danger”. It is hard to agree with such dramatics and they are dealt with in chapter 23. It is also hard to see how a proposal that involves no fiscal transfers or changes to the Treaty can provide a lasting solution to the mess.

Their ‘modest’ proposal seeks “immediate solutions” that are “feasible within current European law and treaties” (Varoufakis et al., 2013: 2). There is some virtue in trying to sidestep the “dyadic choices” that “imprison thinking and immobilise governments” in Europe (p.10) and operate within a time frame that can deliver immediate, if only palliative care, to those most in need. But the modesty of the proposal is its shortcoming. It will not solve the inherent problems within the Eurozone, which are defined by the very political constraints that the authors identify recognise force them to adopt these ‘modest’ proposal, in lieu of much more effective and lasting solutions. The political constraints they identify include those that prevent the ECB from funding governments directly (see chapter 22 for a discussion), the inability to issue Eurobonds and the impasse over the creation of a “properly functioning federal transfer union” (p.3); and the time delays that would be involved in any Treaty change once agreed.

The following discussion focuses only on their debt manipulation proposal, which aims to reduce the debt servicing costs and default risk vulnerability of Member States under the current arrangements. We will consider their proposal to stimulate aggregate demand subsequently. Varoufakis et al. (2013) propose what they term a “Limited Debt Conversion Programme (LDCP)” or a “tranche transfer” (see earlier version, Varoufakis and Holland, 2011), whereby:

• Participating Member States would agree to an ‘accounting transfer’ to the ECB of their so-called Maastricht Compliant Debt (MCD), that is, public debt up to 60 per cent of GDP. The ECB would not buy any bonds from the Member States nor provide any debt guarantees, thus, according to the proponents, it would remain faithful to its Treaty obligations.
• In recognition of this ‘transfer’, the ECB would issue its own debt (ECB-bonds) in the private bond markets at a risk-free interest rate. The Member States and the ECB then would ‘swap’ payments, The ECB would ‘finance’ the servicing costs of the transferred debt and assumes any default risk, while the Member State involved in the ‘transfer’ would be liable for the servicing costs on the ECB bonds, which would be lower than the rates that they could gain themselves in the private markets.
• Upon maturity of the debt, the investor would have a choice – take the terms of the original debt (for which the Member States would be responsible) or roll the debt over at the “lower, more secure rates offered by the ECB” (p.4).
• If the Member State was to default on its payments the European Stability Mechanism would provide the funds.

The obvious question is why bother? Varoufakis et al. (2013) recognise this issue. The ECB already demonstrated with its Securities Markets Program, which began in May 2010 and involved the central bank purchasing unlimited amounts of Member State bonds in the secondary markets (that is, after they had been issued by the government and were being held by private investors) that they could deal the private bond investors out of the equation when it came to setting interest rates (yields on government bonds). In September 2012, the ECB replaced the SMP with the Outright Monetary Transactions (OMT) program, and with a fanfare declared there would be “No ex ante quantitative limits are set on the size of Outright Monetary Transactions” (ECB, 2012). The ECB decision to stand ready to purchase unlimited volumes of government debt means that any private bond trader that tried to take a counter-position against any Eurozone government would lose. Essentially, any public bond dealer will know that they can easily off load any bond purchases in the secondary market to the ECB. The logic of the action is that by buying large volumes of short-term maturity bonds (1 to 3 years) in the secondary market, the price will rise and this will drive down the yields. Bond traders then are forced to purchase longer maturity government bonds if they want higher yields which then drives prices up and yields down. The initiative means that the ECB can set effectively set yields at wherever it wants including zero. It means that all the mainstream economists are wrong if they claim that deficits drive up interest rates to the point that governments become insolvent because the private bond markets will refuse to purchase their debt. That insolvency can only come if the relevant central bank fails in its functions as a currency issuer.

But once you understand the significance of that you also soon realise that the ECB rescue plan is not sufficient to restore growth because it proposed to impose conditionality (austerity) as a prerequisite for participation. The OMT program thus fails to address the core problem that southern Europe is in depression and the only way out is for budget deficits to expand. The ECB stands ready to buy unlimited government bonds – but only if they have succumbed to a fiscal austerity package that ensures their growth prospects deteriorate even further.

Varoufakis et al. (2013: 5) acknowledge that the OMT program “has succeeded in taming interest rate spreads within the Eurozone” but conclude that the implicit threat against bond markets, described above, is “non-credible”. Allegedly, bond dealers will eventually call the ECB’s bluff and expose the OMT program as a paper tiger. This criticism is without foundation. How exactly can the private bond markets “test the ECB’s resolve”? (p.5). The ECB has unlimited Euro capacity to purchase all the secondary market bonds it desires. Of-course, it is the announcement rather than any action that has had the impact, given that the ECB has so far purchased no bonds under the program. The gymnastics involved in the ‘Modest Proposal’ seem unnecessary given that the SMP worked to control yields, as would the OMT program if enacted. Paul De Grauwe and Yuemei Ji concluded that the OMT decision “was a game changer in the Eurozone. It had dramatic effects. By taking away the intense existential fears that the collapse of the Eurozone was imminent the ECB’s lender of last resort commitment pacified government bond markets and led to a strong decline in the spreads of the Eurozone countries” (De Grauwe and Ji, 2013).

There is some uncertainty surrounding the OMT as a result of the decision on February 7, 2014 by the German Federal Constitutional Court (BVerfG) to refer the program to the Court of Justice of the European Union (CJEU) for a preliminary ruling, the first time this has happened. The referral reflects the reality that BVerfG knows the operations of the ECB have to be assessed with the legal structure of the Treaties rather than the German Basic Law. That alone amounted to a rejection of the Bundesbank position, which had opposed the program. While the BVerfG found that there was a good case to be made that the program was outside of the ECBs legal charter, it also recognised that the CJEU, known for its ‘federalist’-type interpretations, could find the OMT program to be legal (Bundesverfassungsgericht, 2014). It The BVerfG considered the program could be construed as an economic policy intervention rather than a liquidity management operation that the ECB held it out as. Interestingly, it was the inclusion of the ‘conditionality’, which clearly went beyond any notion of liquidity management, that provoked the Court’s concern that the program was infringing on the core responsibilities of the Member States under the Treaty. Of further relevance, under the heading “Verstoß gegen das Verbot monetärer Haushaltsfinanzierung” (Violation of the Prohibution of Monetary Financing of the Budget”), paragraphs 84-98 of the Decision make it clear that the BVerfG considers that any ECB measures which have the same impacts as the purchase of a primary bond issue (for example, holding down bond yields) should be treated as “dem unmittelbaren Erwerb von Staatsanleihen gleichkommt” (“equivalent to the direct purchase of government bonds”). This discussion would also impact negatively on the bond buying trickery in ‘Modest Proposal’.

It is also difficult to see the ‘Modest Proposal’ as being consistent with Article 104 of the Treaty if a Member State failed to make payments as agreed. In that case the ECB would have to fund the deficiency, which would be equivalent to offering the prohibited ‘overdraft facility’ to the state.

A further worry about the ‘Modest Proposal’ is that it would in all likelihood promote perverse bond market behaviour and deliver massive corporate welfare to the investment banks. The debt policy would see the ECB take reserves out of the system in return for ECB-bonds. It wouldn’t take long for the bond markets to work out that they could ask for a premium on the ECB-bonds and the ECB would be under pressure to concede. With interest rates low, the private banks could then borrow from the ECB to buy the bonds, which would pay a return higher than the short-term cash.

It might be claimed that the ‘Modest Proposal’ would expose the ECB to insolvency risk itself if it was holding sufficient quantities of zombie debt, which amounted to it losing all its capital. This is not a valid criticism of the ‘Modest Proposal’ or any other that involves the ECB taking on massive quantities of high risk debt. The fact is that the ECB, nor any central bank, can go broke. The days when economist Walter Bagehot, an early editor of The Economist magazine, wrote about the solvency risks of the Bank of England in the 1870s are long gone. A private bank needs capital for satisfying prudential regulations and covering potential losses to avoid insolvency. It does not have a currency-issuing capacity in its own right. While the ECB has an elaborate formula for determining the contributions of capital that each national member bank is required to provide, at an intrinsic level, it has no need for capital. It could operate forever with negative capital in its balance sheet, a state that would signal insolvency for a private bank.

Willem Buiter (2008: 7) wrote that:

… the central bank can always bail out any entity – including itself – through the issuance of base money – if the entity’s liabilities are denominated in domestic current and nominally denominated (that is, not index-linked). If the liabilities of the entity in question are foreign-currency-denominated or index-linked, a bail-out by the central bank may not be possible.

This reflects the basic MMT propositions we developed in Chapter 18. There is no solvency risk for a consolidated government sector – the central bank and the treasury – that only issues liabilities in its own currency. If it issues liabilities (for example, take on debt) – that is denominated in a foreign currency, then insolvency becomes a possibility. In the case of the Eurozone, where there is no fiscal authority, the pecking order is that the member state treasuries are deemed to guarantee their own national central banks which ‘own’ the ECB and which provide lender of last resort facilities to their own banking systems. No fiscal authority backs the ECB but despite all the legal complexities involved in how the national central banks might carry out their lender of last resort duties, the reality is that the ECB is the ultimate lender of last resort in the EMU.

In fact, the ECB could purchase all the outstanding public debt if it wanted to and if it lost capital as a result it could simply replenish it by issuing new currency. It alone issues the Euro. Any discussions that might then arise about the inflationary consequences of such an action, may be relevant to another debate, but take us away from the inane worries of the ECB going broke.

[TO BE CONTINUED – CONCLUDING REMARKS FOR THIS OPTION WILL COME TOMORROW]

Additional references

This list will be progressively compiled.

Arghyrou, M. and Tsoukalas, J. (2010a) ‘The Option of Last Resort: A Two-Currency EMU’, EconoMonitor, February 7, 2010· http://www.economonitor.com/blog/2010/02/the-option-of-last-resort-a-two-currency-emu/

Arghyrou, M. and Tsoukalas, J. (2010b) ‘The Option of Last Resort: A Two-Currency EMU’, Cardiff Business School Working Paper E2010/14, November 2010. http://business.cardiff.ac.uk/sites/default/files/E2010_14.pdf

Borensztein, E. and Mauro, P. (2002) ‘Reviving the case for GDP-indexed bonds’, IMF Policy Discussion Paper, 02/10, September 2002. http://www.imf.org/external/pubs/ft/pdp/2002/pdp10.pdf

Buiter, W. (2008) ‘Can Central Banks Go Broke?’, Policy Insight, No. 24, Centre of Economic Policy Research, May. http://www.cepr.org/sites/default/files/policy_insights/PolicyInsight24.pdf

Bundesverfassungsgericht (2014) ‘Entscheidungen: über die Verfassungsbeschwerde … gegen 1 den Beschluss des Rates der Europäischen Zentralbank vom 6. September 2012 betreffend Outright Monetary Transactions (OMT) und die fortgesetzten Ankäufe von Staatsanleihen auf der Basis dieses Beschlusses und des vorangegangenen Programms für die Wertpapiermärkte (Securities Markets Programme – SMP), BvR 2728/13, February 7, 2014. http://www.bverfg.de/entscheidungen/rs20140114_2bvr272813.html

Delpla, J. and von Weizsäcker, J. (2010) ‘The Blue Bond Proposal’, bruegel policy brief, Issue 2010/03, May 6, 2010. http://www.bruegel.org/download/parent/403-the-blue-bond-proposal/file/885-the-blue-bond-proposal-english/

De Grauwe, P. and Yuemei Ji, Y. (2013) ‘Panic-driven austerity in the Eurozone and its implications’, Voxeu, February 21, 2013. http://www.voxeu.org/article/panic-driven-austerity-eurozone-and-its-implications

De Grauwe, P. (2013) ‘Debt Without Drowning’, May 9, 2013. http://www.project-syndicate.org/commentary/the-debt-pooling-scheme-that-the-eurozone-needs-by-paul-de-grauwe

Goodhart, C. and Tsomocos, D. (2010) ‘The Californian solution for the Club Med’, Financial Times, January 24, 2010. http://www.ft.com/intl/cms/s/0/5ef30d32-0925-11df-ba88-00144feabdc0.html#axzz308OAO0YZ

ECB (2012) ‘Technical features of Outright Monetary Transactions’, Press Release, September 6, 2012. http://www.ecb.europa.eu/press/pr/date/2012/html/pr120906_1.en.html

Enderlein, H., Bofinger, P., Boone, L., de Grauwe, P., Piris, J-C., Pisani-Ferry, J., Rodrigues, M.J., Sapir, A. and Vitorino, A (2012) ‘Completing the Euro. A road map towards fiscal union in Europe’, Notre Europe. http://www.notre-europe.eu/media/pdf.php?file=completingtheeuroreportpadoa-schioppagroupnejune2012.pdf

Issing, O. (2009) ‘Why a Common Eurozone Bond Isn’t Such a Good Idea’, White Paper No. III, Centre for Financial Studies, Goethe-Universität Frankfurt, July.

Soros, G. (2013) ‘How to save the EU from the euro crisis’, UK Guardian, April 10, 2013. http://www.theguardian.com/business/2013/apr/09/george-soros-save-eu-from-euro-crisis-speech

Varoufakis, Y. and Holland, S. (2011) ‘A Modest Proposal for Resolving the Eurozone Crisis’, Policy Note 2011/3, Levy Economics Institute of Bard College, 2011. http://www.levyinstitute.org/pubs/pn_11_03.pdf

Varoufakis, Y., Holland, S. and Galbraith, J.K. (2013) ‘A Modest Proposal for Resolving the Eurozone Crisis, Version 4.0’, July 2013. http://varoufakis.files.wordpress.com/2013/07/a-modest-proposal-for-resolving-the-eurozone-crisis-version-4-0-final1.pdf

Müller, M. (2013) ‘EU Unemployment Insurance: Getting the Eurozone back on track’, thenewfederalist.eu. July 5, 2013. http://www.thenewfederalist.eu/EU-Unemployment-Insurance-Getting-the-Eurozone-back-on-track,05865

Jauer, J., Liebig, T., Martin, J.P. and Puhani, P. (2014) ‘Migration as an adjustment mechanism in the crisis? A comparison of Europe and the United States’, Organisation for Economic Co-operation and Development, January. http://www.oecd.org/migration/mig/Adjustment-mechanism.pdf

(c) Copyright 2014 Bill Mitchell. All Rights Reserved.