Mr Varoufakis` “Modest Proposal“
Some Critical Remarks

Two years ago, Yanis Yaroufakis et al. (2013) made a “modest proposal for resolving the Eurozone crisis“[1], expecting to jumpstart the European economy within months. They called it a “modest proposal“ for two reasons: (i.) The proposed reforms are regarded as being fully in line with the existing constitutional framework in Europe, not requiring any treaty changes. (ii.) Moreover, the reforms do not require any fiscal transfers or guarantees. On his website, Professor Varoufakis promises that his 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.“[2] In this column, I take a closer look at Mr. Varoufakis` proposal and determine whether he is able to keep the promises made.

Components of the reform proposal

From the perspective of Varoufakis et al. (2013), the Eurozone is currently suffering from a combined crisis, composed of four elements: a banking crisis, a debt crisis, an investment crisis, and a social crisis. In order to solve these four sub-crises, the authors propose four instruments and assign them to the following four (already existing) European institutions: the European Central Bank (ECB), the European Investment Bank (EIB), the European Investment Fund (EIF), and the European Stability Mechanism (ESM).

The proposed measures are as follows:

  • Restructuring, recapitalization, and resolution of distressed banks should be carried out directly by the ESM, rather than by a national resolution agency. National authorities should have the option of waiving their right to supervise and recapitalize a failing bank; in this case, the bank must be recapitalized by the ESM. Should resolution become necessary, a haircut on deposits must be avoided (“Case-by-Case Bank Programme“, CCBP).
  • In order to solve the debt crisis, the ECB should offer European member-states the opportunity to convert their public debt into ECB debt obligations. Debt conversion should be limited to a member-state`s “Maastricht Compliant Debt“ (MCD), i.e., to the public debt equivalent to up to 60% of GDP. This is the debt limit allowed according to the Stability and Growth Pact (SGP). Financial assistance to member states shall not be given by the ESM, which has to confine itself to bank recapitalizations (“Limited Debt Conversion Programme“, LDCP).
  • In an effort to reverse economic recession, an “Investment-led Recovery and Convergence Programme“ (IRCP) shall be initiated, which channels public investment funds into social and environmental domains. The programme shall be co-financed through bonds issued jointly by the European Investment Bank (EIB) and the European Investment Fund (EIF).
  • Finally, an “Emergency Social Solidarity Programme“ (ESSP) shall guarantee access to nutrition and to basic energy needs. The programme will be funded through interest income accumulated within the European System of Central Banks (ESCB) from Target 2 imbalances and from profits made through government bond transactions.

Varoufakis et al. (2013) do not consider the ECB´s current OMT Programme as useful for solving the crisis, because its usage is conditional upon supervision by the troika. Countries which would be helped by OMT have to sign a “draconian“ memorandum of understanding before any financial assistance is granted. They are also sceptical with respect to a new “Marshall Plan“ from the Eurozone surplus countries, because this would require approval from the electorate of the surplus countries, which is very unlikely. Rather, they prefer an investment program financed through borrowing from European institutions which do not need any Parliamentary approval.

Evaluation of the “modest proposal“

Case-by-Case Bank Programme

Since Varoufakis et al. (2013) want to grant national governments the option of whether or not to waive the right to supervise and resolve banks in distress, it is very likely that the EMS will soon become Europe`s bad bank. National governments would not resolve any bank with severe financial problems on their own, but rather transfer this responsibility to the discretion of the ESM. The ESM in turn has to restructure, resolve and recapitalize the bank, using European tax payers’ money or guarantees from the national governments. ESM`s lending capacity is currently 705 billion Euro, with paid-in capital of 80 billion Euro and an additional 624 billion Euro in the form of committed callable capital. This is a large amount of money. Yet, by the end of 2014, total liabilities of, e.g., Deutsche Bank comprised 1,800 billion Euros, i.e., two and a half times the funding capacity of ESM. It would need a new capital injection to deal with a restructuring of Deutsche Bank alone.

Because they may always transfer the duty to recapitalize or resolve a bank in distress to the ESM, national authorities have no incentives to supervise banks intensively; the ESM, in turn, has no resources to provide supervision or to resolve a failing bank. It is therefore likely that banks become riskier after implementation of the “modest proposal“. Moreover, because the proposal demands that steps be taken to avoid a haircut on deposits, bank depositors’ incentives to enact market discipline are further diminished. Who should perform bank oversight if all deposits are guaranteed by the government? Currently within the European Union, deposits of up to 100.000 Euro per bank customer are insured by national deposit insurance institutions. Only deposits in excess of these large sums are subject to a possible haircut. It seems that Mr Varoufakis` proposal would help protect the savings of people who make large bank deposits, further shifting the burden of losses to European tax payers.

Limited Debt Conversion Programme

The “modest proposal“ wants to give national governments the option of whether or not to convert their “Maastricht Compliant Debt“ into ECB bonds, without any pre-approval by the Euro-Group and without any conditionality. This resembles the “European Redemption Pact“ recently proposed by the German Council of Economic Advisers (2011). It would separate the debt that has been accumulated to date by individual member countries of the Eurozone first into a part whose value does not exceed the 60% debt threshold of the SGP, and a second part composed of the remainder. Yet, there is an important difference: That made by the German Council of Economic Advisers recommends (i) that the share of sovereign debt exceeding 60% of GDP should be managed at the European level; and (ii) that each country must redeem this debt over a period of 20 years. In contrast to the redemption fund proposal made by the German Council, the “modest proposal“ suggests mutualizing a country`s public debt below the 60% threshold – with interest rates determined by the ECB. If a member state defaults on its ECB bonds, repayment is provided by the ESM.

Varoufakis et al. (2013) claim that they do not want to “reward“ countries which violated basic Eurozone rules; thus they want to convert only the debt which is regarded as “legitimate“ under the SGP, leaving the “illegitimate“ debt (which exceeds MCD) to the member-states. In addition, they intend to prevent a massive reduction of public debt down to MDC levels, which would imply that the public debt of, for example Italy, must be cut by 50% within twenty years or so.[3]

The drawback, however, is a moral hazard. Why should any government which succeeded transferring part of its debt to the ECB – thus gaining additional fiscal leeway – restrict expenditures and increase taxes, instead of making more debt? Why should this government which has managed to “Europeanise“ its public debt become thriftier if it will be paying lower interest rates on its outstanding debt? Why should the ECB agree to such a conversion of national debt into ECB bonds? Just as the SGP failed to restrict additional borrowing above the 60% of GDP threshold, any promise by European governments not to further increase their indebtedness above the “legitimate“ debt level would be non-credible.

Investment-led Recovery and Convergence Programme

Authors of the “modest proposal“ hope to mobilize idle private savings, and expect that the investment projects funded by bonds jointly issued by EIB and EIF will generate revenues large enough to make interest payments. Since these projects are mainly investments into social and environmental projects with only small returns, this assumption seems extremely optimistic. Rather, it sounds more like an invitation to waste money. If investments in other sectors are also financed, the “Investment-led Recovery and Convergence Programme“ starts to look like a revival of the old concept of public investment control – one with which many countries already have bad experiences.

A prominent case in point is Japan, which for decades used an extensive system of financial intermediation by government-run agencies that became known as the “Fiscal Investment and Loan Program“ (FILP). Under FILP, funds were channelled to local governments, government-affiliated public companies, and to government financial institutions that acted as highly compartmentalized and specialized niche lenders; they gave loans to preferred borrowers such as small firms, mortgage borrowers and borrowers in underdeveloped areas. Though FILP intended to foster social goals by financing projects with large positive externalities, it in fact funded wasteful projects and unviable borrowers, mainly for political purposes. The performance of loans under the FILP program was poor, and this was due to the fact that decisions to grant loans were largely politically influenced (Doi & Hoshi, 2003). The IRCP is likely to suffer the same fate.

Conclusions

The “modest proposal“ promises to solve the European financial crisis without using additional tax payers’ money and without revision of the European rules. This is a promise that cannot be kept. The purpose of the “modest proposal“ is to relocate crisis solution authority from the national to the European level and to avoid any conditionality for financial assistance. This may perhaps help to calm down the crisis temporarily, but it does not pave the way for a sustainable solution. To achieve such a solution, it is not the rules of the European Union which must be changed, but rather the rules according to which banks do business. In particular, a massive deleveraging of commercial banks seems to be necessary as well as the end of any preferential treatment for banks` government bond holdings, as under the Basel agreements (Admati & Hellwig, 2013). None of this is addressed by the “modest proposal“.

References:

Admati A. & Hellwig, M. (2013): The Bankers’ New Clothes: What’s Wrong with Banking and What to Do about It, Princeton (Princeton University Press).

Doi, T. & Hoshi, T. (2003): Paying for the FILP, in: M. Blomstrom, et al. (eds), Structural Impediments to Growth in Japan, Chicago and London (University of Chicago Press), S. 37-69.

German Council for Economic Experts (2011): Annual Report 2011/12, http://www.sachverstaendigenrat-wirtschaft.de/aktuellesjahrsgutachten0.html?&L=1

Varoufakis, Y. & Holland, S. (2012): A Modest Proposal for Resolving the Eurozone Crisis, in: Intereconomics, Vol. 47(4), 240-247.

Varoufakis, Y., Holland, S. & Galbraith, J. K. (2013): A Modest Proposal for Resolving the Eurozone Crisis, version 4.0, mimeo, http://yanisvaroufakis.eu/euro-crisis/modest-proposal/

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[1] )     Most of the citations used here and in the following sections come from this source. For an earlier version see Varoufakis and Holland (2012); it should be mentioned that the latest reform proposals were made before Mr. Varoufakis became Greek Minister of Finance, and therefore this proposal does not necessarily reflect the position of the current Greek government.

[2] )     See http://yanisvaroufakis.eu/2013/07/20/debt-redemption-psi-osi-versus-our-modest-proposal-qa-with-portuguese-readers/

[3] )     See also the reference given in Fn. 2 above.

 

I am very grateful for proofreading by Michael Labate. Of course, all remaining errors are mine.

3 Antworten auf „Mr Varoufakis` “Modest Proposal“
Some Critical Remarks

  1. For finance and sovereigns, there is no other way for the debts to be retired or serviced other than by the taking on of new debts. The idea is not to borrow oneself free of debt which is absurd but to maintain a level of perpetual indebtedness as a manageable state of affairs, to gain as necessary the monetary benefits of debt, to escape the pit that repayment represents. The understanding here is that finance entities such as governments outlive their creditors, that debts eventually fade into meaninglessness.
    The suggestion of the Good Ordoliberalists is that there is some sort of debt-free utopia for sovereigns, Kommunen and individuals where obligations are purged by dint of hard work.
    Sorry, but Europe right now cannot support its own debts, only these who believes in science fiction fantasy tell us that Europe can support its own finance debts by way of labor …competitiveness.
    The creditors in Europe cannot , or to put it better, they do not support increased consumption. They refuse to squander a meaningful proportion of their wealth to simply support consume. As the borrowers across Europe imitate their betters, prices declines.
    Some folks in Brussels and elsewhere in Europe still don’t get it. The (falling) prices for goods and services in EU does not measure the worth of production or the level of competitiveness but rather the worth of consumption.
    The gargantuan amounts of European debts today indicates there are really no productive activities or growth, only borrowing platforms and false narratives.
    It seems to me we have really learned nothing from the past financial crisis. Tight your chin straps, the next phase of the great financial crisis has begun.

  2. Ja, I mean everything that has been said and written here has a valid point. Im still of the opinion that everything that has been done so far will lead to very high inflation rates, if not hyperinflation ( not accounted for by government statistics but by observation on the ground ). True to say that hyperinflation is a bit out of reach for now, but looking back to the last 6 years or so, everything that had been done was to contain a debt problem ( with all of the measures we know and we can read about in this Blog ). So far it has only affected asset markets, but once the demand for paper ( and credit ) picks up again ( and the banks will be forced to hand it out ) you will see an explosion. As Mr. Berthold has written extensively, the main problems in the real economy are structural. And for that you need ideas and a functioning brain – Im not sure if thats what we can find in Europe these days. There is no “plan”, there is no future thinking, everything we can read and hear about is the coming Doomsday. So everybody is asking: What does Europe really want ? Probably not the “truth” … .

  3. Hi Mr. Krüger,

    Europe’s problem is the combination of a deflationary monetary policy, a contractionary fiscal policy, and ongoing credit contraction caused by the unending banking crisis.
    The european credit market had a major shock after Lehman defaulted and has suffered ever since.
    Europe’s fuiture is not inflationary, is deflation. Europe is still in the middle of deleveraging proccess and the reasons are ,a lack of credit demand because borrowers are repairing their balance sheets,a lack of credit supply because credit providers are repairing their own balance sheets and credit providers have have raised their lending standards.

    Euch allen wünsche ich ein schönes WE.

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