Two years ago, Yanis Yaroufakis et al. (2013) made a “modest proposal for resolving the Eurozone crisis“, 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.“ 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 ECBÂ´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.
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.
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“.
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/
 )Â Â Â Â 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.
 )Â Â Â Â See http://yanisvaroufakis.eu/2013/07/20/debt-redemption-psi-osi-versus-our-modest-proposal-qa-with-portuguese-readers/
 )Â Â Â Â 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.