Wednesday, 30 March 2011


A couple of days ago I logged onto LOLGreece's Twitter account to an unusual comment:

Now my first instinct was to ignore Dimitris' question. I wrote back to say that I wasn't aware this was a comply-or-explain issue; a needlessly dismissive response which I regret. I am if anything grateful that he brought this to my attention.

The true answer would have been: I'm way behind on the day job; I'm helping my ex move house; I've got to help put a microfinance conference together in Nairobi. And I can't figure out who this Varoufakis fellow is supposed to be. He doesn't sound like the kind of high-profile MUPPET I would spend time ridiculing on this blog.

However, on the DLR to Stratford that is part of my new daily commute I got a brief chance to look Yanis Varoufakis (that's Professor Varoufakis of Athens Uni) and his Modest Proposal up and it turned out I of course did know the man and some of his thinking; though to my regret I can't honestly say I'd heard of this idea of his before and could not put a name to the face without help from Google. This is my omission; not only am I out of touch with Athens' admittedly small Policy circle but as I said I mostly focus on stupid things that are worth ridiculing.

For those of you with the appetite for a little light Eurodrama reading, the most up-to-date version of the Modest Proposal can be found here. It is in reality far from modest, a fairly technical proposal for simultaneously addressing the banking and sovereign crises (in the understanding that one sector will drag the other down perpetually if we don't), by establishing a surplus redistribution mechanism within the Eurosystem, courtesy of the ECB and EFSF. It is meant to be fiscally neutral and hinges on robust stress tests and haircuts for Europe's banks.

Prof. Varoufakis himself is a cool guy, with a brilliant recording voice and a calm discursive manner. The last time I had heard him mentioned by name was while chasing up on the Weisbrot hoax, during which time I was directed by one blog to this Greek TV show excerpt which explained, in a vulgar manner for the most part, the collapse of the Greek economy.  His was one of the few coherent, well-argued and instructive contributions (though I suspected at the time that our politics don't quite match, which they don't). It's worth watching this show for.

I don't agree with a lot of the Modest Proposal (though not the 90% I hastily told Dimitris over Twitter), and I'll explain why. Most of this is due to my politics; the arguments I offer are as good as I can come up with but as with most argumentation they are only a front for my gut reaction. I am happy to be proven wrong though so comments are welcome. Please make sure you've read the Proposal first.

First of all, here's what we can agree on.

I agree with the MP that the Sovereign crisis in Europe requires a comprehensive solution that includes dealing with the undercapitalised banks. I hint at this here, noting also that European leaders will put this off until sovereign jitters reach a hardcore Eurozone member such as France. France is to the sovereign debt crisis what iron is to solar death; the point past which the shit can't be packed any tighter and the whole thing goes supernova. Hopefully I'll be proven wrong and a solution will be given much sooner than that but stupidity is endemic in the corridors of power.

I agree that any solution that does not involve a) serious stress tests (see here) and b) serious haircuts is untenable, even in the fairly short term. Serious stress tests involve the banking book as well as the trading book and in fact I'd like a stress test that simply takes Greek default for granted. How will the markets argue with that?

I agree that netting off bank-sovereign exposures is particularly important as the endless bank-sovereign loop creates incredible potential for contagion. (Trading probably exacerbates this; just think: you can approximate a portfolio of German bank shares with one of Greek bank shares and Greek sovereign CDS and vice versa). I would support netting off even if no other part of the MP is considered.

I agree that Eurozone members should not be asked to provide further bailouts out of taxpayer funds because this will strain whatever goodwill is left towards deficit countries, and that bond buybacks by the ECB will not work. [For some reason this post was deleted; I don't know what happened there but I've now got it back on the blog with the right time and date, too. What would I do without Google Cache?]

I also agree that any good solution must ultimately destroy money. And if it must, then it's best to destroy the original impaired assets than to spare them and transfer the losses to some poor bastard who is not systemically important, i.e. the taxpayer. The MP proposes that, in return for tapping the ECB for liquidity without eligible collateral (under the old rules I take it?) the banks should be required to tear up some of the bonds that they hold. This means that the money supply is reduced, but not by very much since the bonds are heavily discounted by the market already. The only difference is that the bank needs to show a loss, which it might as well.

Now for the bits where I disagree with the Modest Proposal.

First, I think it overlooks just how easy it is for the banks to force the ECB to shelf the idea of bond-tearups or 'haircuts-for-liquidity'. Banks don't want to recognise losses; their optimal endgame is a massive global guarantee that keeps the nominal value of their assets constant for the 7 or so years it will take for the world economy to grow into its balance sheet. It is the easiest thing in the world for them to collude together and decide to resist the ECB's charms just long enough to get it to change its rules - the equivalent of a child holding her breath after being refused a treat. The precedent of the ECB refraining from a scheduled tightening of its collateral rules in the wake of the Greek debt crisis will no doubt reinforce their intentions.

Worse, governments would be powerless to prevent this because a decrease in ECB funding tends to be seen as a victory for their banking systems and thus for themselves. Thus the politicians would not be able to rally public opinion quickly enough and would simply have to hammer out yet another seedy deal with the banks behind closed doors.

Second, I think it overlooks the damage it will do to the ECB's credibility and the damage that will in turn do to the European economy, even before we examine its effects on the ECB balance sheet. Central banks can MAKE MONEY OUT OF THIN AIR. This is the kind of power that needs to be held in check by chains and manacles of steel and probably a magical pentagram or force field of some sort. Why? Because the moment investors suspect that the central bank is pursuing an agenda other than the one prescribed by its charter, inflation expectations go through the roof. And inflation, my friends, causes riots. If the ECB comes under the kind of fire that the Fed is getting in the States the European member states will not back it up or take the blame; they will bury it and dance the Zimbabwean rain dance on its grave.

[LOL. Zimbabwean rain dance? That's racist. And ignorant.]

Third, the proposal that the ECB buy all Maastricht compliant debt off member states overlooks the damage this will do to the ECB's balance sheet, which is already bloated with, frankly, junk. The ECB has already had to tap member state central banks for capital since the crisis, and will have to do so again if its balance sheet expands further or if it is forced to recognise losses on all of this worthless paper. Current assets run to an amazing EUR1,940bn, nearly EUR2tn. The MP furthermore exposes the ECB to enormous interest rate risk as interest rates are bound to go up and thus its holdings of periphery debt at ultra-long maturities are going to take a serious pounding.

Similar arguments for the EFSF. The markets aren't stupid; they know who underwrites the EFSF and will therefore simply do a calculation of the entire Eurozone's solvency and proceed accordingly. The MP should really face up to the fact that the entire bloc may collectively be insolvent. Why won't anyone at least consider this?

Fourth, the MP overlooks the fact that most of the liabilities of member states are not actually captured by securities. Some contingent and implied liabilities can I suppose become explicit but not without all member states tapping the capital markets at once, which will cause chaos, but what of the liabilities implied by pensions or national insurance systems? What of the liabilities that have yet to arise, but which are nonetheless weighing on investor sentiment? If these are factored in, as this study shows, much of the Old Continent is insolvent even if the ECB and EFSF make the debt on its books disappear.

Incidentally, the MP makes no mention of what will happen to creditors that also *happen* to be crucially important pension funds. If this is not dealt with, the implications for social unrest could be substantial.

Fifth, the MP overlooks the fact that its solution will simply make investors wary of the EFSF's own bonds. If the member states don't mind this extreme alchemy to make their own debt go away, will they even think twice before doing the same ot the EFSF's creditors?

Finally, the MP does not address moral hazard. There is nothing in this proposal that will force Europe to consider the sustainability of its debt. In fact, we'll all pat each other on the back for outsmarting "the markets" and go on as before. Already in Greece the expectation (as I argue here) is forming that once we get rid of the Troika straitjacket all of the measures we've had to adopt so far to correct our structural government and current account deficits will just be revoked. I will concede to Prof. Varoufakis that individual public deficits will not matter with a deficit recycling mechanism in place. But it's worth noting that the aggregate deficit of the 'deficit countries' is not cancelled out by the aggregate surplus of the 'surplus countries'. The entire bloc is in (fiscal) deficit, and with record-low interest rates (if the MP succeeds) the bloc's collective debt will continue to grow, until the next crisis blows the whole sorry mess right back to the stone age.

People often grow tired of me as I explain this point, but perhaps I can interest you in another way. The following graph (source) shows that in the US indicators of man-made climate change are more closely correlated to total leverage in the economy (public and private) than they are to greenhouse gas concentrations. Debt is not just a financial obligation; it's indicative of our willingness to waste, to live beyond our (and the planet's) means; our willingness to kick the can down the road, to live large and send our grandkids the bill. Climate change is one consequence of this attitude; the fiscal crisis is another; ultimately until we learn better than this we will run into ever-bigger crises of one sort or another. Don't tempt fate by trying to invent free lunches. They tend to explode in your face like a Smurfs prank cake.

A solution that would get my vote would rely on bail-ins, not bailouts. In a bail-in, creditors who have lent to an insolvent borrower are forced to accept an equity stake in return for their debt holdings - they become part-owners, which means they now share the risk the earstwhile debtors have taken on. This too destroys money but does not force creditors to immediately recognise any losses as the nominal value of the equity is equal to that of the debt they gave up. Here's the catch for me: the sovereigns come into this as well, temporarily; in the great big roundtable of the great European Final Solution, it will briefly be possible for a bank to take an equity stake in a sovereign nation. Having converted all debt to creditors' equity, the netting off begins until there's only two types of stakes left: sovereigns' stakes in creditors and creditors' stakes in sovereigns.

The catch is that creditors cannot be allowed actual equity stakes in sovereigns at the end of the reshuffle. (Since people are asking, the reason is simple: the sovereign -the power of the state- can only be owned by the people. It's legally impossible for somebody, for instance, to buy the right to pass laws, levy tax and sanction the use of force in Greece). The EFSF comes in, swapping sovereigns' claims on itself against the banks' claims on sovereigns, so that it ends up being partly owned by those banks that were net creditors of sovereigns. The sovereigns are once again free of private sector ownership but do end up owning some banks (the ones that, after all debt has been netted and written off, are still undercapitalised), alongside the banks' erstwhile net creditors.

This doesn't provide a surplus recycling mechanism but then I don't actually want one. The member states never wanted one in past treaties, which is why they famously forbade the taking on of one member state's debt by another. We've now got around this but what could the intention of this proscription have been apart from the banning of bailouts?

Now the Federalists among us (don't know whether Varoufakis is one, to be fair, but many people encouraged by his views probably are) want to take advantage of the member states' desperation for cash in order to remake Europe as the superpower they were once promised they would be part of - a no-brainer if one grew up watching too much Voltron but otherwise one that deserves some scepticism and at the very least a referendum.

Don't worry; like Ireland you can ask us again and again, until we give you the 'right' answer, which will then of course be considered binding forever.

1 comment:

  1. oikonomosaris@yahoo.com7 June 2011 at 16:47

    I have very little knowledge of economics so if you could help me comprehend your proposal I would be obliged.You say creditors cannot be allowed actual equity stakes.I don't understand why not and what will happen to those equity stakes?
    Also (if I understand correctly) you are saying that countries that owe to banks swap that debt with the EFSF so that countries owe to the EFSF which in turn owes to banks?
    You also say some banks are going to be owned by sovereigns.Am I correct to assume that that will occur for all the greek banks?


Please remember that I am not notified of any comments and will not respond via comments.

Try to keep your criticism constructive and if you don't like something, do tell me how to fix it. If I use any of your suggestions, you will be duly credited.

Although I'm happy to entertain criticism of myself in the comments section, I will not tolerate hate speech. You will be given a written warning and after that I will delete further offending comments.

I will also delete any comments that are clearly randomly generated by third parties for their own promotion.

Occasionally, your comments may land in the spam box, which may cause them to appear with a slight delay as I have to approve them myself.

Thanks in advance for your kind words... and your trolling, if you are so inclined.