Dear Prof. Varoufakis
Thank you very much for your
swift and good natured reply. I am honoured that you took the time to read my
critique and the respect you have given it.
Background
About a year ago Prof. Varoufakis
and Prof. Holland presented a proposal to solve Europe’s debt crisis. Since
then, the so-called Modest Proposal (MP henceforth) has undergone many
revisions. The most updated version can be found in here. On the 5th
of December 2011 Andreas Koutras published a Critique
of this proposal. Prof. Varoufakis answered these criticisms on the 10th
December 2011 in here.
The current paper is the counter answer to Prof. Varoufakis.
I share Prof. Varoufakis’ view that we need a
totally open minded and rational debate about the causes and solutions to
Europe’s problems. I would also like to add, that due to the seriousness of the
issues, such a debate should be based on facts, evidence and logic rather than
beliefs, convictions, political prejudices, groundless assertions or populist
commentary. I am the first to admit, that unwittingly, I sometimes fall prey to
their attractiveness. Christopher Hitchens, said “What can be asserted without proof can be dismissed without proof”
when asked about the existence of God. If we apply this simple principle to
every debate we would form a better society and a better future for all of us.
Prof. Varoufakis should be
commended for his tireless zeal with which he has undertaken the European
cause. I admire his energy and his ability to raise awareness about such
important issues. Europe and Greece would be a better place if more people
joined this debate and followed his example. Hopefully, this dialogue will show
how urgent is the need to find a stable solution to the debt crisis. The EU is
our home and it deserves another chance.
Introduction
Prof. Varoufakis’ reply starts
with his assertion that:
1. The
crisis will not melt away unless the ECB adopts an active role, and
2. The
ECB will never be allowed, primarily by Germany, to intervene by printing
money.
In relation to (1). The list of
the extraordinary measures that the ECB has taken to tackle the crisis is long
and new initiatives (stealth
Quantitative Easing and lower collateral quality) were added last week (8th
Dec 2011). The quality of the assets that the ECB has taken on its balance
sheet has deteriorated so much that it is fair to say that it has become a
truly big bad bank (dinobank). Any further measures will for sure damage the
already fragile reputation of the ECB and the confidence the market has in it.
So, despite this massive intervention the crisis is growing by the day. This in
my opinion has more to do with the way the EU has structured its financial
incentives and with the lack of democratically accountable common fiscal policy.
As for (2) i.e. the printing of
money; Prof Varoufakis is entirely right. Europeans and not just Germans should
not allow the ECB to print money to bailout failed policies and politicians
unless there is strict conditionality and specific safeguards. For more on the
printing idea read the Gambler’s
Ruin.
With regards to my critique
I am relieved that I have understood the Modest Proposal (MP henceforth)
correctly as Prof Varoufakis acknowledges. In the rest of the text, quotes from
Prof. Varoufakis are highlighted in red. In this note I reply to his answer
(see also PDF):
Let us review the main
attractions of the MP according to Prof Varoufakis:
“….Our main point is that none of this is
even necessary. As argued below, the euro crisis can be dealt without any fiscal transfers,
with no taxpayer-funded bond
buy-backs and without
changing existing Treaties”
Thus if any one or more of these main
points are violated, I contest that the MP would become unattractive, if not
inapplicable. I started my analysis by pointing out an analogy with the SIV.
Prof. Varoufakis criticized it. I am afraid Prof. Varoufakis based his
arguments on a false comprehension of the analogy. Let us see why:
Modest Proposal
Makes The ECB The Mother Of All SIV’s
Prof. Varoufakis criticizes my
SIV analogy and calls it wrong. He further summarizes my explanation as
follows:
“SPVs
were created, as Koutras admirably explains, in order to hide debt and to shift
it from a more creditable (the bank) to a less creditable pseudo-stand-alone
vehicle (the SPV). Our policy suggestion does precisely the opposite.”
Prof Varoufakis has clearly
misread my part. I clearly described the SIVs as companies that were of higher creditworthiness (not less) than
the sponsoring Bank. Moreover, this was done in order to bypass regulations
(not hide debt) and to achieve better funding terms than the less creditworthy
bank. As he understood exactly the opposite, his claim that the MP policy does precisely the opposite means that my
analogy is precisely correct. In
classical logic, the negation of the negation, or double negation, is equal to
the proposition. To recap, the ECB is
used in the MP as a conduit of higher credit quality in order to achieve better
funding than the sovereign states. This is precisely what the ECB is called to
do with the MP and this is exactly what the SIV’s were created for. The MP’s aim
is twofold:
1.
Fund
more cheaply using the assumed higher creditworthiness of the ECB
2.
MP
is allegedly structured so as to bypass the treaty’s straightjackets (MP’s
attractive points according to his author, i.e. Fiscal transfers, taxpayer
funded buybacks, Treaty changes).
Thus, the honourable aim to
bypass laws[1]
and to fund cheaply these assets confirms precisely the SIV analogy. It is for
this reason that I renamed the ECB, ACME-ECB (from the popular cartoon
character Wile Coyote). I think the name caused confusion as I may have not been
entirely clear with the term. I did not mean that there is an off-shoot of ECB
as Prof. Varoufakis was quick to point out.
So, as far as anyone is concerned
the MP is using the ECB as a financial conduit. Yes, it is a refinancing operation
as Prof Varoufakis states. In fact, we could call it the mother of all SIV’s, since it would hold and fund 7 trillion
of Euro in total.
Prof. Varoufakis is absolutely right
in his criticism of the usage of SPV’s and CDO like structures in order to
solve the European debt problem. I fully agree with him. I frequently lamented
this practice, most recently in my EFSF
Leverage post. I am therefore rather baffled that the abuse of the ECB as a
funding conduit by the MP has escaped his scrutiny.
ECB Effectively
Sells Protection For Free.
Prof Varoufakis also seems to
object to my use of the phrase, “ECB effectively sells protection for free”. He
sites as an example the child-parent analogy and I quote:
“When a creditworthy parent negotiates a low-interest rate loan by
which to repay a (less creditworthy) child’s existing high-interest loan on condition that the child meets the monthly
repayments, it is correct to say
that the parent shifts risk from the bank to herself (and this is why the
interest rate charged is reduced).”
Indeed, that shifting of credit
risk is exactly what is called selling protection to the bank by the parents.
Put it another way, the bank is buying insurance (for free) against the child’s
default on payments. Incidentally, the “on condition
that the child meets the monthly repayments” is an empty and worthless
guarantee as we have already accepted that the child’s credit is negligible or
non-existent. That is exactly why the child needs a guarantor.
Prof Varoufakis continues:
“But to describe this operation as the parent “selling protection”
to the bank is to introduce into the equation a transaction that is simply not
there”.
The fact that the parent decided
not to charge any money and transacted for free instead, does not mean that the
guarantee has no economic value or that it is non-existent. The transaction is
there whether money is exchanged or not. There exists economic value transfer
from parent to the bank and is given for free. It is a windfall for the banker.
This is a rather simple and inescapable fact; the parent has sold protection
for FREE. Parents often do this, because they are paid in other non-monetary
terms. The fact however, remains the same; someone has effectively insured
someone else’s debt; the bank investor bought (for free) the protection and the
parent provided it. This is the only financial and economic description one can
give.
Prohibition Of
Overdraft Or Credit Facility Or Any Other Type With The ECB. Article 104.
Prof. Varoufakis emphasises the
point that the MP was designed in order to preclude the violation of article
104. He then goes on totally contradicting his previous statement by saying:
“…that if a member-state defaults toward the ECB then the ECB will have,
effectively, to extend credit to it courtesy of having to meet the repayments
to ECB-bondholders itself. Clearly, in this case, we have a potential violation
of Article 104 in our hands.”
That is exactly the
point, although it is not a “potential violation” but a fully blown
real one. The claim that the MP does not violate article 104 is clearly false
since according to some well-defined and plausible scenarios, the article’s
provision is grossly violated. Thus one
of the so-called “attractive” points, the “no need to change the treaty”, is
gone!
As for his criticism
of the “unlimited liquidity commitment” Prof. Varoufakis confuses the words
unlimited with infinite. The “unlimited liquidity commitment” in finance means
“for any amount”, “uncapped” not as he is claiming infinite. I fully sympathise
with the confusion as this is a term used by finance practitioners and not
theoretical academics with little market experience.
Prof. Varoufakis
however, claims that this violation can be prevented by assigning a
super-senior status to the payments made by the countries to the ECB. He
further adds that all the countries would place a joint guarantee to each
other’s debt payments in order to prevent this violation!! Unfortunately, in
proposing this joint guarantee, he creates even more violations and problems.
Let us see why, by first quoting Prof. Varoufakis:
“Simply by affording (as the Modest Proposal argues) the debit
accounts of the ECB superseniority status. In short, having all member-states participating in the Debt Conversion
operation sign an agreement with the ECB, well in advance, that binds them to
placing the servicing of these debit accounts over and above all of their other
obligations. That way, even if one of the member-states, needs to restructure
its overall sovereign debt, its debit account with the ECB will not be affected
– unless we have massive default and the other member-states do not step I”.
The stumbling points are:
1.
An
individual country can sign a guarantee that it is going to pay you first. i.e
give you seniority over claims. However, this does not mean in any way that
either has the means to pay or the willingness to pay or that it will pay you.
It just gives you priority over payments and not certainty of payments. In
other words, I will pay you first if I
have money to pay.
2.
It
must be obvious to everyone that this joint guarantee of each other’s debt
payments is a blatant violation of the
treaty[2].
There is no joint liability of debts in Europe. Arguing this point further is
unproductive unless we change the treaty of the Union, contrary to MP’s claims.
This proposal unites all the Maastricht debt as a shared liability.
3.
If
a country decides to give seniority to some creditors then this is automatically a default event. This is because the bondholders of all the
other non-Maastricht debt would be immediately subordinated. Furthermore, the
majority of European Bonds contain a “Negative Pledge” clause prohibiting the
issuer from giving any form of security to any other bondholder unless everyone
is part of that security[3].
It is precisely for this reason why even the loans of the IMF are not super-senior,
contrary to popular belief[4].
In the next paragraph Prof. Varoufakis’ argument disintegrates to:
“…it is essential to compare our Modest Proposal not to some airy-fairy,
wishful-thinking-imbued, version of the eurozone but to the
really-existing eurozone. As we are exchanging these ideas, the ECB is already
printing money to buy at least €200 billion worth of stressed bonds on
the secondary markets…. To put the point not too finely, if our Debt Conversion proposal
violates Article 104, the present reality violates it to the power of n,
where n is an increasing function of time”
This is a rather revealing
argument as it introduces the concept of comparison
and degree of violation. In other words, the MP is violating the treaty but
to a lesser degree than others are. So, yes the MP does violate 104 but not as
much as other practices or ideas! It is akin to someone committing a
misdemeanour and claiming that he has not broken the law since he did not
commit a felony like others have.
In conclusion, according to Prof.
Varoufakis’ written reply, the MP does violate the treaty. Hence, its
attractiveness is reduced. In order to fix this violation the MP creates
another violation. The MP creates a joint liability of all the debt by all
countries. This would also violate the original “no fiscal transfer” argument by
tax payers! And the rollercoaster ride gets scarier; the superseniority of this
so called debit account would trigger
defaults on all the European countries barring none.
Will ECB-Bonds Sell?
Prof. Varoufakis says with
conviction that they will sell like hot cakes! He further supports his
conviction with three points:
1.
The
ECB bonds are not CDO-like unlike the EFSF ones.
2.
The
main buyers would be sovereign wealth funds, pension funds and private
investors. Furthermore the credibility of the ECB would be boosted by the Debt
Conversion.
3.
The
ECB’s credibility would be reinforced by the super-seniority status of the
member-states’ debit accounts with the ECB
Let me deal with the
three points in turn:
1)
Firstly,
the comparison of the EFSF bonds with CDO is not entirely accurate. There is no
slicing or tranching of the EFSF bonds. The guarantees given by the countries
to the EFSF are joint. That is however beside the point. Prof. Varoufakis
laments the structure of the EFSF and then advocates doing exactly the same
with the Maastricht debt. i.e. Member states guaranteeing unconditionally up to
60% (of GDP) of each other’s debt!
Neither the bonds
issued by the EFSF nor the ECB proposed ones are bonds backed by a real
business. Let me explain once more what I mean. When someone decides to borrow
money, in any form, bond or a loan or any other, he must explain to his
prospective creditors from where he is going to generate money to repay the
interest and the capital according to the Bonds agreement (indenture). How else
can a prospective investor in these bonds gauge the risk profile of his investment
and form an opinion of their creditworthiness? Once he knows the source he can
form an opinion on the price that he needs to charge and the risk of not
getting his money back. In the case of the EFSF, investors know that they will ultimately
get their money back from the unconditional guarantee of the member states of
EU. Currently, for example, investors demand a premium of around 2% over
Germany for the EFSF bonds, despite all the guarantees. This would be similar
to the ECB bonds. As the ECB does not have a business that generates profits with which to
repay the bonds, the ECB must search for some other source of creditworthiness,
for example from the EU member states. This is why Prof. Varoufakis introduces
the concept of super-seniority and joint liability through the back door. Prof.
Varoufakis claims rather arbitrarily that the creditworthiness (more on this
later on) of the ECB is very high without explaining from where this high
credit steams. As I argued in my original critique of the MP, the ECB can
derive and source creditworthiness only from the member states of the EU and it
is thus constrained by them. This is similar to the EFSF.
2)
I
fail to see the logic in Prof. Varoufakis’ 2nd point. Why would the
taking of 7 trillion euros on the balance sheet make the ECB more creditworthy
to investors? A rational investor would surely think exactly the opposite. Expanding
your balance sheet brings you closer to oblivion than to salvation.
3)
I
dealt with the super-seniority argument earlier on, so I will not repeat the
pitfalls here. I only want to ask, why bother to make such a convoluted
proposal only to end back to the simple joint guarantee by EU countries?
Finally, Prof
Varoufakis says:
“The key to the success of our Debt Conversion operation is the
credibility of the ECB and, in a never-ending circle, the way that the latter
is reinforced by credibility of the Debt Conversion plan itself”
Clearly the ECB is a credible institution but this
refers to the ECB’s ability to control monetary policy and to foster price
stability in Europe. The ECB is not a creditworthy borrower per se. Prof. Varoufakis confuses reputation with financial
creditworthiness. To use the analogy that Prof. Varoufakis favours: The father
may be a very reputable member of the community and an excellent father but
this does not mean he is creditworthy to borrow a few trillion!
Prof. Varoufakis uses his so called Debt Conversion
as the holy grail of his plan. Starting from a fallacious premise as I argue he
does, anything is possible. The so called Debt Conversion relies on having in
place a backstop to the losses of the ECB either by monetizing (printing) or by
having fiscal transfers in place or guarantees by the EU member states. Remove
these hidden assumptions, and the MP does not work. Reading the MP, one is left
with the sense that this (backstop) is a minor detail and that it would never
be invoked. This is not the case. The backstop is essential in providing
creditworthiness to the ECB if the ECB is to issue its own bonds. Without it,
the 7 trillion ECB bonds that the MP plans to issue are ACME junk bonds.
Numerical Example Given by Prof. Varoufakis
In his reply to my critique Prof. Varoufakis gives
a numerical example that describes his proposal. One does not need to have
studied economics or finance to understand that paying lower interest on your
debts would reduce your total debt burden.
Prof. Varoufakis also provides a table of possible
savings but excludes the bad scenarios because as he says he is convinced that
they would not materialise. This is not how proper analysis should be presented
(especially to prospective investors or “buyers” of the MP idea). Any junior
bank analyst knows through his legal and compliance training that research
should contain a balance of good and adverse scenarios.
Even if we do accept that a lower interest rate is
achieved the incentive to borrow more is enhanced[5].
This is exactly what occurred in the last 10y in Greece. Investors assumed that
Greece would never default because Germany and the EU would come to its rescue
(Famous German Put option in finance parlance). As a result Greece paid lower
funding rates in an analogous way with the numerical example given by the MP.
The cheap money skewed economic incentives as it was now cheaper to borrow than
effect real economic and painful reforms. Although as far as I know no EU
country has debt less than 60% of GDP, if it did the incentive would be to
borrow up to that level as it would be the joint liability of all EU states. The
MP just legitimised a floor on debt rather than a cap on it. In the literature
this is known as Moral hazard.
Again the interesting point comes towards the end
of that section when Prof. Varoufakis says:
“Even then, the common knowledge that either other member-states will
come to Spain's rescue (if it needs to write down more than 30% of its debts)
or that the ECB will monetise (a small part of Spain's debts to the ECB) is
sufficient to keep investors safe in the thought that ECB bonds are an
excellent investment even though no member-state stands behind them”.
In other words, when it comes to the crunch the ECB
would have to print money and monetise the debt or the other member states
through their guarantees would make these bonds creditworthy. This is exactly
what I said in my critique. I quote:
“So
what happens if, as in the case of the original ACME, the government bonds
start underperforming or even the sovereign stops servicing them? Does ACME-ECB
have an unlimited liquidity commitment with the Eurozone countries? The hidden
assumption of the MP is that since it is a central bank, it has its own! In the
event that the sovereign cannot make any payments the ACME-ECB would make up
the shortfall for it. This would be done by printing new money or perhaps by
the sovereign pawning some assets with the ECB (giving collateral).”
We now have a rather more complete picture of the
MP. The claim that there is no need for fiscal transfers or taxpayers money is
clearly misleading. The claim that there is no need for treaty changes is
false. The MP, contrary to its claims, introduces collective EU guarantees and
also demands that the ECB print money to save sovereigns who cannot pay. Only
the claim that there is no need to buy the bonds directly is not violated.
In the same section Prof. Varoufakis describes some
colourful scenes of investors flocking to buy these ECB bonds and of jubilant
market traders. Indeed there would be some joyous traders if the MP is applied;
those who have bought CDS protection as the super-seniority would trigger
defaults, those who have sold Euros and bought any other currency as the ECB
would start monetizing the Euro debt and those who are long gold as fear grips
the markets that the MP would be implemented.
Independence of the ECB
I agree with Prof. Varoufakis; the enshrined
independence of the ECB is there to prohibit politicians from influencing its
decisions. He describes rather accurately the attempts politicians are making
to force the ECB to print money. I am however baffled why the MP would increase
this independence. Inadvertently, having to service 7trillion by allowing the
Maastricht debt on the ECB’s balance sheet would make the ECB’s governing
council more prone to political influence and not less. The ECB has already
compromised somewhat this principle by buying directly more than 200 billion
worth of Greek, Italian, and other peripheral debt. If for example Greece
decides not to pay, then the ECB would have to go bankrupt!! This surely points
to less independence. Just imagine what it means if 7trillions are on ECB’s
balance sheet.
Monetary Policy Reversal
As I explained in my critique, for the ECB to need
to fund 1.4trillion every year poses a serious threat to the Monetary policy
implementation. Prof. Varoufakis does not answer the point, so I will repeat
the argument here for clarity’s sake.
Central banks are able to control interest rates by
controlling the supply of money. Put simply, the banks (on aggregate) in Europe
need cash to operate as they do not have enough. Therefore, they go
to the Central bank and they convert some of their assets to cash. In this way,
the Central bank controls the system. If now, as the MP says, the Central bank
needs the cash (1.4trillion) the role is reversed.
It is not the Central bank that sets the monetary policy but the banks
(foreign sovereign wealth funds in Prof Varoufakis’ case) that control the
central bank. This is a very-very serious flaw. It totally negates the raison
d’être of a Central Bank.
Furthermore the imposition of the MP compromises ECB’s independence in defining
and setting monetary policy[6].
Prof. Varoufakis opines, that debt issuance is a
fiscal policy while debt management is monetary policy. Assuming that he is
correct (I am not a qualified economist as he is, so I leave this to be
answered by experts) what exactly does one call the continuous issuance by the
ECB of 7 trillion euros? This is an obvious sleight of hand. He claims that
when sovereigns issue it is fiscal policy but when the ECB does on their behalf
it is a monetary policy.
Prof. Varoufakis goes on, and I quote:
“According to Policy 1, the ECB will not
be issuing member-country sovereign debt. It will be issuing its own
supra-sovereign eurozone-debt, as and when it deems right in pursuit of its own
monetary policy objective, the monetary counter-inflation targeting rule.[2] To
further underline the nature of this defining differentia specifica, the ECB does not (speaking strictly) need to issue its own new debt in
order to service seasoned debt. It could just as well do this by creating new
money (as the Fed has been doing). What Policy 1 is proposing is that, instead
of quantitative easing US-style, the ECB borrows from the market for monetary policy
purposes, recoup these monies long term from the eurozone’s member-states and make money in the process (therefore
strengthening its own balance sheet). How much clearer can this be? And why is
this inconsistent with the ECB’s remit?”
Firstly, the ECB may have a choice on the issuance
of the so called ECB bonds but it does not have a choice of not increasing its
liabilities. One way or another it would have to either print the money or
issue its own bonds at exactly the same time schedule as the bonds redeem. This
restricts the monetary policy choices!
So, according to this the ECB would run an
unbalanced balance sheet. It would not be obliged to issue bonds to cover the
sovereign bonds, but just print a few more billions and bob’s your uncle. Is
this how Prof. Varoufakis expects central banks to act?
What is more, Prof. Varoufakis concludes that the
ECB would make money in the process. It is not clear how this conclusion is
reached. Does the MP also include an arbitrage free way for the ECB to make
money? I have many doubts on this and further clarification may be needed on
how exactly this is going to work.
Conclusion
I want to conclude with a summary table of the MP
main assumptions and attractions before and after the exchange of views and the
clarifications by Prof. Varoufakis.
Original MP claims and attractions
|
Reality after clarifications by Prof Varoufakis.
|
Reason
|
No Treaty changes needed
|
101,103 (consolidated) is violated so Treaty
changes needed
|
Credit and Overdraft, ECB printing, Joint
Liability
|
No Fiscal transfers needed
|
Fiscal transfer could occur
|
EU states guarantee each other’s Maastricht debt
|
No bond buybacks
|
No bond buy backs
|
There are no buybacks
|
No taxpayers money needed
|
Tax payers could pay
|
Tax payers would pay to cover the losses of the
joint liability guarantee
|
No need for EFSF like guarantees
|
Guarantees are introduced
|
Need to make ECB bonds creditworthy
|
No printing of money
|
Printing allowed as part of a new monetary policy
introduced by MP
|
1)
Cover losses in cases sovereign don’t pay
2)
Print for Monetary Policy purposes
|
No debt subordination
|
Maastricht debt is super-senior
|
This would trigger default in all EU countries
|
Apart from the no bond buybacks, all the other
promised attractions of the MP are violated. Furthermore, some elements of the
MP would severely hinder the ability of the ECB to define and conduct its
remit; i.e. Monetary Policy. Prof. Varoufakis rightly says that one cannot
under all circumstances forbid a central bank from printing or monetising debt.
I fully agree with him, even though this is not how the MP is usually
presented. The problem in the MP is that, together with the joint liability of
the Maastricht debt, they are essential and vital parts of the proposal.
Without them the so called debt conversion cannot occur as the ECB bonds would
be considered junk. What is more, monetary policy is in complete jeopardy due
to the reversal of cash needs. The proposal also sets an absolute “optimal”
minimum for a country’s debt. i.e. 60% of GDP.
Prof. Varoufakis interprets the lack of popularity
of the MP to the realm of politics. This may be so. I am not a politician to
judge this. But with respect to practical finance the MP is an impractical and
rather dangerous idea to implement. Bankers and traders have great intuition
and ingenuity when it comes to finding solutions and making money. Good ideas
and good trades usually spring simultaneously from many people. The lack of
enthusiasm among people who spend all their lives looking at the markets and
making a living out of them, for the so called modest proposal, points to a
rather different conclusion; that their time is too valuable to be spent on
this idea.
Finally, I would like to offer my sincere and
unqualified thanks to Prof. Varoufakis who took the time to clarify the Modest
Proposal in such detail.
Andreas Koutras
http://andreaskoutras.blogspot.com/
[1]
Bank regulation on capital
in the case of SIV and Maastricht treaty in the case of the MP
[2] “A Member
State shall not be liable for or assume the commitments of central governments,
regional, local or other public authorities, other bodies governed by public
law or public undertakings of another Member State, without prejudice to mutual
financial guarantees for the joint execution of a specific project.”
[3]
Remember the recent debacle between Greece and Finland on securities.
[4]
The IMF is an assumed preferred creditor and not a preferred creditor on paper.
In other words, there is no mention in any IMF loan documentation that says the
needs to be paid first.
[5]
Look at the housing market.
People where lured by the lower interest rate and borrowed tons of money to buy
houses. This pushed the prices up and this self-feeding (positive feedback)
process was one of the main causes of the current credit crisis in USA, Ireland
and others
[6] Article
105.2 “The
basic tasks to be carried out through the ESCB shall be: to define and implement the monetary policy
of the Community……”