Wednesday, 14 December 2011

Reply to Prof. Varoufakis on the occasion of his blog post on the 10th December 2011.

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.


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. 


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.


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.
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   

[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……”