Can the Eurozone be saved without a treaty change?

20th August 2012

Professor Stuart Holland from the department of economics at the University of Coimbra, Portugal and Professor Yanis Varoufakis from the economics department of the University of Athens, Greece dubbed their concept "A Modest Proposal for Resolving the Euro Crisis".

In it they advocated three policy measures: First that responsibility for recapitalising Europe's banking system be handed over to the European Financial Stability Facility (EFSF); second that the European Central Bank (ECB) undertake a Debt Conversion Program whereby it would issue central bank bonds to ease sovereign funding difficulties; and third using the European Investment Bank (EIB) to fund investment across the region.

Below Professor Varoufakis answers Mindful Money's questions in an exclusive interview:

 

1. Is the model you suggest for the EFSF similar to the proposal to grant a banking license to the ESM? Do you see the fundamental problem with the bailouts to date that they were limited in scale – that is unlimited liquidity provided by the central bank acts as a guarantor of future funding but might actually end up costing less?

No, our proposal regarding the EFSF is substantially different to the suggestion that the EFSF be granted a banking licence. We propose that the EFSF (and the ESM, its permanent successor) be converted into, effectively, a Euro-TARP institution. That is, a fund from which insolvent banks are recapitalised centrally (as opposed via national governments) while the ECB and a massively re-vamped EBA (European Banking Authority) undertake the task of supervising and, potentially, winding down insolvent banks.

The fundamental problem with the current EFSF, as I see it, is not so much its limited firepower (which is, of course, beyond doubt) but, rather, its toxic (CDO-like) architecture. Think about it: When Ireland went bankrupt and drew funds from the EFSF, Portugal guaranteed part of these loans.

When Portugal went under, Spain guaranteed bits of the EFSF bonds that were issued on behalf of Portugal. And now that Spain is buckling, Italy will have to guarantee the new Spanish loans. And so on. In essence, the EFSF bonds, which finance the bailouts, have precisely the structure of a toxic CDO. Thus, we are caught in between a rock and a hard place: If the EFSF is not given enough firepower (i.e. rights to issue at least a trillion of bonds), it is irrelevant. And if it is given enough firepower, its toxicity threatens to bring down the whole of the Eurozone.

To end this conundrum, the EFSF's funding on bank recapitalisations must be separated full from funding of national governments, with the latter task taken over by the ECB. Our proposal (see The Modest Proposal for Resolving the Euro Crisis) is that the ECB issues its own bonds in order to service the Maastricht compliant part of the Eurozone member-states' debt while the EFSF turns itself into a Euro TARP. Failing this, a banking licence for the EFSF coupled with an explicit aim to recapitalize centrally the Eurozone's banks would detoxify the EFSF and put, at least, a temporary end to the deadly embrace between insolvent banks and insolvent states.

 

2. If the ECB issues debt does this entail the same joint-liability problem that Germany has so far steadfastly refused to countenance? That is, is agreement on Policy 1 necessary for Policy 2 to function?

No, it does not. What Germany is currently refusing to countenance, with good reason, is jointly and severally guaranteed eurobonds; i.e. joint debt that needs to be backed up by the German taxpayers to be credible. If, in contrast, the ECB issues its own bonds, the German taxpayer will not be directly responsible for these bonds.

One may, of course, argue that if the ECB fails, then it is German taxpayer that will be called upon to pay the bill. This is not true. Consider what is happening today with Target 2 – the system of liabilities and assets within the ECB system which allows for the common currency to continue in the face of gross capital movement imbalances. As the crisis deepens, Target 2 imbalances are rising exponentially. Yet this is not a problem, and no one really has to pay these liabilities, as long as the probability of a Eurozone breakup is negligible.

If the Eurozone is broken up, these balance sheet liabilities will simply be erased; with the German banks ending up the beneficiaries at the expense of the Bundesbank (something that the latter can take in its stride following the mass capital flight into Germany following a potential euro break up). Similarly with the ECB bonds – the German taxpayer will not be liable for these debts in the extremely unlikely event that the Eurozone breaks up even after the ECB has stepped in and issued bonds on behalf of Eurozone member-states.

Finally, yes, agreement on Policy 1 is a prerequisite for Policy 2 to work. In other words, it is imperative that the banking crisis is separated from the public debt crisis. As long as the two are joined at the hip, so to speak, the Eurozone is doomed.

 

3. What sort of scale would EIB action need to be in order to offer a meaningful stimulus? Moreover, will there have to be a balance between the beneficial impact of each investment to the EIB and the degree to which it benefits the underlying economy of a nation state?

Given the advanced stage of the Depression in the Periphery and the second dip of the Recession in the surplus countries, the EIB-EIF's investment must rise up to 10% of Eurozone GDP. Mind you, it is misleading to think of this as a stimulus. By stimulus, we mean a standard pseudo-Keynesian policy of the state printing money and pumping it, through state channels, into the economy; pretty much what the Obama administration purported to do. Our proposal is that the EIB-EIF are simply allowed to borrow on banking principles (i.e. predicated upon the quality of their business plans) in order to energise idle savings and turn them into productive and profitable investments. In effect, there is nothing new here. The EIB has been doing it for decades. Our simple suggestion is that the EIB is allowed, possibly in collaboration with the ECB and the EU, to finance 100% of projects that it deems potentially profitable.

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