In a few short weeks I shall be discussing the ‘Future of Europe’ in a panel comprising distinguished commentators including George Soros. In preparation, I decided to take a closer look at Soros’ latest proposals for the eurozone. Here are some preliminary thoughts emanating from these proposals which I also compare and contrast to our Modest Proposal.
Soros’ plan works as follows: The ECB guarantees that it will buy any newly issued member-state bonds (Italian and Spanish ones in particular) from all comers and at face value. To bypass the twin no bail out clauses (Lisbon and ECB charter), the EFSF-ESM would insure the ECB for any losses on these bonds. This means that the European Banking Authority will be able to treat these bonds as cash, for the purposes of bank accounting. Thus, the banks would choose to keep member-state bonds, including the periphery’s, on their books so long as their yields exceed the interest rate offered by the ECB on money deposited with it. Competition among banks would then drive bond yields close to the ECB overnight rate of, currently, 1%. As for the older bonds, now that the periphery will no longer be in dire straits (regarding the refinancing of their new debt issues), they will also see their yields fall substantially.
One may question whether the flimsy EFSF-ESM could carry the burden of insuring the ECB for all these bonds that will flood into its balance sheet. Soros claims that it should not be a problem since, under his scheme, member-states cannot and will not default. A never ending virtuous circle will therefore have been established. Which brings us to the usual question, that I can hear many posing in earnest, concerning moral hazard: If peripheral member-states know that the ECB will turn their bonds into money, and that the EFSF-ESM will insure these bonds in case of their defaulting, what is their incentive to limit spending and reining in their deficits?
Soros’ answer is that the fact that the ECB will now become central to the viability not just of the peripheral banks but also of the sovereigns promises to keep the politicians in check and in awe of Mr Draghi. However, Soros does not elaborate on what sanctions the ECB will exact upon potentially recalcitrant governments, once it has guaranteed their bonds at par. It seems that the only answer to this is acquiescence to the inane, procyclical Fiscal Pact first proposed by Mrs Merkel. Herein, therefore, lies the first weakness of Soros’ proposal: it will either crash on the shoals of Europe’s selective obsession with moral hazard (i.e. worrying stiff about moral hazard when it comes to governments but not an iota when it comes to zombie banks) or it will be dragged into the abysmal logic of constitutional bans on structural deficits.
Setting aside this difficulty, Soros’ main claim is that his plan would directly deal with the problem Italy and Spain are facing today: namely, of having been relegated to the state of developing nations that have borrowed in a foreign currency. As for the current patch up ‘solution’, Mr Draghi’s LTRO, he would dismiss it as less effective and potentially more dangerous than his own proposed scheme. And he would be correct in saying so. For not only is the LTRO infusing huge amounts of liquidity into our zombified banks, thus removing any incentive the bankers have to recapitalise, but it is also ineffective in its task of indirectly funding the sovereigns (since, even though it offers banks an opportunity to indulge in ‘riskless’ arbitrage, by buying sovereign bonds, only a portion trickles to the sovereigns as the banks hoard as much cash as possible in order to disguise the gaping holes in their own books).
I have no doubt that the above is correct. However, there are a number of problems with Soros’ proposal. The main one is that he is recommending that, in the final analysis, Europe devises a ‘trick’ by which to allow the ECB to print a few trillion euros so as directly to finance the sovereigns. Soros’ idea may be more elegant than different variants of the ECB-monetisation idea; e.g. Mr Geithner’s crude suggestion that the ECB leverage the EFSF and then have the EFSF buy all new and/or bond issues of fiscally distressed countries; or the proposal that the ECB set minimum targets for peripheral spreads and intervene in the secondary markets accordingly. Yet, its central logic is not substantially different: The ECB will be printing money in order to prop up sovereign debt directly (and not through the circuits of the banking system).
Where there is a will there is a way. If Europe wanted to opt for direct ECB monetisation, it would find a way to do it. Alas, Europe’s problem is the absence of the necessary will to support a proposal like Soros’. Indeed, if Germany decided to let the ECB monetise the periphery’s debt directly (as opposed through, the banks, as with the LTRO), Soros’ method would offer a nice fig leaf behind which to disguise this massive change in its collective mind. The problem, however, as I am sure George Soros understands, is that Germany has not made its mind up to monetise the debt directly. Soros may have an excellent point, that the mere announcement of his form of indirect (bank-EFSF-mediated) monetisation will ensure that no actual money-printing will be necessary. But this is besides the point: Germany is still resolute in its commitment to keeping at bay even the ‘imagining’ of direct ECB-mediated monetisation. In addition, there are also another two weaknesses in the Soros proposal: One pertains to the long run ‘solution’, the other to the strategy for growth that Soros is acutely aware is needed, and which he does mention in his article as something that needs to come from the Union (as opposed to the member-states).
Beginning with the long term, Soros understands well that his scheme (which has the EFSF-ESM guarantee the ECB’s guarantee of member-state bonds) is only a temporary palliative for relieving the debt crisis, until something more permanent and solid is put in place. And what might that be? His answer is loud and clear: jointly issued and severally guaranteed eurobonds. This is, I trust, an error which weakens his case. It is true that Mrs Merkel is allowing the rest of us to imagine that, in the distant future, if like good boys and girls we all adorn the fiscal straitjacket that she is proposing, she will let us have our Eurobonds, at least in the fullness of time. Well, this is, I fear, but a stratagem. Mrs Merkel, whoever happens to be Germany’s Chancellor, will never concede to interest rates that are a weighted average between Germany’s and Portugal’s. With good reason too.
Indeed, as the Crisis is dragging on, it takes an heroic disposition to imagine that the German public will inch more closely towards the disbandment of the bunds in favour of jointly issued eurobonds. Quite the opposite will be the case. German taxpayers will rather see the DM return, with all the demerits it will bring regarding loss of export markets et al, than blend their debt with that of the despised periphery.
Turning, lastly, to the need for a growth spurt that is uniquely capable of ending the debt crisis, Soros’ proposal only alludes to its importance. It is not integrated with a plan for spearheading such growth. The task we ought to give ourselves is to find ways of blending our proposals for countering the eurozone’s structural debt crisis with steps that aim at an investment-led recovery spanning the whole continent (and not just the periphery). The way to link these two grand projects, upon which the future of Europe depends, is to overcome a conceptual error at the heart of the assumption that eurobonds must be guaranteed by member-states, just like the EFSF-bonds are presently. The fact is that it is perfectly possible to issue eurobonds without member-state guarantees, without a european Treasury, without a Debt Agency and without whatever else would turn the common bond issuing exercise into something akin to California and Ohio jointly guaranteeing US Treasury Bills. How?
As Stuart Holland and I have been proposing for a while now, the ECB ought to issue its own eurobonds, under its own name, without anyone else guaranteeing them, and use them to shore up existing Treaties, i.e. by servicing (as opposed to buying) the Maastricht-compliant debt of the eurozone member-states that choose to participate in this, effectively, Debt-Conversion-Scheme. The fact that the remaining Maastricht-exceeding debt remains the sole responsibility of the member-states will offer sufficient safeguards, by itself, against moral hazard and removes the need to introduce a messy, and authoritarian, political-cum-constitutional mechanism by which to circumscribe the member-states’ autonomy. In one simple move (having ECB issue debt in its own name in order to service the eurozone’s Maastricht-compliant debt), we will have removed the two main German objections to Union Bonds: (a) the moral hazard objection and (b) the objection based on the (correct) prediction that jointly issued bonds will have yields reflecting the weighted average of German and Greek interest rates).
More importantly, once the ECB begins to issue bonds on behalf of the Union, it becomes possible to link the debt-conversion process with the much needed investment-led recovery program; with something akin to a New Deal for Europe. As we suggest (Policy 3 of the Modest Proposal), idle global savings can be channelled into productive investments within the whole of the EU. The key is to allow investment to be co-financed (a) by the EIB itself (through the issuance of its own bonds, something the EIB has been doing for decades) and (b) by net issues of project-specific ECB-bonds. A target could be set centrally that involves (a) gross investment for the EU as a whole and (b) patterns of investment such that this ‘surplus recycling’ is made sensitive to the internal balance of payments’ problem. E.g. aggregate investment (financed by EIB and ECB bonds) could be linked to the eurozone’s overall growth performance while the distribution of these funds within the different regions of the eurozone (as opposed to countries) can be calibrated to counter-act the growing trade imbalances.
Soros’s plan is on the right track but suffers from three demerits: It runs against German sensibilities vis-à-vis money printing for the purposes of direct sovereign-debt-finance that bypasses the banks. Secondly, it violates Germany’s legitimate rejection of having its interest rates stretched upwards by eurobond issues that it must jointly issue and back with the periphery. Thirdly, Soros’ plan does not incorporate any mechanism for effecting (a) the desperately needed New Deal for Europe and (b) countering the growing internal imbalance of payments problem (which is, after all, the root problem of the eurozone architectural design). In this light, I still think that our Modest Proposal, suitably amended to take onboard some key ideas by George Soros and others, remains the most fruitful avenue toward a decent European future. Now that the LTRO is about to reveal its weaknesses, and the eurozone crisis is on the verge of a fresh, nasty twist (courtesy of Spain and other major economies entering deeper into recession), it is perhaps time, for Modest Proposal 3.0…
 The obvious question here is: And who will backstop these ECB-bonds? The answer is: While the ECB-bonds will be guaranteed by the ECB itself (and not by the surplus, AAA-rated, countries), it is the member-states that will be, under the supervision and even coercion, of the ECB meeting, long term, the maturing ECB-bonds repayments (that are issued in order to service the member-states’ Maastricht-compliant part of their debt). Additionally, we could have the ESM-EFSF guarantee, in a manner resembling Soros’ idea, part of these debts by the member-states to the ECB.
This column was first published on Yanis Varoufakis’ Blog