Since the eurozone crisis started dominating the news in late 2009, there has been only a handful of economists who have called it by what it really is: a balance of payments crisis. None of them has ever gotten a Nobel Prize for economics and hardly any of them is a frequent guest in the mainstream media. A future post is specially reserved for them.
But till that post I need to pick out two economists who have gone much further than merely explaining the crisis. They have even proposed a solution, in fact not less than a year ago. These are Yanis Varoufakis and Stuart Holland, professors of economics at the University of Athens and of Coimbra respectively. Since I consider their proposal the only workable solution publicly known so far for overcoming the euro crisis (to my knowledge at least), I feel the need to make a brief assessment of it. Their proposal is called the “Modest proposal for overcoming the euro crisis”.
The “Modest proposal” is a proposal for the existing institutions of the eurozone to work together in order to tackle a three-dimensional crisis. According to the authors, the eurozone currently faces three crises at the same time:
-A sovereign debt crisis
-A banking crisis
-A growth crisis
At the centre of the three crises lie the internal imbalances in the balance of payments of the euro member states, caused by the euro’s original design. What they argue is that the euro does not include a “recycling mechanism” for the money flows within the eurozone similar to what the Bretton Woods system included, with the IMF and the World Bank recycling the US current account surpluses into capital account deficits towards the developing nations.
Varoufakis and Holland suggest that the eurozone set up a mechanism similar to Bretton Woods within the currency block. Below I will give a summary of it, but it is definitely worth reading the entire proposal here.
The “Modest proposal” is based on three policies, each one addressing each crisis.
Proposal 1: The euro at its current form cannot ensure that sovereign debt is a “risk-free” asset in the same way as it is in any country that issues its own currency and therefore countries face the risk of a run on their bonds. The Maastricht treaty in 1991 stipulated that the EU member states maintain a government debt to GDP ratio of no more than 60%. However peculiar it seems now, upon the euro adoption several countries did not fulfill this criterion, notably Belgium, Greece and Italy.
Since the countries have already agreed to maintain a public debt to GDP ratio of up to 60%, the ECB could service this part of their debt by issuing its own bonds. Two are the most crucial points of this policy: first, that the ECB does not buy the debt of the countries but only services it. This means that the debt does not have to ever been repaid, but only the interest on it has to be paid by each state to the ECB. The second point is that the ECB does not finance the government debt by issuing euros but by issuing bonds. These bonds would obviously not increase the monetary base of the eurozone.
Proposal 2: The EFSF is not used anymore to (re)finance government obligations but will be used to recapitalize the European banks with equity. The amount of capital that each bank will need to raise will be determined by rigorous stress tests.
Proposal 3: The European Investment Bank issues its own bonds and uses the proceeds to finance investment and growth in the areas of the Eurozone which are most in need of capital. The role of the EIB in this respect is to balance the current account surplus of the stronger euro countries with a capital account deficit towards the less developed and less competitive euro members.
For quite long I have considered the “Modest proposal” to be the only available solution to the euro crisis. It is truly an ingenious proposal which can tackle each problem of the eurozone at once. But what I would like to do here is highlight some of its disadvantages (presented in order of least important to most important):
- It is too complicated for politicians and journalists to understand. It also makes some people feel uncomfortable with the idea of the ECB and the EIB issuing bonds, fearing that this leads eventually to debt monetization and deeper fiscal integration. Mind that this is not a weakness of the proposal itself, but a weakness of the audience it tries to reach.
- It appears to be self contradictory by calling for tackling the sovereign debt crisis and the banking crisis when the crisis is most obviously a balance of payments crisis. In my belief (and also in the belief of the authors) we do not really face a debt crisis. So why should we address the sovereign debt and the banking crises from the beginning?
- It is extremely difficult to estimate the true capital requirements of the banks. The market is so broken and prices so distorted that hardly any euro asset can be valued correctly at the moment. The results of the tests will thus be based on arbitrary shocks and wrong base valuations.
- The European banks will strongly resist any idea of forced state recapitalization; and governments will probably find it easier to pass “necessary” austerity measures than putting some bank bonuses and their own party’s funding at risk.
- It does not tackle the fundamental flaw in the euro’s original design exactly where it is. For this reason the EIB bonds will not be a fully automatic mechanism of money recycling.
- It requires the EIB to do what the Eurosystem is most clearly mandated to do, namely to maintain price stability in the eurozone.
Of course it would be almost meaningless to criticize the “Modest proposal” without putting any other option on the table. But I will. The option I will propose is extremely simple, fair and economically sensible. It is so simple that it can actually be drawn on a napkin and be described on the back of it. And if it does not solve all the problems of the eurozone, it will at least be a giant first step towards a final solution.
Before presenting it though, I will have to take you on a journey into the darkest and most dreadful corner of the Eurosystem. It is the place where the Eurosystem keeps its most hideous secrets and which even central bankers are terrified to visit. This place is called TARGET2.