Yanis Varoufakis at the INET conference in Berlin

Yanis Varoufakis has been covering the Euro Crisis for quite some time and wrote a “Modest Proposal” to solve the crisis early on,  that he updates regularly. I have been following his writings and also recommended him in my recommended economics blogs list (in German). I fully agree with Yanis, and have written it over and over, that a ruthless recapitalization of European banks is one important part of a solution to this crisis. His other proposals I find less convincing.

Let’s have a look at his recent post “Fiscal Waterboarding versus Eurobonds: Misrepresenting the latter to effect the former”. In essence, Yanis says that jointly and severally guaranteed Eurobonds are not the answer because they involve transfers from core to periphery taxpayers. He claims that he has found a way around this, by having the ECB issue bonds on the member states’ behalf, have the states pay off their debt at the ECB, and have the EFSF/ESM guarantee the losses of the ECB “in the remote case that some members do not redeem its bonds in the distant future”.

How is this different from a jointly and severally guaranteed Eurobond? Let’s leave out the political mess and just focus on the economics. The ECB’s role ensures that interest rates on the these bonds are very low. This lowers the debt burden of, say, Italy. However, there is no guarantee that Italy will be able to service its debt in the future. Who is standing behind these ECB bonds? Either the ECB itself, which means that it needs to be recapitalized (= will transfer lower profits to the governments). Or the insurance by the EFSF/ESM will cover losses. Either way, the other European governments pay. So there is not a big difference here: ECB bonds transfer risks.

Where I can see a difference is in interest rates: Eurobonds will have yields above German rates (some weighted average of all Eurozone yields), whereas ECB bonds will probably have German rates, so Germany won’t pay more than before. Fair enough. But the problem here is that ECB bonds might increase the yield on other bonds. Sounds silly? It is not.

If the states have to recapitalize or insure the ECB, these countries’ risks increase. The ECB bond is just a Eurobond with a higher seniority, if you want: the loss-absorbing capacity of the ECB is around 2,000 – 3,000 billion euros, but this capacity is directly related to government revenues. ECB bonds will therefore be repaid first, at the expense of the government revenues that are available for other bonds. This leads de facto to a lower seniority of the normal bonds, which as we all know leads to a higher yield on these junior bonds. So by giving out ECB bonds, the yields on other bonds are likely to increase.

Yanis would have to make a more convincing case that by having the ECB issue bonds, some risk is taken out of the market, and are not just redistributed like in the case of Eurobonds. But where? There might be a safety and liquidity premium for ECB bonds that lowers yields overall, which the Eurobonds do not have to the same extent (as they are by no means perfectly safe). There might be other reasons, but in my view ECB bonds are not a silver bullet, and very close to the commonly proposed Eurobonds.

His conclusion is that Germany refuses his proposal…

… [f]irst, because Germany does not really want interest rate relief for the struggling Periphery. For some reason, which I shall not elaborate on here, Mrs Merkel feels that fiscal waterboarding is what the Periphery needs more of these days.

Secondly, because such a scheme would mean that Germany would lose its capacity to leave the eurozone as a common debt external to the European System of Central Banks will be born by the ECB, thus making it impossible for any member-state to up stumps and leave the euro. Such a loss of its ‘exit card’ (that only Germany truly owns) will reduce the German chancellor’s bargaining power, within the eurozone, inordinately.

I think both is incorrect. The pressure on the countries in the periphery has certainly helped to change their domestic policies, and I am sure Yanis agrees. More pressure is surely not in Germany’s interest, as it threatens to break up the Eurozone, which would be very costly by almost any calculation I have seen.

The second aspect sounds very weird to me: a German exit is surely not the main reason why Germany has bargaining power. A German exit would be extremely complex, legally nigh impossible, and threatening Germany’s industry that just recovered from several negative shocks (reunification, globalization, EU enlargement, higher financing costs).

Yanis writings on the Euro Crisis are important for me because they challenge my thinking, and I like that. But except for the banking aspect, I am having trouble with some of his views. Besides the above on ECB bonds, I diagree with…

• … his tendency to blame Germany for economically exploiting Europe. That is a very one-sided view of what Germany’s economic development is about, and why it developed the way it did. So far, Germany has not gained from being in the euro (contrary to what is written again and again), and it is likely to foot a massive bill when this whole mess is over (partly self-inflicted, I know, but almost surely not the major part of it).

• … his tendency to make this Euro Crisis look like an easy-to-solve problem which is not backed-up by any theory or evidence from the past, as far as I know. It is a full-blown mess (on a continent with legally mandated free capital movement) that is and always was very difficult to solve – including the question what a “fair” distribution of the burden looks like, irrespective of the usual moralizations.

• …  his diagnosis that Europe suffers from an under-investment crisis. That is a strange view given that Greece, Ireland and Spain received massive EU and capital market help to over-invest in infrastructure and real estate in the past. Europe suffers from a lack of smart investment and even more importantly, from a lack of efficient, growth-promoting institutions. If he meant to say that the periphery (and the Eurozone as a whole) suffers from a lack of aggregate demand (AD), I fully agree with him. But again, there are problems with dividing up AD in the Eurozone, and above all, a problem with getting the ECB to stabilize aggregate demand, and not headline inflation.

PS: I do recommend you have a look at his blog, though, and read his views for yourself. Also, check out his Modest Proposal. You might also be interested to buy one of his books, for instance his recent “The Global Minotaur”.