Monday, August 22, 2011

Why Eurobonds are Essential and Fiscal Union a Folly

Why Eurobonds are Essential and Fiscal Union a Folly*

(Or how to escape the equally untenable positions of German economists
Thomas Straubhaar and Otmar Issing)

Yanis Varoufakis
of Yanis

August 17th, 2011

The context: In the middle of a mighty bushfire the fire brigade just held a summit between its chief fire fighters (Mrs Merkel and Mr Sarkozy) to discuss the importance of biodiversity, leaving the flames to destroy the forest. Italy and Spain are collapsing. The EFSF, the only institution that was set up to deal with the fall of member-states, is both too feeble and too toxic, while the ECB is, knowingly, fighting a losing battle in the secondary bond markets. Eurobonds are the only short term brake that may slow down, indeed reverse, these developments. And yet Mrs Merkel and Mr Sarkozy were the only Europeans yesterday that did not discuss… eurobonds. Elsewhere, even in Germany, eurobonds are appearing as a fait accomplis. The trouble is, they are erroneously identified with fiscal union.

The argument here: Eurobonds are the only impediment to the euro’s unravelling. But a transfer or a fiscal union (that most Germans fear) is neither necessary nor desirable. The way forward must involve eurobonds issued and guaranteed exclusively by the ECB - as proposed by the Modest Proposal.

In my previous post, commenting on George Soros’ three point plan for addressing the euro crisis, I argued against jointly guaranteed eurobonds in exchange for centralised fiscal limits and a loss of national authority. Why? Because such a solution is practically infeasible, financially suboptimal, economically recessionary and politically undemocratic.

The gist of the problem can be gleaned through two articles written by two German economists that adopt diametrically opposed positions on eurobonds et al. One is Thomas Straubhaar (Professor of Economics at the University of Hamburg), the other Otmar Issing, one of the euro’s architects.

Professor Thomas Straubhaar’s Six Point Plan

In an article recently published by Der Spiegel Professor Straubhaar embraced the idea of a fully fledged fiscal/transfer union ”…in which all members are jointly liable for each other’s obligations”. In addition to these commonly guaranteed eurobonds, he advocated that the EFSF be given an unbounded funding limit to deal with member-state insolvencies. In exchange, member-states should forfeit national autonomy in relation to fiscal policy and in inverse proportion to their usage of the common funds raised via the touted common eurobond.

In greater detail, Professor’s Straubhaar’s six points can be summarised thus:

The German and French leadership pledge their preparedness to use all the means at their disposal to prevent fellow euro-zone countries from going broke - something similar to their commitment that all bank deposits would be safe after the Crash of 2008
The European Financial Stability Facility (EFSF), should be expanded without limits. Loans at cheap interest rates and with long maturities will be offered to any euro-zone country that needs it in exchange of the loss of sovereignty of fiscal policy.
The European Central Bank (ECB) to cease and desist from bond purchases. “Bringing debt under control is a matter of financial policy. It’s a problem that states should solve - and not the central bank.”
Institute a fiscal or transfer union in which all members are jointly liable for each other’s obligations.
The ECB and other EU bodies should not utilise the ratings of the ratings agencies
Eurozone countries should orchestrate a shift in power from markets to the Union (e.g. ban short-selling permanently and “keep public budgets in order over the long term”
Otmar Issing’s objections

In sharp contrast, Otmar Issing, in an article in the Financial Times, presented the reasons why jointly guaranteed eurobonds ought to be shunned. He writes:

“The idea of issuing bonds which all member states of the eurozone guarantee insofar seems sensible, as it would immediately lower interest rates for the highly indebted countries. However, there is a problem too, given it would also lead to higher interest rates for those countries that enjoyed credibility with financial markets in the past. Those who claim that this effect would be small succumb either to an illusion or deliberately underestimate this risk.”

Issing’s point is that joint guarantees mean debt pooled across the different eurozone members, which will necessary translate into an averaging out of interest rates. Therefore, the benefits to the deficit nations will be bought at the expense of higher interest rates paid by the surplus member-states.

While it is impossible to know how the markets will price such jointly guaranteed eurobonds, Herr Issing’s argument is not to be dismissed lightly. Even if he is wrong (as the Modest Proposal‘s co-author, Stuart Holland, wrote in his recent letter to the Financial Times), his argument will prove exceptionally powerful within the German polity and electorate, effectively operating as an impediment to German acquiescence to the fiscal union proposed by Professor Straubhaar and others.

But there is a second argument in Otmar Issing’s piece which should not be taken lightly: Alluding to both Soros’ and Straubhaar’s suggestion that member-states in need of financing from eurobond-sourced funding fiscal autonomy must first forfeit their autonomy, Issing mentions, quite rightly, that this constitutes a violation of the time-honoured Bostonian principle (No Taxation Without Representation). His words were: “This type of political union would not survive. Its collapse would be brought by resistance from the people. In the past cries of “no taxation without representation” have brought war. This time the consequence would be to threaten the collapse of the most successful project of economic integration in the history of mankind.” I very much fear he is right.

Straubhaar and Issing are both wrong: Fiscal union, loss of national autonomy and eurobonds do not have to go together

Otmar Issing is right: Commonly guaranteed eurobonds may turn out to be financially of much less value than currently imagined and, more importantly, they will prove extremely unpopular both by the electorates of the surplus countries (who fear higher interest rates) and of the deficit countries (for whom the euro’s preservation is not worth more than the preservation of their hard-earned democratic representation rights). Moreover, even if we were all agreed on effecting the fiscal union advocated by Professor Straubhaar, George Soros and others, the political process of changing the Lisbon Treaty will not even have progressed before the euro has collapsed.

Having paid him his dues, Herr Issing’s negative assessment of the fiscal union solution, part of which are the jointly guaranteed eurobonds, does precisely nothing to suggest a way out of this Crisis. Herr Issing may have good reasons to distrust the EFSF, excellent arguments against turning the ECB into a bad bank, and a decent case against fiscal union. What he lacks is a policy recommendation for stopping the euro’s unfolding. Repeating ad nauseum the importance of fiscal discipline, in the midst of an almighty deleveraging debt-recessionary crisis, is to demonstrate a unique capacity to misread our collective predicament.

Eurobonds and a continental consolidation without a fiscal union: The Modest Proposal‘s gist

At the very least, it is good news that this debate is being held, even belatedly. The change of heart in Germany, which led opinion makers there even to contemplate fiscal union, reveals the extent to which this Crisis has propelled the public debate in the surplus countries. From staunch denial we have now shifted to a reasoned assessment of our collective options. Clearly, the Crisis has put paid to unsustainable faith in the eurozone’s main policy (of expensive loans by the surplus to the deficit member states in exchange for stringent austerity measures).

This is the good news. The bad news is that the debate seems to have swung to the opposite side of a sterile debate on whether the eurozone should or should not embrace a fiscal (or transfer) union. This abrupt shift of the pendulum can be as problematic as its initial reluctance to move an inch. Indeed, I very much fear that the pendulum’s recent swing, e.g. Professor Straubhaar’s article, does not augur well for the eurozone. The problem is that the Gestalt Shift we Europeans need is not one that takes us from exorcising a fiscal union to embracing it but, rather, one that allows us to see that a fiscal union is neither necessary nor sufficient for arresting the Crisis and rationally recalibrating the eurozone.

Otmar Issing’s article contains all the elements that ought to convince us the a fiscal union will not happen before the euro is history. Which means that the change of heart represented by Professor Straubhaar’s article will come to naught. Yet this does not spell the end of either homogenous eurobonds (as opposed to the EFSF’s heterogenous ones) or of the idea of some consolidation of the European continent (starting with a redesign of the eurozone’s architecture) that is both feasible and sensible. Indeed, the very purpose of our Modest Proposal was to point the way to a politically neutral, yet highly rational, debt management scheme that is consistent with a growth strategy and, importantly, a cleansing of our banking sector. No fiscal union, no loss of national sovereignty; just a rational plan according to which the ECB can act as a go between global capital and the eurozone’s private and public sectors. In short,

Policy 1 of the Modest Proposal recommends that the ECB issues its own bonds in order to finance the servicing of only the Maastricht-compliant debt. Thus, this new bond will not have any effect on German interest rates since (a) Germany will not be guaranteeing these eurobonds, and (b) the ECB’s issue will be revenue-neutral (in the sense that the ECB only services the Maastricht-compliant debt but debits its costs of the member-states, albeit at the lower eurobond interest rate). Moreover, the fact that only the Maastricht-compliant debt is transferred to the ECB (courtesy of the debit accounts that the ECB will open for each member-state, and into which the latter will be making their payments in the long term, so as to shoulder the burden of the ECB’s eurobonds)
Policy 2 of the Modest Proposal finds a non-degenerative role for the currently toxic EFSF: It turns it into a much needed banking sector re-capitaliser and pan-European banking supervisory authority
Policy 3 of the Modest Proposal maps out a pan-European investment policy which, based on the existing capacity of the European Investment Bank to mobilise international capital for investment purposes in both the private and the public sectors, boosts it substantially by pairing it to the ECB’s new (see Policy 1) powers to issue eurobonds - effectively extending the usage of these ECB-bonds from the realm of managing the Maastricht-compliant debt to that of funding an investment-led recovery (along the principles of Roosevelt’s New Deal).
The main point to note here is that the three policies that make up the Modest Proposal address the concerns of both polarised camps: the one represented here by Herr Issing and the other expressed through Professor Straubhaar’s article. The former can rest assured that, when the ECB starts issuing its own bonds, the surplus countries’ interest rates will not be affected in the slightest (just like they were not when the European Investment Bank started issuing its own bonds); there will be no moral hazard problem necessitating the institutionalised loss of national autonomy (since the ECB-eurobonds will not finance debts over and above the Maastricht limit); and, lastly, the EFSF will not drag them down (the way it is currently doing). As for the other, pro-fiscal union, camp, the Modest Proposal gives them all they need while liberating them from the disadvantages of a fiscal union: A homogenisation of the Maastricht-compliant debt, the end of the euro’s unravelling, a pan-European New Deal-like investment-led Recovery Program and a future for the ideal of a United Europe.

Summing up

The debate in Germany, and of course elsewhere, has left Europe’s leadership behind. However, the polarisation between advocates and opponents of fiscal union is unhelpful. Eurozone consolidation, debt homogenisation, an end of the banking crisis and a pan-European New Deal can all be effected without loss of national autonomy, without forfeiting the truly precious Bostonian Principle (of No Taxation without Representation) and without having the surplus countries guarantee the debt of the deficit nations. The key to achieving this golden rule are ECB-issued eurobonds guaranteed by no one else than the ECB itself.

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