Modigliani-Miller and Yanis’ response No. 2

Yanis answers once more, directly to the first part of my response, before I had the chance to write my second part. He suggests that we should clearly mark our responses as this discussion is likely to continue – which I look forward to! So this post is KE3 in response to YV2.

I understand that Yanis does not want his Modest Proposal (MP) to be taken apart; he rightly says that it is a combined effort, where each part reinforces the other. However, he goes a little too far in my view and makes assumptions about how the combined beneficial effect of the MP will look like that somewhat mutes a necessary discussion about each bit separately.

I agree with Yanis that the unusually low interest rates of Germany are in part a sign of panic and disruption rather than a sign of German fiscal brilliance. And likewise for Spain or Italy, with opposite sign. But apart from that, a very famous theorem, Modigliani-Miller, tells us that the structure of how a company finances itself – under lots of idealizing conditions – is irrelevant for how much it is worth. For the MP and other suggestions of how to structure European sovereign debt, this means that when the “blue” part of the debt has higher seniority and thus, lower rates, the yields on the “red” debt will be so high that the interest rate cost will be the same in total. In theory, that is, without panic or disintegration or mutualization of debt.

Yanis knows all this, of course. And given the current situation, I expect (as he does) that the MP will lower the total interest rate costs of, say, Italian debt, so Modigliani-Miller doesn’t apply. However, will it be enough to bring the marginal rates on “red” debt to a sufficiently low level? As Yanis writes, correctly in my view, market discipline will be strengthened: the rates on “red” debt will probably go up, beyond the yields that Italy and Spain are paying now, not to mention Greece. After all, in a country like Italy with >100% of GDP in debt, the upper half (the “red” debt) would have to bear all the risk. Even in benign economic circumstances, this would lead to very high yields in my view.

Then what? If you put a lot of faith in the MP, you will argue that it doesn’t matter much as the MP will make “the crisis go away”. Unfortunately, this also ends the debate. So let us for the sake of argument put less faith in the full MP, for instance because wage and price differentials across Europe will not go away easily, leaving countries like Greece and Portugal in recession for a long time. Or because property busts like the ones in Spain and Ireland are hard to handle even outside of a currency union. As marginal yields set the incentive for how much to borrow, the pressure by markets will be very high. Will this lead countries to enact the exact austerity policies that are part of the problem right now? Fiscal waterboarding by markets, so to speak? I consider that quite likely. These countries may need a grace period, and how should we implement it?

This brings me to another misunderstanding about the MP: how is the transition period supposed to look like? Will each bond holder get two new bonds: one which is backed by the ECB, the other by the national government? Or will countries, as I assumed, just replace bonds that run out with ECB bonds? The latter will run into legal problems, as new debt will be senior to existing bonds which, as far as I know, would be a default event on existing bonds that often have a pari passu clause. On the other hand, it would give countries a grace period in which they don’t have to turn to the market, which could be helpful in current circumstances. It would be great if Yanis could clear that up.

No diamonds without pressure? Yanis’ response, Part 1

What is the right amount of pressure? Pressure gauge by wwarby

Yanis Varoufakis, whom I recommended to you in my last post, has written an extensive reply, for which I would like to thank him. I also think that such a debate is the best way to counteract the unfortunate mutual disdain that seems to be growing between Greece and Germany. I don’t ask for much (…!?), my dear readers, but I do ask you to read his response in full. My response will be split into several posts, there is simply too much to discuss. I will start with market pressure on the periphery.

Before I start, let me add two apologies. I did not represent his Modest Proposal entirely correctly because that would have taken more space than I thought was necessary for the key issues. But it turns out: I was wrong. Second, if Yanis and other readers felt that I was accusing him of a blame game, something I despise myself, my apologies. I’ll explain what I meant in a soon-to-follow post.

Regarding market pressure, Yanis writes:

Mrs Merkel told us only the other day that her objection to eurobonds is that they will reduce interest rates; something she said is counterproductive because it takes countries like Italy and Spain off the hook. … [Kantoos] may agree with Mrs Merkel (that high interest rates must be maintained as an incentive) – but this only means that [Kantoos] agrees with the first reason I gave as to why Germany is resisting proposals such as ours [The Modest Proposal, K.].

However, with Yanis’ Modest Proposal, interest rates on the non-ECB-backed bonds will go up, and in part considerably so. What is more, he writes that this is a good thing:

Since we divide each member-state’s debt between Maastricht-compliant and the rest, and suggest that the ECB manages the former but not the latter, it would be rather helpful if a ‘healthy’ interest rate spread emerges between the two classes of debt making sure that, while the Maastricht-compliant debt of fiscally-stricken member-states is cheap to refinance, there is a market determined premium to pay for excessive public debt.

So Yanis agrees with Merkel?! After all, it is the margin that counts for incentives, not the average interest rate paid on debt. So what’s going on here?

Yanis would probably argue that the transition period of the Modest Proposal, during which countries can get up to 60% of GDP at the ECB at low rates, will take countries off the market for the next couple of years, and reduce pressure. This is where Yanis disagrees with Merkel and the German position. Then again, he also seems to argue that a proper market signal is probably a healthy corrective in general, as reforms and spending cuts are hard, painful and politically difficult – which is the basis for the German position. His view is not entirely clear, in my view.

My point was that too high market pressure, that forces countries into massive austerity and political turmoil, is destructive and not in Germany’s interest, for the reasons described by Yanis in his response:

From experience, I can tell you dear reader that the severity of the cutbacks in Greece have reduced our society’s capacity to reform. … [R]eform requires investment. Any CEO will tell you that to improve management structures one needs to invest in them. Greece, Italy, Spain et al are so busy cutting that no investment goes into genuine reforms. … [T]he cruelty of the austerity packages (that is evident for all who have eyes to see, and want to use them) destroys the common will to effect reforms.

In my view, and here I disagreed with Yanis, more (!) pressure is not Merkel’s aim either. Yanis wrote in his original post somewhat ambiguously (emphasis mine):

Mrs Merkel feels that fiscal waterboarding is what the Periphery needs more of these days.

Anyway. The more important question is whether giving countries a grace period might lead to too little pressure?

On the one hand, the economic situation is horrific in Greece or Spain as it is. I think one could make a valid argument that additional pressure through the market is not necessary in order for these countries to reform (which is much more important than short-term budget cuts). What is more, the outstanding debt under the Modest Proposal, that will still be traded on the market, will give countries at least an indication of what they will face when they have to turn to the market again. But is it credible that these countries have to return to the market? Can the eurozone afford this, if yields are still 8% or more? Will therefore the medium-term fiscal incentive be enough?

On the other hand, and this is something I would like to hear Yanis’ views on, a dismal economic situation alone may not lead to the most needed reforms. The powerful groups in society may still get what they want, at the expense of the overall economy and society. It is, after all, not a coincidence that Greece is in the current economic mess, is it? A grace period is fine, but conditionality, by the IMF for instance, may still be helpful to focus reforms on the right areas, and to prevent that policy makers back down when bureaucrats, banks, protected professions, public sector employees or the rich resist reforms. As far as I know, the IMF has learned a lot from past failures. It did a good job in countries like Iceland according to those involved and was not the one in the troika that focussed on austerity. The EU/ECB plus European politics is clearly not the right institution that should impose conditionality, however.

Yanis’ position is very similar to that of the German government: market incentives are helpful. Yanis acutally wants to strengthen them with his Modest Proposal (on the margin where it matters). Whether an unconditional grace period is appropriate at the moment is an open question, in my view. For the sake of the countries themselves, it might be good to engage the IMF that forces the elites to take on the most needed reforms.

Yanis Varoufakis on “fiscal water-boarding” and ECB bonds

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”.

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