Yanis Varoufakis: Why Reinhart and Rogoff are Wrong About the Eurozone’s Debt Structure and the Costs of Debt Mutualisation

Yves here. I don’t know whether to be relieved or annoyed to see Carmen Reinhart and Ken Rogoff retreat from their pro-austerity stance and endorse debt restructuring, since their prior view (that budget-cutting was necessary and productive) served to justify considerable and unnecessary pain being inflicted on periphery Eurozone countries to preserve the illusion of health of French and German banks.

But as Yanis Varoufakis points out, although Reinhart and Rogoff are retreating from much of their erroneous thinking, they haven’t renounced all of it.

By Yanis Varoufakis, a professor of economics at the University of Athens. Cross posted from his blog

Carmen Reinhart and Kenneth Rogoff recently published a notable IMF working paper (13/266) entitled ‘Financial and Sovereign Debt Crises: Some lessons learned and those forgotten’ (December 2013). Their overarching claim is that the advanced economies are wrong to pretend that the present levels of debt can be sustained by means of fiscal austerity and without debt restructuring, sustained inflation or a combination of the two. This is a sensible argument, well grounded on empirical and historical evidence, that governments would be wise to internalise. 

However, while the general thrust of the Reinhart and Rogoff paper is indeed reasonable and in principle useful, their discussion of Eurozone debt crisis is founded on a factual error that, since 2010, has been underpinning erroneous policy responses to the Euro Crisis.

Here is the contentious paragraph: “…the size of the problem suggests that restructurings will be needed, particularly, for example, in the periphery of Europe, far beyond anything discussed in public to this point. Of course, mutualization of euro country debt effectively uses northern country taxpayer resources to bail out the periphery and reduces the need for restructuring. But the size of the overall problem is such that mutualization could potentially result in continuing slow growth or even recession in the core countries, magnifying their own already challenging sustainability problems for debt and old-age benefit programs.” [p.10, emphasis added]

In the above paragraph, Reinhart and Rogoff are, in effect, restating the Merkel rationale for rejecting Eurobonds. When they speak of debt mutualisation, they take it for granted (mistakenly) that debt mutualisation can and must only come in the form of jointly and severally guaranteed Eurobonds; that is, bonds issued with the backing of all the Eurozone member-states jointly. Under such a scheme, Germany and… Greece, Holland and Portugal, Austria and Spain, etc., will be backing some form of common debt (or bond). Naturally, the interest rate that this common debt will incur will be some weighted average of the interest rates of the member-states’ government bonds. In short, Germany will be paying more to back this common bond than it now pays for its bunds, and Greece will be paying less than it would have had it been issuing its own bonds. In this sense, Reinhart, Rogoff and Merkel are correct: Germany, and the rest of the surplus Eurozone nations, will be subsidising the deficit member-states (in contravention of the Lisbon Treaty and Germany’s constitutional court strictures). Moreover, it is quite likely that, under such a scheme, not only will the joint interest rate prove too high for countries like Germany but, to boot, it may well turn out to be insufficiently low for countries like Greece!

Nevertheless, it is a serious mistake to identify debt mutualisation with jointly and severally guaranteed Eurobonds. For there is another mechanism by which to mutualise debt and substantially reduce the Periphery’s aggregate debt without incurring any costs upon countries like Germany. [t is the mechanism that we have included as Policy 2 (ECB-Mediated Debt Conversion) in our Modest Proposal for Resolving the Euro Crisis; and which can be shown to reduce the debt crisis’ burden not only on the Eurozone’s peripheral countries but also on Germany.

Key to this alternative, mutually beneficial, debt mutualisation scheme is that no government backs the new, common (or Union) bonds. Instead, part of the public debt of each Eurozone member-state (the part that it was allowed to have according to the original Maastricht Treaty – let’s call it ‘Maastricht Compliant Debt’ or MDC) is mutualised through the issue of bonds by the European Central Bank itself (ECB). Here is how this ECB-mediated debt conversion works:

The ECB announces forthwith that it will be undertaking a Debt Conversion Program for any member-state that wishes to participate: The ECB will service (as opposed to purchase) a portion of every maturing government bond corresponding to the percentage of the member-state’s public debt that is allowed by the Maastricht Treaty. To fund these partial redemptions on behalf of some member-state, the ECB will issue bonds in its own name, guaranteed solely by the ECB but repaid, in full, by the member-state. Upon the issue of ECB bonds, the ECB will simultaneously open a debit account per participating member-state into which the latter is legally bound to make deposits to cover the ECB-bonds’ coupons and principal. These debts of member-states to the ECB shall enjoy super-seniority status and be insured by the European Stability Mechanism against the risk of a hard default. This Debt Conversion Program, which involves no debt monetisation by the ECB, and no guarantees of part of the Periphery’s debt by Germany, will instantly engender large interest rate reductions for fiscally-stricken states without any concomitant rise in the long term interest rates that Germany pays (since Germany is not guaranteeing the Program). [For more details, see Policy 2 of the Modest Proposal here.]

Epilogue

Reinhart and Rogoff make a good point regarding the advanced economies’ current state of denial: Fiscal consolidation cannot address the debt crisis that has befallen them and debt restructuring will, eventually, prove unavoidable. However, when it comes to the special case that is the Eurozone, the almost complete lack of common debt within the Euro Area makes it possible to reduce the total amount of debt through a clever form of mutualisation that does not involve redistributing debt from the deficit to the surplus nations. Assuming that debt mutualisation can only come in the form of jointly and severally guaranteed Eurobonds is both incorrect and an impediment to the development of sensible public finance policies in Europe.