Why Reinhart and Rogoff are wrong about the Eurozone’s debt structure and the costs of debt mutualisation

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.

27 thoughts on “Why Reinhart and Rogoff are wrong about the Eurozone’s debt structure and the costs of debt mutualisation

  1. How does the ECB determine how much capital (euros) to release in the Banking system? Is it like a set percentage a year? So would any interest in bond rates above the rate of capital inflow guarantee some type of default mathematically? Like if you issue a bond for a euro and then require to pay back the euro plus interest doesn’t everyone eventually run out of euros (i.e. eventually you have more bond assets than euros in the European continent? Or does the ECB give each member country a couple billion euros a year to keep away deflation & default? How can this possibly work for one country to run a surplus wouldn’t like 5 have to run a deficit?

    Am I missing something? Or did someone draw up the European union on a napkin?

  2. How does the ECB determine how much capital (euros) to release in the Banking system? Is it like a set percentage a year? So would any interest in bond rates above the rate of capital inflow guarantee some type of default mathematically? Like if you issue a bond for a euro and then require to pay back the euro plus interest doesn’t everyone eventually run out of euros (i.e. eventually you have more bond assets than euros in the European continent? Or does the ECB give each member country a couple billion euros a year to keep away deflation & default? How can this possibly work for one country to run a surplus wouldn’t like 5 have to run a deficit?

    Am I missing something? Or did someone draw up the European union on a napkin?

    • The ECB does not inject capital to the banking system.It injects bank reserves and the amount is elastically determined by demand.Money is endogenous to the system.
      What you describe ” Like if you issue a bond for a euro and then require to pay back the euro plus interest doesn’t everyone eventually run out of euros….”
      is what happens when credit expansion halts and becomes credit contraction as in the case of Greece now.

    • Thanks Crossover! So credit expansion through banking loans driving capital expansion works the same in Europe as the US (minus central taxation and spending)? And so ECB bonds are analogous to US bonds and Greek bonds to state of California or Texas bonds?

    • “Thanks Crossover! So credit expansion through banking loans driving capital expansion works the same in Europe as the US (minus central taxation and spending)?”

      More or less yes.That’s how the majority of capitalist monetary systems works.

      “And so ECB bonds are analogous to US bonds and Greek bonds to state of California or Texas bonds?”
      With some respects they are similar.In the abstence of a centralized european treasury, bonds issued by the ECB can be thought of as equivalent to those issued by the US treasury.However the US treasury does not expect (and does not need) local governments to service its debt The governments of the eurozone members are a hybrid between the federal and the local gvt in the US.They are similar to the federal government in terms of being the governments of whole countries and not states inside countries yet they don’t enjoy complete sovereignty like the Federal US Gvt. does, as if they are local state gvts.They dont issue their currency like the US govt. does so they are currency users just like the local US gvts.

      Practically the EZ countries have managed to make the worst combination possible between being a local and a federal government.

  3. If the “ECB-Mediated Debt Conversion” is such a great way to creat a free lunch, why is not everyody doing it it and we will all be millionaires?

    • You are obviously not interested in understanding its simple logic. In which case, you never will. (Since when has the utilisation of a ‘parent’s’ greater creditworthiness as a means of reducing interest payments amounted to a free lunch?)

  4. Yanis- as an untrained (but yet also untainted !) as an economist- may I pose a very simplistic / naive question. If the bonds you proopose are backed by the ECB, aren’t the various ECB nation states ultimnately backing the ECB ? so isnt this just a matter off semantics ultimately to a bond purchaser who is focusing on counterparty risk ?

    • If they are going to be secured notes and along with the super-seniority status the ECB will enjoy above all other lenders as the proposition goes, then the ECB will not suffer losses since there will be adequate collateral.Eurozone members who are not going to participate in the scheme will not have to cover any losses on behalf of the ECB..

      On the other hand since you are mentioning semantics, even if the ECB does suffer losses, does it really matter? It is the currency issuer and its balance sheet poses no constrains on its role as the monetary policy coordinator.These losses have only accounting substance as does the ECB’s capital.

  5. Dear Yanis,

    Since the better part of 6 years I am studying the economical, political and historical aspects of this so called “crisis”, I prefer the term global heist. Studying both fractions, leaving out the conspiracy bull, from the academic world, I finally came to ask a simple question: “What is the real reason for the ongoing austerity ponzi scheme propaganda?”

    Here is an answer that I consider the most plausible.

    Warning: This is a Mark Blyth lecture, hence you have to be capable of following scottish high speed accent, but it is worth every minute to concentrate!

    My favorite quote from this, as usual highly entertaining lecture, is when he asked about what happend to the biritish economy from 1850-1914 with a debt to GDP ratio of 240%:

    “They ran the whole damn world, Reinhard/Rogoff …95% MY ARSE!”

    On Mark Blyth:
    Quote:
    Mark Blyth is professor of international political economy at Brown University. He is based in the Department of Political Science, but his research begs and borrows from multiple fields. He is particularly interested in how uncertainty and randomness impact complex systems, particularly economic systems. He was a member of the Warwick Commission on International Financial Reform that made a case for macro-prudential regulation. He is the author of Great Transformations: Economic Ideas and Institutional Change in the Twentieth Century (Cambridge: Cambridge University Press 2002), and most recently, Austerity: The History of a Dangerous Idea (Oxford University Press 2013). His academic writings have appeared in such places as the American Political Science Review, the Review of International Political Economy, and the Journal of Evolutionary Economics, while his more popular writings have appeared in Foreign Affairs and Foreign Policy magazine.

    Best
    Georg

  6. On a different note, Pissarides proclaimed a couple of weeks ago that the EZ should either change *soon* or be dismantled in an orderly fashion. I did not see any reporting on what changes he proposed. Has he put any proposals forward, in particular wrt the Modest Proposal?
    Thanks.

  7. Pingback: Yanis Varoufakis: Why Reinhart and Rogoff are Wrong About the Eurozone’s Debt Structure and the Costs of Debt Mutualisation | Jo W. Weber

  8. “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.”

    A bond jointly and severally guaranteed by Germany and Holland and … is more secure than a bond guaranteed only by Germany. Therefore, shouldn’t the interest rate on debt so guaranteed by several states be lower than the lowest interest rate on the individual debt of those states?

  9. Pingback: Yanis Varoufakis: Why Reinhart and Rogoff are Wrong About the Eurozone’s Debt Structure and the Costs of Debt Mutualisation | naked capitalism

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  11. I see that you object to the reinhart-Rogoff assertion that
    “Of course, mutualization of euro country …for restructuring.”

    However, I am perplexed by the next sentence of R-R:
    “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. ”

    I really don’t see how mututalization—of any kind—implies growth reduction in core countries. Is this “obvious”? Do they imply it gives the periphery a competitive edge against core economies? Is it about investment in periphery? Or is it just B.S.?

    • It is based on their (erroneous) claim that debt mutualisation will decrease aggregate Eurozone debt at the expense of higher debt/deficit for Germany. If that were so (which it is NOT), there is an argument that Germany would have to cut down on government spending and thus restrain its economy’s growth. Of course this is all wrong, as my piece has shown.

    • I see…
      Then, to your argument that it need not be so, one could add that debt mutualization, even of the R-R kind, will anyways have a less contracting effect on core countries than the current policy, of bilateral loans which periphery countries cannot repay and will end up as big losses for core country budgets.

    • RR wrote the notorious paper which according to them demonstrated that higher debt/gdp becomes a burden on gdp growth.Not long after it went public it was completely torn down, nevertheless it explains their thesis.

  12. This is a really hopeful piece of easoning! Also, you explained it very clearly, so that I as a layperson can follow your reasoning! Thank you1
    There was just one phrase I didnt understand: “……..the almost complete lack of common debt within the Euro area…”
    Would you explain what common debt is?

    And a question : your solution sounds like a win-win-win-win solution.

    Is it possible that there are parties in whose interest it is to NOT implement this intelligent strategy you propose?

    • It is a mutually advantageous solution. So, why is it not embraced by Berlin? I have answered this question a long time ago in this post: http://yanisvaroufakis.eu/2012/05/24/fiscal-waterboarding-versus-eurobonds-misrepresenting-the-latter-to-effect-the-former/ The gist of my answer is pasted below:

      So, why do they not opt for this simple solution? For two reasons that they do not dare say out loud.

      First, 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.

      And so, Europe’s knickers remain in a knot, while the eurozone is disintegrating fast.

  13. That’s an approach to quick the can down the road, but you only diminish the cost of interest payments of part of the outstanding debt, but peripherials with a debt/gdp ratio over 100% combined with fiscal deficits and low growth in absence of inflation might increase the debt burden even more… In my opinion a reestructucturing process would be needed and be realistic about how much taxes a country can collect and the level of welfare services to be provided.

  14. 1) Interest on jointly and severally guaranteed Eurobonds would tend to the lowest, i.e. German level, not to some average. Perhaps even lower than Germany; for liquidity reasons, but also: creditor has regres not only on Germany but also on Finland, Holland, etc. So Eurobond is a creditworthier option than Germany alone.

    2) Wouldn’t granting super-seniority status to ECB bonds weaken the creditworthiness of regular govt. debt (current or to be issued). And may as such, since for the problematich countries the share of non-MCD is still large, perhaps increase the average interest for weaker countries…

    By the way I quoted from an article of yours excellent piece on “The most stupefying defence of austerity is…”.

  15. 1) Interest on jointly and severally guaranteed Eurobonds would tend to the lowest, i.e. German level, not to some average. Perhaps even lower than Germany; for liquidity reasons, but also: creditor has regres not only on Germany but also on Finland, Holland, etc. So Eurobond is a creditworthier option than Germany alone.

    2) Wouldn’t granting super-seniority status to ECB bonds weaken the creditworthiness of regular govt. debt (current or to be issued). And may as such, since for the problematich countries the share of non-MCD is still large, perhaps increase the average interest for weaker countries…

    By the way I quoted from an article of yours excellent piece on “The most stupefying defence of austerity is…”.

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