Reply No. 2 (YV2) to Kantoos Economics on the merits of the Modest Proposal

Kantoos Economics (KE) just posted the first installment of a reply to my long rejoinder to his original comment on our Modest Proposal.[1] Two are the main point raised by KE, and to which I respond below: One concerns the tradeoff between (a) maintaining market pressure on member-states to keep their public debt under wraps while (b) alleviating the crushing effect of unsustainable interest rates on their public finances (see Spain, for instance). The second point addresses the question of what to do with member-states for which the Modest Proposal’s Policy 2 (ECB-mediated debt conversion of their Maastricht-compliant debt) will simply not be enough. Should there be some grace period? Should the IMF be engaged? Both are excellent points, to which I shall now turn.

Point 1: Interest rate signals versus fiscal waterboarding

KE rightly interprets the Modest Proposal’s key aim vis-à-vis interest rates: On the one hand to reduce massively the average interest rates that the Eurozone as a whole pays to borrow in the money markets (as a currency block, that is) while, on the other hand, creating a new type of interest spread that is the best ally of the Maastricht criteria: a spread between the interest rate a member-state must pay to service its ‘good’ (Maastricht-compliant) debt and interest rate it must pay on the remaining ‘bad’ debt.

Presently, the Eurozone is typified by one type of interest rate spread only: that between the few surplus countries, like Germany, and the rest. Having Spain pay 6.5% on all its debt (‘good’ and ‘bad’ alike) while Germany pays net to nothing to borrow again on all its debt (‘good’ and ‘bad’ alike) is highly distortionary. It really reflects a macroeconomy, sporting a common currency, that has got all its signals confused. Our ECB-mediated Maastricht-compliant debt conversion scheme will accomplish two things:

First, it will push down to less than 2% the cost of servicing the Maastricht-compliant debt of every member-state within the Eurozone. Thus average interest rates in the Eurozone will fall very, very significantly and, as a result, all interest rates (including those Spain and Ireland, to mention two, are paying for their ‘bad’ debt) will fall, reducing the mountain of interest that needs to be paid by the Eurozone in aggregate over the next, say, twenty years. This will bring excellent effects on market sentiment towards the prospects of the Eurozone as a whole.

Secondly, interest rate spreads between Germany and the rest will diminish (let’s call this ‘across-country spread’, or ACS) with their ‘place’ being taken by the interest rate spread that each member-state will be facing between its ‘good’ and its ‘bad’ debt (and call this Intra-country spread, of ICS). ICS will, of course, depend entirely on market sentiment regarding the extent to which the member-state has kept its debt on a leash. But, unlike the burgeoning ACS today, it will no longer burgeon as a result of the capital flight from countries like Spain to Germany. Put differently, today, the bloated ACS reflects more the state of the Eurozone’s disintegration than emitting any useful signal about Germany’s and Spain’s relative efforts in reining in their debt.

In summary, we commend Policy 2 of the Modest Proposal as a means of steering a clever course between the competing demands of (A) not just maintaining market discipline for member states, but in fact reinforcing it; and of (B) eliminating interest rate spreads that make life within the Eurozone simply impossible for the majority of member-states.

Point 2: And what if this ECB-mediated conversion of Maastricht-compliant debt is not enough to get countries like Spain (and of course Greece) out of the woods? What do we do? Bring in IMF-like programs and conditionalities?

KE and I agree that, even if our policy regarding debt (as discussed above) is adopted, there will be a lot of mopping up to do afterwards. That, while the Crisis will become far less acute, it will not go away. However, this is precisely why the Modest Proposal has three pillars; why it is founded on three policies. Policy 1, let me remind the reader, concerns the complete and immediate unification of the banking system. Suppose, for a moment, that it were implemented tomorrow. Suddenly, neither Madrid nor Dublin would have to labour under impossible burden of re-capitalising their insolvent banks. Remember: the money for these recapitalisations come from the centre of the Eurozone anyway; from the EFSF (or will do so in the case of Spain, once Rajoy’s idiotic resistance to the inevitable ends). What we are suggesting is that this capital infusion bypasses the state governments altogether. The benefits from this are enormous. First, it means that Americans, the Chinese, the Japanese will no longer have to fear that to transact with a Spanish firm may mean that the Spanish cheque they will receive may bounce as a result of Madrid’s fiscal implosion. The benefits to European trade from this will be enormous. Secondly, by taking the bank recapitalisation away from the national governments (and shifting it to the centre of Europe; to the ESM-EBA-ECB nexus) we sever once and for all the cosy, hopelessly corrupt, unedifying relationship between local bankers and local (or national) policitians. Thirdly, national budgets get a chance to breathe and national governments (especially the Dublin one) an opportunity to balance its books without the nightmare of discovering around the corner some new black hole in one of the nation’s idiotic banks.

Then there is Policy 3, which effectively calls for the Europeanisation (via the EIB-EIF) of investment. This is a central plank of the Modest Proposal. Taken together with Policies 1 and 2 (i.e. the debt conversion operation, to which we dedicated most of our discussion, and the unification of the banking systems), the Modest Proposal effectively suggests the Europeanisation (without Federation, which is neither necessary nor desirable – at least for now) of banking, public debt (the Maastricht-compliant part of it) and investment. This three-pronged Decentralised Europeanisation project (as I like to call it) will not only make the Crisis go away but also allow us to impose a simple conditionality on member-states: a balanced budget provision, just like the one that applies in the United States. No need for grace periods, for IMF-like programs, for economic czars etc. In this manner, the peoples of Europe will recover their sovereignty over things that matter to them (e.g. health, education, culture, internal solidarity), they will have an opportunity to elect governments that balance the nation’s books and, of course, will be living in the shared prosperity of a Eurozone that, centrally, and rationally, manages banks, a ‘legal’ common debt and investment flows.