Varoufakis’s Ill-Advised Visions

Yanis Varoufakis, the Greek finance minister, studied mathematics and economics. Theoretically at least, he should therefore be in a much better position than his colleagues from other Eurozone countries to come up with a proposal on how to fix the Eurozone.

And he has indeed given it a try. Together with Stuart Holland and James K. Galbraith, he wrote a book titled “A Modest Proposal for Resolving the Eurozone Crisis.”

In the book, he promises a pain-free solution to the Eurozone crisis, one that supposedly does not put any additional burdens on the creditor countries like Germany, while it offers significant improvements of the economic situation in Europe’s South.

Even better, Varoufakis’s proposal supposedly does not require changes in EU treaties and institutions. If this were true, Varoufakis and his colleagues would not only qualify for the Nobel Prize in economics, but the one for peace as well!

Unfortunately, it is not just that easy — as a deeper look at the four solution proposals identified by Varoufakis shows:

1. The banking crisis

Diagnosis by Varoufakis: “There is a common global banking crisis, which was sparked off mainly by the catastrophe in American finance. But the Eurozone has proved uniquely unable to cope with the disaster, and this is a problem of structure and governance.”

To resolve the banking crisis, Varoufakis proposes to restructure insolvent banks on the European level using the European Stability Mechanism (ESM).

This is in line with the proposal of other experts who want to overcome the vicious linkage between governments and banks where overindebted governments have to stabilize overleveraged banking systems. Today, any banking crisis has the potential to become a crisis of the state as well.

What Varoufakis and his colleagues do not mention, though, are the costs involved. The European banking crisis is in reality a debt crisis of the European private sector.

The low interest rates following the introduction of the Euro led to a credit boom in today’s crisis countries. As a result, the debt level between 2000 and 2008 rose by 221% in Ireland, 149% in Greece, 146% in Spain and 89% in Portugal.

At the same time, the banking sector has worked with ever more leverage, i.e., lower equity ratios. Each banking crisis is therefore homemade.

According to my estimate, a minimum of three trillion Euros of debt cannot be paid back in the Eurozone. Even conservative estimates put the prospective losses of banks in the range of one trillion euros.

A restructuring by the ESM would imply that the costs are born by all Eurozone countries according to their share in the ESM. Germany would have to cover 27% of the costs – independent of where the banking crisis originated.

Bottom line: This proposal represents nothing less than a mutualization of significant amounts of bad private debt on a European scale. Without any doubt, Europe needs a restructuring of bad debt in an organized way, including some mutualization.

But it would be better to agree on such a restructuring using a Eurozone redemption fund and agree on the amounts upfront. That way, the creditors would contribute to the solution, but could insist on specific reforms in the debtor countries in return.

Varoufakis’s proposal on the other hand equals a blank check with a major transfer of wealth between Eurozone members.

2. The crisis of government debt

Diagnosis by Varoufakis: “The credit crunch of 2008 revealed the Eurozone’s principle of perfectly separable public debts to be unworkable.”

Varoufakis and his colleagues propose to pool the debt of Eurozone governments up to a level of 60%. To achieve this, the ECB should buy up government bonds and finance these purchases by issuing bonds itself. The assumption is that this would lead to lower interest rates. Basically, it would be a Eurobond issued by the ECB as intermediary.

Since the promise of Mario Draghi to do “whatever it takes,” interest rates in the Eurozone have dropped significantly. As interest rates are at multi-century lows – if not all time lows – and the spread of periphery bonds to German Bunds has come down significantly, the effect of such a measure would be limited.

Therefore, Varoufakis has further refined his idea in interviews since. The ECB should buy the debt directly and swap these in perpetual, interest-free bonds. This equals a debt cut using the ECB balance sheet. As this would apply to all Eurozone countries, there would be no redistributional effects between countries.

Bottom line: It is not the first time that the idea of a debt cancellation on the balance sheet of the central bank is put forward. More then two years ago, a similar discussion started in the UK.

Proponents of such a solution to the government debt problem don’t see inflationary risks, as the money is already in circulation. In addition, they argue that it would be a one-off measure and would not involve any ongoing financing of governments by the central bank. Critics fear a loss of trust in money and see the risk of major inflation.

Nobody knows for sure what the implications would be. Nevertheless, this idea has received some prominent support, most recently by the McKinsey Global Institute.

3. The investment crisis

Diagnosis by Varoufakis: “Lack of investment in Europe threatens its living standards and its international competitiveness.”

Varoufakis and his colleagues propose a “New Deal” for Europe. An investment program on a European scale should lift demand and stimulate the economy. This should be financed with bonds issued by the European Investment Bank (EIB). These new debts should not be included in the calculation of public debt levels.

Without any doubt, spending and investments have dropped significantly compared to the level before 2008. But one has to keep in mind that the level before the crisis was not sustainable as it was driven by a debt-financed boom.

Meanwhile, the new EU Commission has launched a 300 billion euro investment program. But the quality of the proposed investments is doubtful. According to some sources, only one-third of the proposed investments to be funded on EU level could support long-term economic development.

Bottom line: In past decades, we could witness, especially in Japan, that debt-financed government investments are not sufficient to restore economic growth. It is doubtful that a European program would yield better results. On the contrary, most of the money risks being wasted on useless projects.

In addition, to exclude these debts from the official debt statistics does not change the fact that it represents additional debt. It would be much better to implement reforms in Europe to make private investments more attractive.

4. The social crisis

Diagnosis by Varoufakis: “From Athens to Dublin and from Lisbon to Eastern Germany, millions of Europeans have lost access to basic goods and dignity. Unemployment is rampant. Homelessness and hunger are rising.”

The solution that Varoufakis proposes is a European social welfare program. The interest earned by the individual central banks of Europe on their TARGET II receivables – which are basically against each other — should be used to finance this program.

The social situation in the crisis countries has without any doubt deteriorated.

Bottom line: The German Bundesbank is the main creditor within the ECB network. This is due to capital flight from the crisis countries and the repatriation of private credit. This means the Bundesbank has become the major creditor of these countries which implies the risk of significant losses.

The interest earned by the Bundesbank should according to Varoufakis be used to finance the social welfare program. This implies a redistribution of wealth from the German taxpayer to fund social welfare in other countries.

With other peoples money

Varoufakis has witnessed the effects from a misguided austerity policy in Greece. It is impossible to save yourself from bankruptcy. The economies of the crisis countries are hardly growing and debts continue to grow faster. The current approach to fixing the Eurozone is a failure.

But his diagnosis of the crisis is incomplete. He is not looking at the root causes of the debt problem, but rather sees the main reason of our economic problems in the need to rescue banks. This is not true. Government debt was already elevated before the onset of the crisis and private debt is an even bigger problem.

It is necessary to address the debt overhang. We need to restructure these debts in an orderly way, with solidarity between countries and support from the ECB. Debt restructuring in exchange for economic reforms has to be the basic principle.

The proposal by Varoufakis is quite different. Instead of tackling the root causes of the European crisis, he looks for a major debt mutualization through the backdoor (via the ESM) and an open monetization of government debt by the ECB. In other words, Varoufakis is asking for a blank check from the creditor countries to keep things just the way they are.

There is nothing “modest” in this proposal. It is rather greedy.