Thursday, December 18, 2014

Europe is a Cow

The Greek etymology of Europa (ερυ- "wide" or "broad" and ψ"eye(s)" or "face"), suggests that as a goddess she represented a cow (with a wide face). See also Antonio Carracci (b. ca. 1583, Venice, d. 1618, Rome),The Rape of Europe, currently being shown at the exhibition "From Guercino to Caravaggio", Palazzo Barberini, Rome. 

1. Costs and benefits of the Euro

The introduction of the Euro involved for all the EMU member states significant benefits and costs.  Benefits include: a greater economic and financial integration of trade and investment; a rate of inflation lower than the Bundesbank best performance with the DM; and ten years of an interest rate on public debt rapidly converging to a common, decreasing level.

At the same time national governments lost the use of several instruments of economic policy: monetary policy, delegated to the ECB; the nominal exchange rate of the national currency (the alternative “internal” devaluation through lower price and wage inflation than competitors being conflictual and impopular), and fiscal policy now subjected to a much stricter discipline (Maastricht, Growth and Stability Pact, followed by the Fiscal Compact).

Italy had the additional cost of a fiscal squeeze undertaken in order to approach the required pre-requisites – an excellent investment in view of the benefits obtained as a result.  In the transition to the Euro, Italy and Greece recorded an initial burst of inflation caused by the lack of price monitoring and control on the part of the government; this immediately eroded the international competitiveness of both countries, which could no longer be restored through devaluation.  Monetary sovereignty had already been surrendered by the government to the Italian Central Bank in 1980.  A greater financial integration turned into a channel of contagion in the subsequent crisis.  And, above all, on 19 October 2010 in Deauville, Angela Merkel and Nicolas Sarkozy decided that ESM bailouts would inflict losses on government creditors – a position ethically unimpeachable but infelicitous, because it caused a further widening of the spreads of long term interest rates on the public debt of member states with respect to German Bunds.  Thus began the Eurozone tribulations, characterized by stagnation, record unemployment, deflation, still today in the grips of the deepest crisis ever experienced by modern capitalism.

In fact the Great Crisis of 1929 had seen a rapid recovery already from 1933 thanks to the public investment of F.D. Roosevelt’s New Deal, while the crisis that began in 2007 and is still rampaging has been aggravated and prolonged by the perverse austerity policies imposed by International Financial Organisations and the European Union.

2. Euro’s diseases

The Euro suffered from policy errors by various national governments, including the fiscal profligacy of Southern members, but above all from two congenital diseases and a subsequent degenerative disease.

First, the Euro’s premature birth, before political and fiscal integration (and before defence and foreign policy integration): the Euro should have been the very final stage of European integration, its crowning, instead of which it was used to accelerate integration processes, pushing la finalité politique through the tensions generated by monetary dysfunction.

Second, the ECB was born incomplete, not to say mutilated, not so much because of its independence, which is common to the major central banks in the world, but because it was modelled on the Bundesbank, and even more than the latter was totally separated from fiscal policy, without the virtually unlimited power to buy government bonds enjoyed by other central banks otherwise equally independent (as the Fed or the Bank of England or the Central Bank of Japan). Moreover the ECB was born without the usual powers of supervision, recapitalization/consolidation/liquidation of commercial banks, and without the safety net of a common European insurance of bank deposits (the amount nominally insured today is the same throughout the Eurozone, but is the responsibility of national Treasuries, and is therefore worthless in case of a country’s default).

The degenerative disease of EMU has been the progressive economic divergence of member states, not only in terms of monetary and fiscal parameters for which a statutory convergence was envisaged but not observed, but also in terms of other real and financial parameters whose convergence should have been a condition of entrance and continued membership of the Eurozone but was not, such as the unemployment rate, the share of non-performing loans, international competitiveness.  Such progressive divergence created strong and increasing centrifugal tensions.

3. Possible solutions

Monetary policy on its own is not sufficient to re-launch the European economy, in spite of the original and courageous initiatives of the ECB President Mario Draghi (LTROs, OMTs and other unconventional initiatives), also because of the policy constraints imposed by Treaties and/or by the pressures of Northern member states.  It is enough to consider the failure of Japanese policies of Abenomics, i.e. monetary expansion accompanied by modest fiscal stimuli and structural reforms.

International trade, which since the 1970s had been a dominant factor of global economic growth, in the last years has slowed down more than global GDP; the IMF confirms that it has reduced considerably its earlier role in growth promotion.

Many quarters invoke “structural reforms”.  A reform by definition ought to be a change for the better, and a structural reform a significant change for the better, which therefore should be politically uncontroversial and unanimously acceptable. But such reforms raise three serious problems.  There is no agreement on the desirability of this or that reform, in view of their re-distributive effects; any positive effect, if any, can only accrue in the long run (5-10 years); and there are structural reforms that, although clearly beneficial in the long run, in the short run can have strong negative effects. For instance, a competition increase reducing prices today would promote undesirable further deflation; this kind of structural reform is like an investment that although beneficial is not always sufficiently profitable to be recommended.

A reduction of public expenditure in order to reduce taxation (as anticipated but not yet implemented by the Italian spending review) has a positive effect only if it reduces the waste of resources, but otherwise a balanced reduction of both public expenditure and taxation can only have a recessionary impact on income and employment, as demonstrated by Haavelmo.  What might be desirable is an increase of public investment funded by the reduction of current public expenditure.

A superior solution would be a collective large-scale public investment undertaken at the European level. The trouble is that Europe’s so-called virtuous countries, which would be in the best position to undertake a growth-promoting role – thanks to the low interest rates at which they can borrow and their greater margin for fiscal manoeuvre – are stubbornly reluctant to do it.  And the Union budget, at a miserable 1% of European GDP (compared to 20% in the USA), does not allow any large scale initiative.

It might seem that the recent Juncker Plan, with investments of the order of €315bn over three years beginning in the autumn of 2015, represents an important progress in this direction.  But in truth these investments include a presumed and unrealistic multiplier effect on private investments, of the order of almost 15 times.  European Union funds would be only €21bn, of which 8bn diverted from other important uses, 8bn consisting only of guarantees, and 5bn provided by the EIB and unlikely to be fully available without its re-capitalisation.  It is believed that at the moment the funds really available for the Plan are of the order of €2bn – a sick joke (“Europe’s alchemist”, “Laughingly inadequate” The Economist 29 November. See also Mazzucato and Penna, The Guardian, 27 November). 

Jacques Drèze and Alain Durré (CORE 2013) have proposed the issue of bonds indexed to average growth rate of the Eurozone on the part of the ECB or other EU agency, which would then swap them with government bonds issued by member states indexed to national growth rates, in proportion to their share in European GDP.  In such a way the EU agency would be able to insure member states against macroeconomic shocks, paying a subsidy to under-performing states out of the profit made on the bonds of over-performing states, at zero cost.  This is a brilliant scheme, which however in case of default by countries participating in the scheme would inflict serious capital losses on the emitting European Agency.

Pierre Pâris and Charles Wyplosz (2013, 2014) have proposed a scheme called PADRE – Politically Acceptable Debt Reduction in the Eurozone, similar to a proposal of mine of 2013 – consisting in the mobilization of ECB seigniorage for the purchase and retirement of government debt of all countries holding shares in the ECB (including 10 countries that are members of the EU but not of EMU), in the same proportions of the shares they hold.  Therefore even a possible default by a large country would not damage other members and would not involve a Transfer Union.  In his Caffè Lectures of 2011 Willem Buiter estimated the present value of ECB seigniorage at about €3300 billions, but seigniorage mobilization for Eurozone debt reduction is unlikely to be acceptable to the Northern members of EMU.

4. Disintegration of the Eurozone?

Over the last years there has been frequent discussion of the possible disintegration of the Eurozone, with the return to national currencies by the weaker or the stronger members.

The recovery of national monetary sovereignty would allow weaker members the use of all the instruments of monetary policy, and the ability to recover international competitiveness through exchange rate devaluation.  However European fiscal discipline would continue to apply to all EU members even after ceasing to be members of EMU, by virtue of the Growth and Stability Pact.

The initial exchange rate between the Euro and the new national currency would be irrelevant, because the same rate would apply to prices.  But its use as an instrument of economic policy would involve for the weaker members the cost of successive devaluations, higher inflation and higher interest rates, as well as the revaluation of debt; exiting stronger members would face the cost of revaluations making them lose international competitiveness.  All exiting countries would also face the large scale cost of exit from the entire European Union, that requires the single currency as a part of the obligations of membership – the acquis communautaire (except for Denmark and the UK that negotiated a derogation from the Maastricht Treaty before signing it).

Even under unchanged current policies, sooner or later the economic crisis might well come to an end thanks to the automatic mechanisms that always operate in the course of any economic cycle in a capitalist system.  Once the floor of zero gross investment is reached, further falls of investment come to an end, stabilizing national income; at that point net investment is negative and gradually eliminates excess capacity; gross investment resumes first to replace excessive capacity losses, then to exploit the superior technical opportunities accumulated during the crisis; and the ensuing multiplier/accelerator interaction boosts growth further.  Growth revival, however, might happen too late to prevent the disintegration of the Euro (just as it happened with the ruinous disintegration of the USSR and the rouble in 1992).

If this happens this Europe of ours will have betrayed the vision and the values of its Founding Fathers.  And we would not even be able to cry over the inglorious end of the European project because the Europe we have today is no use to us, and it most certainly does not deserve our tears.

[Note: An Italian version of this paper was presented at a Round Table on “Perspective of European Economic Policy”, at the Conference for the Centenary of Federico Caffè’s Birth, Sapienza University of Rome, 4-5 December 2014].

Friday, November 14, 2014

What if… Gorbachev had succeeded?

On 7 October 1989 Mikhail Gorbachev visited Berlin for the celebration of the GDR 40th-anniversary, and said: “History punishes those who come too late” (Childs 2000): the statement criticised Honecker but was best suited as his own epitaph. 

But let’s try and imagine what might have happened if Gorbachev’s perestroika had actually succeeded.  Five years ago I wrote a paper developing this theme and presented it at a Conference in Warsaw. The paper illustrated how Gorbachev might have succeeded in achieving the radical reform of the Soviet political and economic system, the construction of market socialism, the re-structuring and acceleration (uskoreniye) of the Soviet economy, and the possible though unlikely continued existence of the USSR.

I should stress that this was not, or at least was not meant to be, an exercise in 20/20 hindsight. Alternative courses can be formulated without the possession of perfect foresight of the state of the world in 1985-1991.  Nor is a change in Gorbachev’s initial conditions required, of the kind “If only he had come to power in 1974, at the height of the fourfold rise in the oil price ...”. This exercise was meant as a genuine counterfactual alternative. Its purpose is that of damning Gorbachev’s disastrous economic strategy and showing that he and his economic policies, more than anybody else’s doings, are ultimately responsible for the collapse of  socialism in the Soviet Union, for the failure of an alternative design of market socialism, and for the immense human cost of post-socialist Transition.  A similar exercise, considering counter-factual alternatives to the actual course of Transition in Cental-Eastern Europe, is only outlined to suggest that Transition might have been handled at a lesser human cost. 

In order to succeed, Gorbachev would have had to act swiftly, instead of practically wasting his first two years in power (1985-87), and lay down sound economic foundations for perestroika: eliminate repressed inflation, preferably through a confiscatory currency conversion; break state monopoly of foreign trade, introduce rouble convertibility on current account, liberalise trade, foster competition. By 1991 he would have also legalised private ownership and enterprise, given state managers bonuses geared to market performance, implemented small privatisation, commercialised state enterprises, begun some privatisation of large enterprises and banks. On Christmas Day 1991, instead of resigning as President of the Union, he could have celebrated the victory of economic perestroika.

What next? There would have been still thorny choices and therefore possible mistakes to be made, before completing Transition and after. Gorbachev would have needed continued vigilance and sound economic advice, for instance to avoid too rapid dis-inflation at inordinately high real interest rates, as happened in 1994-95, and the consequent recession; to avoid an unsustainable combination of overvalued exchange rate, high interest rate to support it, and a public debt increasing as a result of high debt service, as happened in 1998 under the IMF’s watch; to avoid the unnecessary cost to the budget of switching the pension system from PAYG to a funded system.

As a result of the good economic foundations of economic perestroika, and the avoidance of these kinds of subsequent pitfalls, income losses from the Transition recession would have been lower, and growth would have accelerated earlier and faster than it actually was and did. The welfare of Russians would have improved significantly and continuously as a result. The same reasoning applies to all other Transition economies that to a greater or lesser extent followed stabilisation and Transition paths out of sequence or to excess. It is impossible to have unanimity about whether the measure taken were or were not mistakes, and how serious, let alone quantify the gains. But pretending that there were no serious unnecessary mistakes in the Transition is neither reasonable nor respectable. 

The improved economic performance would have generates political consensus, but not necessarily to the point of providing permanent democratic support for a political regime associated with significantly large state ownership and associated political values (of equality, solidarity, participation, etc.). In some Transition countries post-communist parties were returned to power in democratic elections (e.g. Poland, Hungary, Slovakia) after being defeated,  but only intermittently, not permanently; some party alternation in power is an integral part of democracy. But non-persistent, intermittent market socialism cannot deliver its expected economic and social advantages. When democratic support for an ecomic system is lacking or is not permanent, then its maintenance over time requires necessarily forms of political repression. There is a high political price to pay for an economically successful and persistent market socialism – as confirmed by "market socialist" countries such as China, Vietnam, Belarus, Uzbekistan. 

Would an economically successful Gorbachev have been able to hold together the Soviet Union? There would be economic advantages to be shared out, from holding it together.  A continued Union would maintain and promote intra-Union trade volumes thanks to the single currency, and sustain inter-republic imbalances through transfers within the All-Union budget and inter-republic credits.  An early initiative and widespread economic success, including internal and external convertibility of the rouble, would have lessened centrifugal forces. If some political and administrative autonomy was granted to the 15 republics as well, the chances of retaining the Union would have improved. But the Soviets had seldom solved ethnic conflicts, mostly they had only suppressed them (just as they had done with inflation). Independence aspirations would have made it difficult for Russia to retain close ties even with republics that economically had most to gain from continued integration, like Ukraine. The probability of holding together the Union would have been greater than zero, but not significantly greater. 

Would a successful market-socialist Russia have been able to hold together CMEA/Comecon? Arguments similar to those for holding together the Soviet Union would apply, but would be much weaker. The international socialist division of labour had a bad name, in spite of Soviet subsidisation of its Comecon partners since 1974, by supplying oil and raw materials at below world prices. Memories and accusations of earlier Soviet exploitation through trade were still deeply ingrained. In January 1990 Comecon partners de facto destroyed it by trading freely rather than continue the old trade arrangements, even at the cost of paying higher prices for oil and materials. By September 1991 Comecon was officially dissolved. Comecon Soviet trade partners were already negotiating European Association Agreements and aid programmes with the European Community (now the European Union).

Gorbachev's hypothetical successful perestroika would not have led to Comecon survival.  At most, perhaps, a couple of years earlier he might have been able to extract economic assistance from the West in exchange for his acquiescence to the re-unification of Germany – for which he got nothing at all – and for the Finlandisation of Eastern Europe – a prospect overtaken by events in 1989.   

What difference would Gorbachev’s hypothetical successful perestroika have made in Russia? Only an alleviation of the pains of Transition in the 1990s; there would have been not very much difference in the 2000s, considering that in his second presidential term Putin had already reversed enterprise ownership trends, re-acquiring greater state control in many sectors and a majority stake in energy (Hanson, 2008). By comparison with the sensitivity of Russian performance to the price of oil, probably Gorbachev’s success would have been equivalent to a ten-year-long rise of $10 on the price of a barrel. (According to the Bank of Finland Research Department a $10 permanent increase raises Russia’s growth rate by 1%). The recent implosion of the US and global financial system had a far greater effect on Russia’s prospects.

What difference would Gorbachev's hypothetical successful perestroika have made to modern geopolitics? An earlier economically stronger Russia would have probably contained USA bids for the "American Century", thus sparing them the humiliation of their century ending so soon after it had barely begun.  Certainly Georgia would not have responded to encouragement by George W. Bush and Dick Cheney to attack Russia. But the Twin Towers had nothing to do with Russia, and it is impossible to tell whether the major armed conflicts that followed their attack – in Afghanistan and Iraq – would have been prevented by an economically stronger Russia. Most probably not.

Gorbachev’s and the whole Transition’s economic débacle clearly reduced the demand for socialism on a world scale, but his success would have made no difference for European social-democracy, as it would not have prevented the disintegration of the Italian left or the degeneration of British Labour into New Labour, nor favoured Zapatero’s victory in Spain. Probably both the European Union and NATO would have been smaller than they are now.

A Russian economy made stronger by an efficient Transition would have been less vulnerable to the contagion of global financial turmoil, both in the South East Asian crisis of 1997 (that was an important factor in the Russian crisis of 1998), and today. But a stronger Russia would have neither prevented such global financial crises, nor contributed much to their resolution. 

We should leave the future to futurologists. In 1989 Fukuyama’s conjecture  about The End of History was falsified before the ink had dried. All we know for sure, whether Gorbachev had or had not been successful in implementing economic perestroika, is that – as prophesised by a wall graffiti in London in 1991: "The future is not what it used to be".    

I have been asked where the paper referred to above was published and whether it is available on line. "A counter-factual alternative for Russia's post-socialist transition" was presented at an international conference on The Great Transformation, 1989-2029, TIGER at Kozminski University, Warsaw, 3-4 April 2009, published in Conference proceedings, as Grzegorz W. Kolodko and Jacek Tomkiewicz (Eds), 20 years of Transformation Achievements, Problems and Perspectives, Nova Science Publishers, New York, 2011,  
The typescript can be downloaded here.

Wednesday, July 16, 2014

Stuck In Transition

The EBRD Transition Report for 2013, published last November, was entitled Stuck in Transition? By the time of the EBRD Annual Meeting of 14-15 May 2014 the cosmetic question mark was no longer appropriate.

In 1991 the EBRD – European Bank for Reconstruction and Development – was set up in London in order to assist the post-socialist transition countries, and to promote their sustainable development as open market economies. Initially the EBRD operated in 28 countries: the 15 Republics from the Former Soviet Union, 6 countries from Central-Eastern Europe (Bulgaria, the Czech Republic, Hungary, Poland, Romania, Slovakia), 5 Republics from Former Yugoslavia, plus Albania and Mongolia.  Soon the Czech Republic was declared to have completed its transition and dropped out, but two additional members from the further split of Former Yugoslavia were added: Kosovo and Montenegro. Then 6 countries from Eastern and Southern Mediterranean were added, assimilated to transition economies because of similar problems of stabilization, re-structuring, and the change of their political and economic institutions: Cyprus; Turkey; Egypt, Jordan, Morocco, Tunisia. Today the EBRD has 35 countries of operation, and 66 shareholders. Next Libya is lined up for membership.

Since 1994 the EBRD has published in November every year a Transition Report, monitoring economic and institutional developments and constructing synthetic indices summarizing the progress of individual countries in various aspects of their transition process. In November 2013 their Transition Report was entitled: Stuck in Transition?, with a cosmetic question mark at the end. The Report acknowledged that since the mid-2000s the reform process seemed to have stagnated in transition countries, actually registering some reversals reflected in the “downgrading” of EBRD indices. The inflow of Foreign Direct Investment had slowed down and in some countries was reversed, also as a result of the end of US Monetary Easing pre-announced by Ben Bernanke. Economic growth, as a result of the 2008-2009 global crisis and the Eurozone Crisis of 2011-2012, had slowed down to well below pre-crisis levels: only 2% was expected in 2013. Productivity growth - under current policies and institutions – was going to be modest during the current decade and decline further in the next decade: therefore economic convergence with developed countries was at risk. Further economic reform meets social, political, human and capital constraints.

But for the EBRD Stuck In Transition? was only a rhetorical question. The preannounced end of US Monetary Easing did not materialise under Bernanke or his successor Janet Yellen. The Eurozone Crisis was countered by the ECB unorthodox new measures introduced by Mario Draghi. FDI was bound to resume its course. In November 2013 economic growth in the area was projected to accelerate to 2.7% in 2014. There was said to be a virtuous circle between democratization and institutional development, and between the progress of institutions and economic growth. For the EBRD all was well really in the Transition.

The question mark may or may not have been justified in November 2013, but by the time of the EBRD Annual Meeting in Warsaw on 14-15 May 2014 it undoubtedly was no longer appropriate. The virtuous circle between institutional development and economic performance would turn into a vicious circle if exogenous shocks adversely affected either factor. In 15 of the EBRD countries of operation, as a result of the global crisis, public opinion had turned against market reforms, especially in the more democratic countries, thus breaking the link between democratization and the development of institutions. “Private capital flows to the transition region as a whole had remained relatively low and a continuation of cross-border deleveraging was delaying the resumption of credit growth” (EBRD, May 2014). Turkey took a turn for the worse, with widespread political unrest and its violent repression, and associated economic slowdown. There were adverse political developments and serious new economic problems in Egypt. And above all the confrontation between Russia and Ukraine caused a slowdown in Russia (with consequent rouble devaluation and stock exchange fall) and a recession in Ukraine, which adversely affected other Central European countries, especially the Baltics and Serbia. The end of recession in Slovenia is not enough of a compensatory factor.

The latest EBRD growth forecasts for 2014 in the transition area have been cut back from 2.7% to 1.4%, and an improvement to 1.9% in 2015 was regarded as possible but problematic. The EBRD most likely outcome is near zero growth in Russia this year and minimal growth in 2015, and in Ukraine a 7% decline this year and stagnation next year. But the EBRD worst-case scenario is extremely worrying: the implementation of threatened economic sanctions against Russia would immediately precipitate a Russian recession, and bring growth in the whole area to a complete halt, with serious contagion implications for the entire global economy.

On 26 July in Saint Petersburg Professor Ruslan Grinberg, Director of the Institute of Economics of the Russian Academy of Sciances, convened a Founding Conference with the purpose of setting up a new Centre for the Economic and Socio-Cultural Development of the CIS and Central-Eastern Europe.  Against the background illustrated above a renewed focus on these countries, with their distinctive features due to the common Soviet-type starting model, is undoubtedly most opportune, timely, indeed absolutely necessary.

In brief, the Agenda of such a Centre ought to include a re-consideration of alternative models of capitalism other than the hyper-liberal, crony [“oligarch” in Russian] capitalism that has prevailed in the transition; re-thinking the role of the State in the transition process, re-vamping its functions in market regulation and the very creation of market institutions, infrastructure investment, the financing of research and innovation, the alleviation of poverty and unemployment and the guarantee of social peace.  On this last point the EBRD 2013 Report rightly lays great emphasis on the need for “economic inclusion” for the success of any market economy. Inclusion is understood as broad access to economic opportunities regardless of gender, social class and urban/rural background, especially for young adults. 

More generally, intellectual inspiration could be drawn from the comparative analysis of transition experiences to-date but also from recent publications including for instance Thomas Piketty’s Capital in the Twenty-First Century (2013), Mariana Mazzucato’s The Entrepreneurial State (2011) and Grzegoz Kolodko’s monumental work on transition and on globalization. Inter-disciplinarity is essential. We wish Professor Grinberg every success with his new venture.

Friday, April 4, 2014


The word "Padre" is immediately and inexorably associated in my mind, due to my early Catholic indoctrination, with the utterance “forgive me for I have sinned”.  But these days PADRE is also the acronym for another kind of forgiveness, of part of public debt in Eurozone member countries.  Politically Acceptable Debt Restructuring in the Eurozone is a proposal put forward by Pierre Pâris (CEO and Founding Partner, Banque Paris Bertrand Sturdza, ex-Barings and ex-Morgan Stanley) and Charles Wyplosz (The Graduate Institute, Geneva, ICMB and CEPR), “To End the Eurozone Crisis, Bury the Debt Forever”, VoxEU, 6 August 2013, and in their fuller Special Report 3, Geneva Reports on the World Economy, ICMBS and CEPR, January 2014, launched by CEPR in London on 4 March).  See also Carlo Clericetti, 15 February 2014.

The PADRE scheme envisages the substantial reduction of Eurozone public debt, say on average by one half of its current level, through the retirement of government bonds by the European Central Bank, proportionally to individual country shareholdings in the ECB, financed through the securitization of shareholders’ entitlement to ECB seigniorage.

[Reminder: The Bank of Italy website defines Seigniorage as “the flow of interest from the assets held against notes in circulation (or, more in general, against the monetary base).” In the case of the Eurosystem, it is included in the definition of “monetary income” which according to Article 32.1 of the Statute of the ESCB and of the ECB is “The income accruing to the national central banks in the performance of the ESCB's monetary policy function. ” (ibidem). The legislation on how the “monetary income” of the national central banks of the participating member states is distributed can be consulted on the ECB website.]
Therefore by definition – by benefiting all members proportionally to their shares – PADRE would not imply any resource transfer from any country to another, nor any burden on “virtuous” countries to the advantage of allegedly profligate and undeserving other members (as it would happen by pooling public debt), or associated moral hazard: existing bonds would be replaced by bonds issued and serviced by the ECB on behalf of member countries mobilizing their shares of ECB seigniorage, at an interest rate estimated by Pâris and Wyplosz of the order of 3.5%, only marginally higher than the Bund rate of about 3.3%. This is why such a scheme should be “politically acceptable”, especially since a safeguard clause would stop undisciplined countries from resuming their earlier bad behaviour.  The debt/GDP ratio and the associated spread on public debt would be permanently and painlessly reduced at a stroke.

Pâris and Wyplosz estimate that as a result of this operation Italy’s Debt/GDP ratio would fall from 133% to 80.4%. Beside Italy, only Greece, Ireland and Cyprus would remain above the statutory 60% fixed by the Maastricht Treaty, while Estonia, Latvia, Slovakia and Luxemburg would end up with positive net public assets instead of public debt.  Interest payments would fall not only because of the fall of debt but also because of the lower interest rate charged on new issues. The Fiscal Compact, currently a Damocles’ Sword on many EU countries, would become manageable: in order to comply with it Italy for instance would need a primary surplus of just over 1% for twenty years instead of over 3.5% (one twentieth of the Debt/GDP ratio in excess of 60%).

In order to obtain this result the ECB would have to buy €4,592 bn of bonds, on which it would pay €161 bn interest a year. The trouble is that the two economists estimate average yearly seigniorage revenue at only 1.1 bn, though rising at a steady rate over time. Pâris  and Wyplosz reckon that it would take 50 years before seigniorage could match interest costs. Still, the tangible immediate gains make the proposal a solution preferable to other alternatives considered and rejected by Pâris  and Wyplosz.

-      -- Consolidation through budget surpluses would take, from the peaks reached by the more highly indebted Eurozone countries, a time scale of twenty years, with front-loaded recessionary side effects.

-      -- The sale of public assets, totaling 37% of GDP in the Eurozone, often might be against national interest, would require a massive administrative effort “probably beyond reach”, more time than the two-three years available for it to be effective, and realization prices are bound to be disappointing especially in the recession.

-       --  Classic debt restructuring, deep enough to bring debt down to 60% of GDP would trigger off a bank crisis, for much indeed most of national debt has migrated to commercial banks, whose rescue would require government intervention and more debt; moreover bailouts are no longer available on an adequate scale and, even if they were they would simply add to public indebtedness and make the situation worse. 

-       -- Debt forgiveness would involve a transfer from better-off countries to crisis countries, politically and economically impossible other than perhaps for a single small country.

-       --  Finally, debt monetization in the Eurozone could only take the form of ECB purchases of government bonds, which run up against the same kind of objections as its Outright Monetary Transactions, and in any case leave governments with the burdens of both interest payments and repayment of principal at maturity.

The proposal put forward by Pâris and Wyplosz is a variation of debt monetization aimed at overcoming these drawbacks. I am strongly convinced that the PADRE proposal is excellent. Not least because, independently and contemporaneously, I made a nearly identical proposal in a post on this Blog, on 8 August 2013. 

In that post I took as starting point Willem Buiter’s estimate of the present value of ECB seigniorage, which he defines somewhat more broadly than the definition given above, as the profits obtained from monetary base issues, including the interest obtained from the investment of past issues, plus the anticipated inflation tax i.e. the loss in real value of the stock of monetary base caused by expected inflation, as well as the unanticipated inflation tax. 

This present value of course is not recorded in the ECB balance sheet, but is estimated by Willem Buiter to be of the order of €3.3 trillion (in The Debt of Nations Revisited: The Central Bank as a quasi-fiscal player: theory and applications  2011).  I wrote then “Its use to retire a sizeable part of Euroarea members’ debt in the same proportions in which they hold ECB shares would solve the Euro crisis without transforming the Eurozone into a “Transfer Union”, as it would not involve any redistribution across member states.  Potentially inflationary consequences of such an operation could be neutralized by reducing the size of the ECB balance sheet (selling assets and reducing loans), sterilizing monetary liabilities, raising obligatory reserves and raising the remuneration of excess reserves in order to induce banks to keep them inactive”. 

Indeed my own version of the PADRE proposal was put forward in an earlier post, and re-quoted in my post on The ECB firepower of 23 August 2012:

"Suppose the ECB bought a balanced packet of 100bn of EMU government bonds in the same proportions in which EMU countries hold shares."

"Roughly 30% of ECB shares are held by 10 EU members who are not EMU members (with the UK at 14.5%), the rest is divided among EMU members: Germany 18.9%, France 14.2%, Italy 12.5%, …, Spain 8.3%, Greece 2%, Portugal 1.75%, , Ireland 1.11%, … Malta 0.06%. Therefore the bond packet bought by the ECB would contain 100/70 or roughly 1.43 times each EMU member’s share in ECB capital, eg Spain €11.869 bn."

"Suppose that subsequently Spain defaults and its bonds lose 50% of their value. Germany [as ECB shareholder] loses 0.189*0.5*11.869bn euro, or €1.1216205 bn. An equivalent amount out of the €18.9bn outstanding German debt purchased by the ECB could be cancelled, and so on for all corresponding losses of other EMU members."

"Non-EMU-member Shareholders would have to be compensated by the ECB for 30% of the loss of value of Spanish bonds, i.e. would have to be paid dividends of 0.30*11.869 bn euro; all ECB outlays to come from ECB profits (including seigniorage if need be, in which case non-EMU members might not be entitled to compensation …)."

"In conclusion, EMU non-members would be compensated for their participation in the cost of Spain’s default with dividends, while EMU members would be compensated by the withdrawal of a corresponding value of their bonds (without prejudice for the present entitlement of non-EMU members to benefit or not to benefit from euro seigniorage)."

“So, there is no reason for peripheral (i.e. high spread) eurozone members to panic - yet. Where there is a will there is a way. And financial markets believe in the “Draghi rally”.”

The seed of such an idea came from an editorial comment in of 24/7/2012 (unsigned, perhaps by Wolfgang Munchau?), reporting on various proposals for the ECB to undertake Quantitative Easing like the Fed. The comment noted that a European QE is not against the EU Treaties, if the ECB would buy governments bonds from every Eurozone country [emphasis added]. All I did in my post The ECB firepower of 26/7/2012 (the day of the historical pronouncement by Mario Draghi committing the ECB to support the Euro) is to specify that government bonds from all Eurozone countries should be bought in the same proportions in which they are ECB shareholders, with dividend compensation paid out to other, non-Eurozone shareholders. In such a way there is no mismatch between the composition of ECB assets and liabilities due to Quantitative Easing, and no cross-country transfer is involved.

It is true that the ECB has a capital of only €6bn in the process of doubling over 5 years, but - even setting aside Paul de Grauwe’s powerful argument that a Central Bank does not need equity capital at all - the off-balance-sheet resources corresponding to the present value of the ECB seigniorage are undoubtedly large enough to save the euro without invoking Eurozone or EU solidarity.

The existence of such formidable weapon in the ECB armoury does not indicate whether and when it will be used. But the very fact that it might – Willem Buiter always had indicated “quasi-fiscal abuse of the Central Bank” as a likely resolution of the Euro crisis – ought to set a limit to the downwards spiral of credit ratings and the escalation of spreads. 

The only difference between my proposal and the PADRE proposal by Pâris and Wyplosz is minor technicality: in their scheme the ECB buys bonds of a country, then it exchanges them against a perpetual, interest-free loan of equivalent face value, which remains indefinitely as an asset in the books of the ECB but will never be paid back (unless the ECB is liquidated); the counterpart of this operation will appear on the liability side of the ECB’s balance sheet as an equivalent in the monetary base. Pâris and Wyplosz also regard this as non-inflationary in the present conditions of near zero money multiplier, and otherwise envisage that the ECB could raise reserve requirements or sterilize the bond purchase programme by issueing its own debt instruments.

Great minds think alike, pity that nobody listens. Which is why, after describing the equivalent of PADRE, I wrote “However this kind of operation would go against the grain of German and other Nordic members’ monetary conservatism and is unlikely to be undertaken.”   The Karlsruhe German Constitutional Court decision of 14 March, asserting the legality of the European Stability Mechanism against the challenge of 37,000 German claimants, does not yet change the perspective of opposition to any such scheme by the Bundesbank, by its President Jens Weidmann and other German conservative circles. Pâris and Wyplosz seem to be more optimistic. I wish them good luck, wholeheartedly.

UPDATE (05/04/14)
I sent a preview of this post to Charles Wyplosz, Professor of International Economics and Direcctor of the Geneva
International Center of Monetary and Banking Studies, and an old friend. He wrote me a kind and generous e-mail acknowledging our independent development of the same idea, which they intend to mention in their subsequent work on PADRE.

Apparently they now have a forthcoming variant of their scheme that leaves the ECB out of the picture, to assuage German and other Nordic opposition. In that scheme, an agency does the buying, borrowing and swapping in perpetuities while the governments request that ECB sends its seigniorage income to the agency until the costs have been fully absorbed.

There are still a number of loopholes left, of course. “Some are legal but others are economic, including a sharp financial gap in the early decades. The kiss of near-death, though, is that governments must give up seigniorage for decades and, as we all know, governments can renege. We try to stack the cards against that but we will never satisfy those that require a 100% guarantee that it will never happen. “

Charles and Pierre now have some doubt about whether PADRE is indeed politically acceptable. They are “on the road, trying to sell it to officials and central bankers, even including a Bundesbank seminar in May.” Charles believes that there is interest, with strong support in highly indebted countries and no rejection yet in the virtuous countries. At this stage the main problem is that politicians believe that the crisis is over and have zero appetite for solutions to a problem that no longer interests them. Charles tried to place this kind of comment on my Blog but for some reason did not succeed, I am delighted to do it at his suggestion.

Tuesday, March 18, 2014


One of the factors that have slowed down Italian growth in the current crisis, even relatively to a sluggish Eurozone, is undoubtedly the endemic accumulation of large scale arrears in Public Administration payments to enterprises for their supply of goods and services to central and local government. True, the very expectation of payment delays tends to be built into enterprise costs and therefore inflate the volume of public expenditure, but even so the build-up of arrears remains a sick anomaly in any market economy, which especially in a tight credit market such as at present can drive even healthy, successful enterprises to lay-offs and bankruptcy.
The very scale of such public arrears is uncertain, which makes it worse. A year ago the Bank of Italy estimated the commercial debt of the Public Administration to be of the order of €90 bn at the end of 2012.  Since then €24 bn have been paid off, but there have been new gross additions to the total. A conservative estimate of current arrears is above €80 bn (La Repubblica, Economia e Finanza, 10 March 2014, p.2) while estimates by the Confederation of Italian Industry put them at as much as €120 bn. Many of the arrears involve off-budget, non-certified expenditures.
The idiosyncracy, not to say the idiocy of the “internal” Growth and Stability Pact constraints, translating Maastricht macroeconomic constraints into local authorities’ microeconomics, often prevents payments even when expenditures are properly budgeted for and finance is available. Anal retention on the part of high officials of the Ministry of the Economy and Finance, also in order to avoid possible accusations of payments breaking European constraints, is an additional factor. But an accounting convention that wholly or partly reckons expenditures and revenues on a cash basis (“bilancio di cassa) rather than on accrual (i.e. including also receivables and payables, as in the “bilancio di competenza”) actually provides an incentive for the Public Administration to obtain, as it were, free credit from enterprises in a way that does not affect adversely its financial performance, regardless of the massive costs inflicted as a result on the economy and its viability and growth.

Clearly from a substantive viewpoint it makes no difference whether the Public Administration owns given arrears to enterprises, or borrows from banks or the financial markets an equivalent amount to pay them off, in which case it does not augment its debt but simply transfers it from the enterprises to new creditors. Financial markets are most unlikely to respond adversely to the Public Administration reducing payments arrears through additional borrowing. But with cash accounting the arrears are not counted as part of expenditure or as a component of debt, whereas the equivalent borrowing does in its entirety. Hence the incentive to let arrears grow.

The popularity of cash accounting belongs to a past in which the control of the  money supply in order to control inflation was a paramount preoccupation at all costs, even if the accumulation of Public Administration arrears towards enterprises involved the collapse of the real economy.

This accounting convention has already made immense damage in the course of post-socialist transition in the early 1990s, when the International Monetary Fund made monthly disbursements to Russia conditional on its respect of cash limits to the state budget deficits, thus encouraging the explosion of arrears owed to enterprises. or owed to state employees, or even to old age pensioners. As the Russians used to say, “Pay As You Go” then meant: First you pay, then you go. Italian so called “esodati”, whose entitlement to pension matured through early retirement was vanified by the sudden rise of pensionable age decreed by the indefensible, unconscionable Minister of Labour Elsa Fornero of the Monti government, could choose this as their motto.

Such an obtuse and nonsensical policy fostered by the IMF in Russia in the early 1990s, in addition to an interest rate positive and large in real terms up to usury levels, and an associated overvalued exchange rate, led to mass unemployment and the parallel accumulation of inter-enterprise debt of the order of 40% of manufacturing enterprises turnover. This de-monetisation of the economy was one of the most important factors in the transformation recession of Russia in the 1990s, which destroyed more than one third of Russian GDP. By the same token the build-up of arrears is one of the factors that took current Italian recession above the European and Eurozone average.

Moreover, accounting conventions differ in Italy and Europe, and for different items of expenditure. Capital account expenditures (perhaps 20% of total arrears, though the precise proportions are also unknown) are always accounted for on a cash basis, both in Europe and in the “internal” so-called Growth and Stability Pact. Current account expenditures (the remaining roughly 80% of arrears), on the contrary, are accounted for on an accrual basis by Europe, and on a cash basis according to the “internal” Pact. Thus past current account expenditures, already accounted by Europe on accrual, can be paid without impacting the European 3% deficit ceiling in the payment year, having been accounted for already in the deficits of past years; whereas capital account payments in 2014 count against the deficit ceiling in that same year.

Franco Bassanini (President of the Cassa Deposity e Prestiti, CDDPP, a public agency managing postal savings, funding infrastructure and public enterprises) and Marcello Messori (Rome LUISS University) worked out for the ASTRID Foundation a clever and simple method for getting rid of all Public Administration payment arrears, both on capital and current account, without infringing expenditure and deficit (and therefore debt) ceilings.

Namely, Public Administrations would be asked to verify, and either challenge or certify within a period of 2-3 months, any claims of payment arrears by commercial suppliers. Certified credits would be guaranteed by the state (guarantees being a contingent quasi-fiscal liability of the state, not accounted for as expenditure) and could therefore be discounted by banks at a small premium (of 1%-2%, and anyway under 2% for the credit to continue to enjoy the state guarantee).  Banks would have an incentive to accept them because they could always use them as collateral with the ECB to obtain liquidity, and moreover would improve the position of Public Administrations towards the banks themselves. Beneficiary enterprises could in turn reduce their liabilities towards suppliers, invest and hire new employees. VAT owed on unpaid arrears and currently suspended would also be paid, providing additional government revenue. J.P. Morgan calculated that in Spain, which was suffering from a similar predicament and paid off about €30 bn of Public Administration commercial debts, GDP grew by 1.2% as a result; in Italy the impact on growth could be greater. (See the interview with Franco Bassanini in La Repubblica, 10 March).

On 18 March 2013 EU Vice-Presidents Antonio Tajani and Olli Rehn had already accepted that “attenuating factors could be applied to the liquidation of commercial arrears” from the view point of the Growth and Stability Pact, but the principle was implemented only partially, thus involving the Ministry of the Economy and Finance in complex intermediation to establish eligibility and priorities, that slowed down the reduction of arrears. And last summer amendments removing state guarantees and establishing undetermined ceilings to arrears reduction stopped payments altogether under Enrico Letta’s government.

In a recent TV programme Franco Bassanini declared that current account arrears (which he put at between €20 bn and €100 bn) could be specifically removed from the “internal” Growth and Stability Pact, having been already included in past deficits, and paid by next June, while capital account arrears (of between €5bn and €10 bn) could be paid by 21 September as announced by the new Premier Matteo Renzi. Public Administrations without the necessary funds could take a 5-year loan guaranteed by the state, which in case of insolvency would be acquired by the CDDPP, on a longer maturity basis of the order of 15 years. More power to his elbow.