MODEST PROPOSAL FOR OVERCOMING
THE EURO CRISIS
Department of Economics
University of Athens,
Department of Economics
University of Coimbra
(*) This proposal was first tabled in November 2010.
Since then, it has been updated on a number of occasions in
response to developments within the Eurozone and comments sent to the
authors by a large number of readers.
The authors wish to thank them for playing an active part in
seeking to effect a Gestalt shift by which a fresh perception of what
is feasible may gain ground.
In seeking to placate credit rating agencies,1 the governments of
the Eurozone are undermining Europes credibility with electorates,
markets and, ironically, the credit rating agencies themselves! Instead
of closing what was already recognised as a democratic decit, they
deepen it and, in the process, reinforce the Eurozones unfolding
Eager to please the markets, Europes leaders ignore Treaty
commitments to economic and social cohesion and, indeed, undermine them
with a series of decisions (or lack thereof) which attach a major
legitimation crisis onto an already vicious economic crisis.
Thus, not only the EUs economic future but that of European
democracy is endangered as well.
Not all governments or ministers have been equally compliant.
There have been several calls for new institutions for European
They fall in two categories: Proposals that require greater
federalism on the lines of common fiscal policies and fiscal transfers.
Such proposals are blocked by a general consensus that federalism
is either utopian or undesirable.
Then there is the second category of proposals which, on lines
similar to our own (notably by Jean-Claude Juncker and Giulio
Tremonti), they have been kept off the official agenda.
Meanwhile, the mixture of policies adopted, by which to face down
the crisis, comprises new expensive loans (to already insolvent
member-states), more austerity (which guarantees a reduction in their
national income) and, possibly, the prospect of some debt-buy outs.
In the present perplexing situation, one thing is crystal clear:
That the combinflation of policies adopted, based on the triptych
loans, austerity and debt-buy-outs, is failing both economically and
On 14th March, and then again on 25th March 2011, the EUs
leadership failed to agree on how to increase the EFSF bailout fund,
deferring their decisions (with the fall of the government in Portugal,
following that in Ireland) until June.
The surplus countries (Germany, Finland, Austria and the
Netherlands) are objecting to open-ended, unlimited liability lending
to the fiscally challenged periphery.
Germany and Finland resist the fiscal transfers necessary under the
EFSF and, post-2013, a European Stability Mechanism.
Our main point is that none of this is even necessary.
As argued below, the euro crisis can be dealt with without any
fiscal transfers, with no taxpayer-funded bond buy-backs and without
changing existing Treaties.
What Europe needs is today is:
A commitment to stabilise the current debt crisis by transferring a
share of national debt to Europe which (at less than one per cent of
GDP) has next to none (and until May last year had none at all).
To hold the transferred debt as Eurobonds and offer net issues of
such bonds which would create a highly liquid market in European paper,
attract capital from the Central Banks of surplus economies and
Sovereign Wealth Funds.
The very agencies whose triple-A ratings of the bank-generated
toxic debt drove the financial sector into insolvency.
This new, highly liquid, market for Eurobonds will, in itself,
lessen volatility in the remaining bonds of member states as well as
attract funds to the centre with which to co-nance recovery and turn
the Eurozones current weakness into a major strength.
To utilise this inward ow of capital, in conjunction with the funds
raised by the European Investment Bank (EIB) (from its own bonds
issues), to finance the European Economic Recovery Programme to which
the Union has been committed since 2008 but which is currently blocked
by deationary policies that risk a double dip recession not only in
Europe but also for the US.
To achieve such a Eurobond funded recovery (by shifting excess
savings into investments, rather than printing money) by drawing on the
precedent of the US New Deal; a singular attempt by the Roosevelt
Administration to build up a fresh condence in the ability of
governments to govern at a time of crisis (rather than be serial
victims of a vicious circle which leaves neither states nor markets in
To thereby contribute to a more balanced recovery of the global
(which is one of the main stated aspirations of the G20) and do so
by recycling global surpluses into productive, socially useful and
environmentally sustainable investments.
A key to this is not fiscal transfers but a tranche transfer:
transferring a share of national debt and borrowing to Eurobonds held
and issued by the European Central Bank (ECB).
One of us, 2 recommended a new institution to issue such Eurobonds
in a report to Jacques Delors in 1993.
The Breughel Institute more recently has done the same.
The EIB has declined to issue the bonds, which is sensible since
there is a difference between bonds as instruments of debt
stabilisation and bonds for investment in recovery.
But the fiscale of the current debt crisis is such that we do not
need a new permanent institution (such as the European Stability
Mechanism, ESM, intended for 2013), nor a temporary institution such as
the European Financial Stability Fund (EFSF), but one which is
sufciently established both to command the respect of financial markets
(including global bond markets) and to deter short-term speculation.
If such a tranche transfer of debt were up to 60% of GDP (as Policy
1 recommends), it would reduce the default risk for the most exposed
member states by lowering their debt servicing costs, and signal to
bond markets that governments have a proactive response to the crisis,
rather than are victims of unelected credit rating agencies.
Importantly, the tranche transfer would not be a debt write-off.
The member states whose bonds are transferred to the ECB would be
responsible for paying the interest on them, but at much lower rates.
This also would strengthen rather than hazard the Stability and
Growth Pact (SGP).
At present the SGP lacks credibility not only because France and
Germany weakened it in 2005 but because the macroeconomics of debt
reduction do not add up.
When rating agencies are serially downgrading member states"
sovereign debt, and causing them to renance at rate of from 7 to 10 per
cent, this is unsustainable and the edge of the cliff of default.
In contrast, a tranche transfer would ensure that the remaining
debt held by most member states (except Greece, which is the outlier
here) would be within national SGP limits (60% of GDP).
For countries like Greece, it would be over this but with a
manageable excess next year of 27% rather than 87%.
Policies 1&2 of the Modest Proposal address this further.
Yet debt stabilization alone cannot be the complete answer to
Europes political crisis.
The Eurozone needs to reinvigorate its 2008 commitment to a
European Economic Recovery Programme by learning up from Roosevelts New
Deal, whose success gave Truman the condence to fund the Marshall Plan
from which Germany herself was a principal beneciary and which she
gained on the basis of debt restructuring and grants (rather than
repayable, expensive loan finance).
The key to the New Deal, it must be remembered, was not cutting
investments nor raising taxes but borrowing to invest through US
These do not count on the debt of US states such as California or
In parallel, there is no need for the Eurobonds (which can match
those issued on its own account by
the European Investment Bank (EIB) see Policy 3 to count on the
debt of EU member states.
Net issues of ECB Eurobonds neither imply fiscal transfers nor a
buying out of national debt, nor national guarantees.
The EIB, already double the size of the World Bank, has issued
bonds for fty years without such guarantees.
Eurobonds issued by the ECB would, in addition, attract surpluses
from the Central Banks of the emerging economies and from Sovereign
Wealth Funds eager to achieve a more plural and more secure global
reserve currency system.
Both the US and the trade surplus economies (China above all) would
gain if this is part of a European Recovery Programme, whereas
contraction of the European economy (as an outcome of debt
stabilisation without such a programme) would reduce their exports
risking also a double-dip global recession.
Our proposal therefore is radical but modest since it does not need
Several commentators have claimed that monetary union without a
common fiscal policy is doomed to failure.
But EU bond finance for a European New Deal would not need the
equivalent of a US Treasury, nor common fiscal policies, nor finance
from German or other taxpayers, nor a revision of the terms of
reference of the European Central Bank, nor a new European Economic
The institutional framework is place already.
Within existing Treaty provisions, since Maastricht, the heads of
state and government in the European Council can decide "broad economic
guidelines" for "general economic policies" which the ECB has been
obliged not only "to note" or "to respect" but "to support".
This wording was in fact lifted direct from the constitution of the
Article 282 of the Lisbon Treaty simplied this to: "The primary
objective of the European System of Central Banks (and the ECB) shall
be to maintain price stability" but that: "[w]ithout prejudice to that
objective, it shall support the general economic policies of the Union
in order to contribute to the achievement of the latters objectives?.
Some European economies, like others, are currently undergoing
But these are not due to excess demand.
They are caused by rising commodity and food prices with high
growth in the emerging economies, by some structural factors and, last
but not least, by speculation.
The speculation, in particular, should be addressed, as Nicolas
Sarkozy has acknowledged.
Arguably more food should be available for consumption rather than
for conversion into biofuels.
But neither of these will be redressed by more European austerity,
while with a European Recovery Programme more firms could assure
themselves of sustained cash ows from revenues (rather than from
raising prices to compensate for the lower cash ow in recession).
To pre-empt claims that new terms of reference will be needed for
the EIB, let us be clear: They are not needed! Since 1997, on the
initiative of then Portuguese Prime Minister Ant?nio Guterres, and
recommended to him by one of us,3 the EIB gained a cohesion and
convergence remit from the European Council to invest in health,
education, urban regeneration, environmental technology and small and
Since then the EIB has quadrupled its annual lending to over "80bn,
or two thirds 5 of the own resources of the European Commission, and
could quadruple this again by 2020, making a reality of the European
Economic Recovery Programme.
In this sense, a New Deal for todays Europe is much more tangible
than Europes leaders think.
The EIB as the investment arm of a European Recovery Programme
therefore already has macroeconomic potential.
This is especially the case when investment multipliers are taken
As illustrated later, these multipliers can be as high as 3 (i.e.
for every euro invested, "3 of additional GDP is generated).
Thus an addition to EU investment of one per cent of GDP by the EIB
registers up to treble this in terms of an investment-led recovery.
It generates related investments and sustains rather than drains
the private sector.
Finally, the macroeconomic recovery foreshadowed here, to which the
EU has been formally committed since 2008, does not need to be
monitored or surveyed either by the European Commission or the ECB.
The criteria have already been established by the European Council
decisions since 1997.
Nor need there be a question of where the demand can come from.
The very nature of the current crisis is the co-existence of
insufcient effective demand (yielding low growth) with massive latent
demand for investments in precisely the social and environmental areas
which have been remitted to the EIB since 1997.
THE NATURE OF THE CRISIS
Each response by the Eurozone to the sovereign debt crisis has been
This includes, back in May 2010, the joint European Union (EU)
International Monetary Fund operation to rescue Greece and the European
Financial Stability Facility or EFSF intended to support the rest of
the fiscally challenged Eurozone members (e.g. Ireland, Portugal,
More recently, European leaders announced their provisional
agreement to create a permanent mechanism to replace the EFSF (called
the European Stability Mechanism, or ESM) as well as a series of
measures aiming to stabilise the crisis.
Yet the crisis intensied.
The reason is that the crisis is systemic and multiple including:
" a sovereign debt crisis, a banking sector crisis and an
" The reason the EUs current policies are failing financially,
economically and politically is that they seek to address one of its
three manifestations, the sovereign debt crisis, while displacing the
banking sector crisis and deepening unemployment and recession in all
save its core economies.
This exclusive focus on sovereign debt is counter-productive:
instead of reducing the debt-to-GDP ratio of the stricken
member-states, it makes it worse.
The debt burdens of the fiscally stricken nations are confronted
by: 6 huge, expensive loans to, effectively, insolvent states; new
institutions which lack credibility on financial markets, not least
since governments as yet have not been able to agree their criteria
(e.g. the EFSF); the negative effects of raising the funds to be loaned
by utilising toxic financial instruments which contain a vicious
default dynamic (that increases the likelihood of contagion within the
Eurozone) and massive austerity drives that reduce employment, income
and revenues for the member states burdened with these new loans.
But the immediate effect is a worsening of the other two crises:
the banking sector and under-investment crises.
Europes private sector banks are over-laden with worthless paper
assets (both private and public).
They are black holes into which the ECB is pumping oceans of
liquidity that only occasion a trickle of extra loans to business since
the banks are using the money to recapitalise without writing down debt
that still is toxic.
Meanwhile, the EUs policy mix in response to the sovereign debt
crisis, founded primarily on austerity drives (as a condition for the
new loans), including the aim to halve fiscal decits by 2013,
constrains economic activity further and fuels the expectation of
future sovereign defaults.
The mechanism designed to raise funds for Ireland, Greece and now
Portugal neither assures them of avoiding default, nor the risk of the
same for other member states such as Portugal.
So the crisis is reproducing itself rather than being resolved.
The problem with loans and bond buy-back schemes is that they do
nothing to address either (a) the banking sector crisis or (b) the
under-investment crisis, and (c) have minimal effects on the debt
We therefore propose four main principles for a more Comprehensive
Principle 1: The triple debt, banking, and under-investment crises
must be tackled together.
National debt stabilisation needs to be matched by a restructuring
of the banks.
Recession of national economies needs to be offset by realising the
formal commitment of the Union to the European Economic Recovery
Programme and respect for Treaty commitments to economic and social
cohesion, both of which are undermined by a strategy focusing only on
national debt and decit reduction.
Principle 2: Shareholders rather than depositors in the banks which
caused the financial crisis should share in the pain.
Depositors and precautionary holdings in banks by individuals and
pension funds should be protected.
Speculative holdings relying on ECB bailouts should not.
Determining these will take time.
But commitment to the principle should be from now.
Both bank losses and portions of sovereign debts should be
restructured in a transparent and socially equitable manner, rather
than making electorates alone responsible for the banks errors.
Principle 3: The crisis needs structural proactive change, not
reactive responses to exposed sovereign debt.
German, Dutch, Finnish and Austrian taxpayers should not be asked
to shoulder new loans for insolvent countries.
Fiscal transfers should be within the agreed framework of the
Structural Funds through the Commission's "own resources?, rather than
a response to the sovereign debt crisis.
The structural change should be one by which a major share of
national debt is transferred to the Union to be held by the ECB as
Principle 4: Such a "tranche transfer" to ECB Eurobonds should not
count on the national debt or member states nor need be guaranteed by
them anymore than are EIB bonds.
A key parallel, as in the recommendation by one of us of Union
Bonds to Jacques Delors, which he included in his White Paper of
December 1993, is that US Treasury bonds do not count against the debt
of the states of the American Union such as New York State or Vermont,
nor are guaranteed by them.
Therefore EU Eurobonds need not and should not count on the debt of
EU member states, nor be guaranteed by them.
THE PROPOSALS THREE MAIN POLICIES
Policy 1 Stabilising the sovereign debt crisis Institution: The ECB
(European Central Bank)
1.1 Tranche transfer to the ECB
The ECB takes on its books a tranche of the sovereign debt of all
member states equal in face value to up to 60% of GDP.
1.2 ECB bonds
The transferred tranche is held as ECB bonds (?-bonds hereafter)
that are the ECBs own liability.
1.3 Fiscal neutrality (i.e. no fiscal transfer)
Member states continue to service their share of hitherto sovereign
debt now held by the ECB.
To do so, each participating member-state holds a debit account
with the ECB which it services long term at the lower interest rates
attainable by the ECB as the central bank of the Union.
Formerly sovereign national debt transferred to the ECB reduces the
burden of the most exposed member states without increasing the
debt burden of any of the remaining member-states.
1.4 National debt reduction
The transfer of debt of up to 60% of GDP to the ECB means that most
European member states then are Maastricht compliant on their remaining
national debt and do not need to reduce it within the terms of
reference of the SGP.
Greece would need to do so but at some 27% of GDP in 2012 rather
than 87% such reduction would be feasible especially if the deationary
effects of current policies are offset by its share of EIB financed
cohesion and convergence investments.
1.5 The SGP and the Tranche Transfer
The national SGP limits therefore become credible with the tranche
transfer to the ECB.
For such a member state as Greece, whose remaining national debt
exceeds 60% of GDP, the transfer should be conditional on an agreed
schedule for its reduction.
Policy 2 Tackling the banking sector crisis Institution: The
European Financial Stability Fund.
2.1 Rigorous Stress Tests
Rigorous stress tests to be conducted centrally (as opposed to by
national watchdog authorities) that assume an average haircut of 30%
for sovereign bonds of member-states with debt-to-GDP ratio exceeding
70% and a 90% haircut for toxic paper found in the banks books.
The degree of recapitalisation necessary for each Eurozone bank
should be computed on the basis of these tests.
2.1 Banks seeking long term liquidity from the ECB
Funded by net issues of Eurobonds subscribed by the central banks
of surplus economies and sovereign wealth funds, the ECB can make
medium term large liquidity provisions to the private banks conditional
on haircuts on the existing sovereign bonds in their portfolio.
Re-capitalisation of banks should be short-term, once off and
undertaken by the EFSF rather than a future ESM.
It also should be in exchange for equity.
If a bank cannot raise the necessary capital to meet the
re-capitalisation target computed above, then the EFSF (and later the
ESM) should require a swap of capital for public equity in the bank.
The finance for this could be from bonds issued by the EFSF/ESM
rather than national taxation.
The return on the bonds should come from the dividends on the
equity paid to the EFSF.
Summary: The purpose of Policy 2 is to cleanse the banks of
questionable public and private paper assets so as to allow them to
turn liquidity that comes their way in the future into loans to
enterprises and households.
The problem, currently, is that if banks are submitted to rigorous
stress tests, several may be found to be bankrupt.
Thus, Europe needs simultaneously to lean on them to come clean but
also to help them do so without insolvency.
Policy 3 European Recovery Programme
Institutions: The EIB (European Investment Bank), the ECB (European
Central Bank) and national governments
3.1 Co-nancing the EIB commitment to cohesion and convergence
As indicated earlier, since 1997 the EIB has been remitted to
contribute to both cohesion and convergence through investments in
health, education, urban renewal and environment, green technology and
new high tech start ups.
But while it has done so with success, quadrupling its own
borrowing and investments since then, its investments in many cases (as
with the TENS) have been constrained by the national debt and decit
limits of the SGP.
There is a strong case for maintaining that national co-nance for
EIB investments should not count on national debt and that this should
be allowed within the 2005 revised terms of the Stability and Growth
Pact (see below).
But just as EIB borrowing for investment through its own bonds is
not counted against national debt by any of the major Eurozone
countries, nor need be so by others, ECB bonds which could co-nance EIB
investments " by the analogy with US Treasury bonds should not do so
The analogy with US Treasury bonds, which do not count on the debt
of member states of the American Union, should be seized upon.
It would take the brake off the TENs and especially the high speed
rail networks which, in several member states, still are being
postponed because national co-nance counts within the current
interpretations of the SGP.
These in themselves could constitute "1 trillion of investments in
the decade to 2020.
Also, while their environmental impact in the case of motorways is
open to challenge, priority could be given to rail networks which are
both less directly polluting and, in the case of shifting freight from
road to rail, and for medium distances from air to rail, indirectly so.
3.2 Extension of the role of the European Investment Fund
The original design by one of us 4 for the EIF was that it should
issue Union Bonds.
But a parallel recommendation to Delors for the EIF, and which
inuenced his gaining consent from the Essen 1994 European Council to
establish it, was that it 10 should offer public venture capital for
small and medium firms rather than only equity guarantees.
The Council declined this at the time, but Econ, which constitutes
the governing body of the EIB/EIF Group, could remit it to do so.
A similar constraint on EIF finance for small and medium firms and
new high-tech start ups was that it initially would not consider an
application for equity guarantees of less than 15 mecu and then
declined direct applications for such guarantees rather than offering
them through private sector banks or other financial intermediaries.
This was compromised both by the concern of private banks to gain
loan finance as counterpart packaging of such equity guarantees and
denied the original design for the EIF which was to enable SMEs to
avoid the need for interest repayments during the initial years of a
new high tech start-up in which revenue was either nil or negligible.
Econ, therefore, should determine that the EIF, co-nanced by both
EIB and ECB bonds issues, should offer equity rather than only equity
guarantees and do so through "one stop shops" in each of the national
capitals of the EU member states to which SMEs, currently starved of
finance from the concern of banks to recapitalise, can readily have
Summary: Policies 1 & 2 will reduce but not eliminate the
Eurozones sovereign debt and private banking sector burdens
Only development and real recovery will do the trick.
Thus, the Eurozone (especially the periphery that has been in the
doldrums for years) requires a productive investment drive.
This is a task well suited to an existing institution: the EIB.
The EIB has a formal commitment to contribute to both cohesion and
convergence, where key cohesion areas include health, education, urban
renewal and the environment.
However, at the moment, EIB investment projects are co-nanced on a
50-50 split between the EIB and the memberstate in question.
The EIBs 50% does not count against national debt but the 50% of
the member-states contribution, if borrowed, does.
At a time of fiscal squeeze amongst many member-states, these
co-nancing rules severely circumscribe the utilisation of the EIBs
Once, however, member-states have debit accounts with the ECB (see
1.3 above), there is no reason why the member-states 50% co-nancing of
a worthy (from a pure banking perspective) investment project should
not be funded from that debit account (i.e. against the ECBs Eurobonds).
Thus, while the ECB is the guardian of stability, the EIB is the
safeguard of recovery through investments funded by its own bonds and
from transfers to it of net issues of Eurobonds by the ECB.
It already has been remitted by the
European Council to invest not only infrastructure but also areas
of social cohesion including health, education, urban renewal,
environment, green technologies and support for SMEs " all of which are
in the joint EIB-EIF criteria since Lisbon 2000 (the EIF is now part of
the EIB Group).
Moreover, the EIF (European Investment Fund) " as recommended above
" should offer equity capital to new high tech start ups rather than
only venture capital guarantees.
REGIONAL AND GLOBAL IMPLICATIONS
Our Modest Proposal outlines a three-pronged Comprehensive Solution
to the Eurozone crisis that respects three principles: (1) Addressing
the three main dimensions of the current crisis rather than only that
of sovereign debt; (2) Restructuring both a share of sovereign debt and
that of banks; and (3) No fiscal transfer of taxpayers money.
Additionally, it requires no moves toward federation, no fiscal
union and no transfer union.
It is in this sense that it deserves the epithet modest.
Three existing European institutions are involved.
First, the tranche transfer to the ECB stabilises the debt crisis.
Second, the EFSF is relieved of the role of dealing with the
memberstates sovereign debt and, instead, acquires the role of
recapitalising stress tested banks (in exchange for equity).
Third, the EIB is given the role of effecting a New Deal for Europe
drawing upon a mix of its own bonds and the new Eurobonds.
In effect the EIB graduates into a European Surplus Recycling
Mechanism; a mechanism without which no currency union can survive for
But this also has global implications.
There are major structural asymmetries not only within the European
Union but also between different regions of the global economy.
Some of these range wider than the terms of reference of this
For example, consider the Ricardian hypothesis that the pursuit of
comparative advantage will maximise welfare for all economies.
This hypothesis relies (as Ricarco demonstrated himself) on the
assumption of perfect capital immobility.
But in our world nothing is as mobile as capital! Think of the the
combinflation of foreign direct investment and technology transfers
from West to East, and especially the combinflation in China of
transferred capital and technologies with a literate but low cost
labour force (not to mention world class communications and
Such developments have realised the conditions for Adam Smith?s
absolute advantage in a manner that cannot readily be offset only by
exchange rate changes.
In turn, this makes the recycling of global surpluses more
imperative if the G20 is to achieve the more balanced recovery of the
world economy to which it aspires and which even a continental economy
such as China needs given that a major share of its GDP is
Such a recycling of global surpluses to co-nance economic recovery
ensure that Europe sustains global trade while this does not put it
as a Union at risk in view of the fact that, unlike the US, it is
broadly in balance with the rest of the world.
But this also is relevant to a reversal of the beggar-my-neighbour
deation of mutual spending and demand implicit in current EU responses
to the sovereign debt crisis.
For Europe now constitutes a third of the global economy.
If it combines contraction of its own global demand with a serial
default of its most indebted member states, it would risk the
disintegration of the Eurozone which would, in turn, bring about a
terrible condence crisis not only in the EUs economic governance, but
also on markets.
Then the risk of a double dip recession may well exceed that of
2008, spill over to the US and restrain the growth and development of
emerging economies such as China, L.
America, India etc.
Lastly, issues of sustainable development, rather than simply GDP
growth, are central to an agenda for avoiding the second trough of a
double dip recession, as are issues of economic and social inclusion
for not only Europe and the US but also the emerging and less developed
But these should be on the agenda of the G20 with Europe able to
show that it can assure its own economic governance rather than be
mastered by the credit rating agencies and the whims of speculative
The discussion which follows relates these themes to analytic
issues missing from the current debate.
In a sense, the current section seeks to answer some of the
questions that readers of earlier versions of the Modest Proposal have
put to us over the past months.
5.1 The Fallacy in the Crowding Out Hypothesis
The crowding out hypothesis lies behind every recent EU policy for
dealing with the sovereign debt crisis.
It assumes that public spending drains rather than sustains the
private sector and crowds out private sector investment, jobs and
The fallacy in this thinking is not that this may be the case, but
that even Milton Friedman admitted that it only would be so at full
employment, which we do not have.
So far, every cut in public expenditure in Greece, Ireland,
Portugal or Spain has reduced investment and employment.
In short, the EU is adopting policies of cuts on a theoretical
assumption that is false.
5.2 The Neglect of Negative and Positive Multipliers
For Milton Friedman to claim that public investment and spending
"crowds out" the private sector, he had to ignore Keynes" claim for
Multipliers from public expenditures and investment generate jobs
(employment multipliers), incomes (income multipliers); tax from people
in work rather than
unemployed and claiming benets (scal multipliers) and demand for
both investment goods and services from private sector firms (matrix
Under Friedman's inuence, the study of multipliers went out of
But recent ndings from the Observatoire Fran?ais des Conjonctures
"conomiques show that fiscal multipliers range from over one for
Germany to nearly two for France, with a UK investment multiplier of
over three (see table below).
This means that negative multipliers from cutting spending and
investment would mean a contraction of European economies several
multiples more than the cuts themselves.
Multipliers from Public Expenditures and Investments
Biau & Girard (2005)
Giordano et al.
Creel et al.
Observatoire Fran?ais des Conjonctures "conomiques.
5.3 Lessons from the New Deal
As we have repeatedly stressed, a key historical context is the
contrast between what Eurozone governments are attempting now and the
1930s New Deal in the United States of America.
The Roosevelt administration did not seek to put the US economy on
a path to recovery by cutting public expenditure.
Indeed, when it temporarily sought to balance the federal budget,
based on evidence that the crisis had subsided in certain states and
sectors of the American economy, recovery stalled and, in 1938, the
crisis was back with a vengeance everywhere.
Europe, we are afraid, is about to learn the same lesson the hard
But there is another, even more crucial, lesson that European
leaders must learn: the only way of dealing with a debt crisis during a
recession is by restructuring debt rationally and in a top-down
fashion, utilising innovative instruments in order to channel new
borrowing toward the mobilisation of investment (public and private in
which positive multipliers have a key role to play).
In the US case, this involved borrowing to invest in infrastructure
and social projects through US Treasury bills (or bonds).
At this point, it is important to compare and contrast the two
Europe is forcing upon its surplus states the task of raising (or
guaranteeing) loans for the decit states that are to be used not for
investment purposes but in order to repay the quasi-bankrupt banks;
banks whose books are so problematic that they hoard whatever funding
they receive, thus behaving like black holes which absorb, and waste,
the continents economic dynamism.
Moreover, to receive these loans, the decit states are compelled to
cut public expenditure at a time of closures of firms and rising
In turn, the accelerating recession causes a greater shift of
capital and people from the decit to the surplus states while, in
aggregate, demand falls throughout the Union.
5.4 Not yet federal
Had Roosevelt followed that model, instead of issuing US Treasury
Bills to fund the recovery, he would have forced California and the
State of New York to guarantee loans for Illinois and Ohio that would
be dispensed if only the latter experienced reduced state and federal
investment on their territory.
It would have been a recipe for disaster that not even Roosevelt
predecessor (Herbert Hoover) would have fathomed.
And yet, this is precisely what we are witnessing in the Eurozone
as a type of sinister medicine which, rather than curing, is deepening
the current crisis.
In due course some EU member states may seek yet closer Union on a
But this is not for tomorrow.
The current Proposal has the merit of being con-federal rather than
But whether Europe is federal or not, it needs immediately to cut
its current Gordian Knot on debt, rather than vainly seek to unravel it.
Policy 1 of the Modest Proposal squares the policy circle neatly
and requires nothing more than minimal tampering with existing Treaties.
Policy 2 deals with the banking crisis by utilising one of the
existing new institutions (the EFSF).
Policy 3 presses the European Investment Bank into service, turning
it into the engine of growth and recovery that Europe is missing sorely.
5.5 The tranche transfer, economic recovery and the SGP
One of the main implications of a transfer of a tranche of
sovereign debt of up to 60% of GDP to the EU is that the remaining
national debt of most member states would be SGP compliant without
further revision of its rules.
The revised Stability and Growth Pact of March 2005 already allows
that leeway will be given where countries spend on efforts to: foster
international solidarity and to achieving European policy goals,
notably the reunication of Europe if it has a detrimental effect on the
growth and fiscal burden of a member state.
There are four provisions within this text.
The latter two were called for by Germany because of its own
To take them in order:
The European Economic Recovery Programme clearly is a "European
policy goal" which has been adopted by governments and endorsed by the
There has been a "detrimental fiscal burden" for most member states
since they salvaged the toxic debt of major European banks.
There will be a "detrimental effect on the growth" of member states
if fiscal decits are halved by 2013.
A beggar-thy-neighbour deation in a third of the global economy
(i.e. in the EU), if not offset by a counter-recessionary recovery
programme, will do nothing not foster international solidarity.
A tranche transfer to offset (a) the detrimental fiscal burden for
most member states (since they salvaged banks) and (b) the detrimental
effect on the growth of member states cutting fiscal decits are,
therefore, compatible with the revised SGP.
Furthermore, the net Eurobond issues by the ECB ought to be
understood in the context of fullling the European policy goal of the
European Economic Recovery Programme and fostering international
6 Does the proposed tranche transfer require Treaty changes.
The answer is negative
The relevant Treaties from Maastricht to Lisbon do not allow:
The purchase of member-state bonds by the ECB, which effectively
rules out the financing of members states from the "centre".
Cross-nancing between member states " the no "bail out" clause
which renders each member-state wholly liable for its debts.
But the Treaties therefore do not disallow a tranche transfer
since, at the time, no one had considered that there could be the need
Yet nor, therefore, is a Treaty amendment needed for such a tranche
transfer now rather than a European Council decision, whether or not on
the formal recommendation of Econ, that this constitutes a "general
economic policy of the Union in order to contribute to the achievement
of [its] objectives" of which survival of the Eurozone clearly is one
and of which the European Economic Recovery programme is another.
By contrast both provisions i and ii above have been disregarded as
a result of the crisis.
The ECB has been forced to purchase bonds (albeit in the secondary
markets), while debt buyouts involve cross financing of debt between
member states, which our tranche transfer would not.
The same disregard for Treaty provisions is implicit in the
provision that an ESM "if established by 2013" should purchase more
bonds in the primary markets and should require a Treaty amendment
which not only comes with no guarantees that it will carry the needed
consent of all Eurozone parliaments but also risks rejection by the
German Constitutional Court.
The tranche transfer we are proposing is thus far closer to both
the "spirit of the law" and the "letter of the law" compared to current
It is neither a bond purchase nor a form of direct financing.
If the ECB could create, under current Treaties, a portfolio of
bonds purchased in the secondary markets, it can create another one in
which the transferred tranches of hitherto sovereign national debt will
These are not new bonds, they are not bonds purchased by the ECB,
and they do not constitute any form of fiscal transfer as long as they
continue to be serviced, long term, and, in a fiscally neutral manner,
by the member-states.
Thus Policy 1 is not in breach of the Treaties whereas both the
current ECB assets purchase programme and the EFSF are.
Similarly, net bond issues by the ECB to co-nance the European
Economic Recovery Programme jointly with the EIB are not purchased by
the ECB but would 16 be funded by non-EU central banks and sovereign
Nor need they be guaranteed by member states in a manner which
would need to be underwritten by taxpayers" money in the event of a
default (at least not anymore than EIB bonds or US Treasury bonds are).
5.7 Do we need a common debt agency?
Should there be a common European debt agency that issues all
euro-area bonds under strict rules (e.g. debt breaks, constitutional
amendments and balanced budget conditions)?
We propose that there should not, both because this would be
strongly deationary and also because it is not needed either for the
tranche transfer or to achieve a European Recovery programme.
Take for instance ECB governor Lorenzo Bini Smaghi's proposal to
create a European agency that issues centrally all government bonds on
behalf of the member-states.
This is a welcome addition to the debate on Eurobonds which has
broken out only after parallel proposals were made in December last
year by JeanClaude Juncker, Chair of the Eurogroup (and Prime Minister
of Luxembourg), and Italian Finance Minister Giulio Tremonti.
But the Smaghi proposal comes with strict central control of
Given that the EU is not a Federal State, and thus does not feature
a democratically accountable Department of Treasury, allowing a central
debt agency (possibly under the aegis of the ECB and the Commission) to
set the limits of member-state borrowing would be extremely deationary,
especially during an economic downturn.
Given that our Policy 1 introduces Eurobonds as means of financing
only the Maastricht-compliant debts of member-states, and Policy 3
extends the use of these ECB-issued eurobonds only for investment
projects that are centrally approved (on both banking and convergence
and cohesion criteria determined by the European Council for the
European Investment Bank), there is no need for central control of all
Member-state borrowing over and above the Maastricht limit will
carry its own, market determined, risk premium.
Investors then take that risk and thats the end of the story.
5.8 Is Policy 1 inflationary?
A response to Policy 1 is that the tranche transfer we suggest may
prove inflationary or, at the very least, that it will bring pressure
to bear upon the euros international standing (and, thus, its value
relative to the US dollar and other international currencies).
Too much money chasing too few goods can generate demand pull
But shifting savings into investments does not, unless an economy
is already at full capacity a state of things that is as far from
current reality as one can imagine (consider the currently high
structural unemployment of the vast majority of member states)
Scarcity and cost-push pressure can also be inflationary.
But there is no cost push inflation from wages, not even in Germany
(where average wage rises have failed to breach the 2% level).
Where there is inflation this is for other structural and
speculative reasons: structural in the sense that demand for fuels from
agriculture has pushed up the price of food, while demand for both food
and other commodities with high growth from the successful emerging
economies has caused a combinflation of both precautionary and
speculative buying on forward markets.
Rather than a tranche transfer or net issues of Eurobonds being
inflationary, we submit the opposite to be true.
First, the tranche transfer we recommend will be monetarily neutral
for two reasons: it will require no money supply increase (indeed, it
will reduce the current pressures on the ECBs money supply since it
will render unnecessary the continuation of the ECBs bond purchases in
the secondary markets) and, additionally, it will be self-nancing (as
the member states, on whose behalf the Eurobonds will be issued, will
service the Eurobonds long-term).
Secondly, the issue of large quantities of long term Eurobonds will
create a highly liquid market for euro denominated paper of the highest
calibre, the result being that the euro will attract increasing
attention from sovereign wealth funds even to the extent of giving
Europes common currency an edge in the struggle to acquire the kudos of
an alternative reserve currency.
In short, Policy 1 would have precisely the opposite effect,
boosting the attractiveness of the euro and Eurobonds to the worlds
Inversely, a major and sustained European Economic recovery
Programme should ensure that upwards pressure on the euro is restrained.