Saving Europe with sovereign equity

One way to think about the European financial crisis is that it is a matter of capital structure. Countries like the United States and Great Britain are equity-financed, while countries like Greece, France, and Germany are debt-financed. [1] There is no question that some European countries have very real problems. But there is also no question that no matter how badly a country may be arranged, nations cannot be “liquidated”. A “bankrupt” state must be reorganized. If Greece were a firm, a bankruptcy court would not sell critical assets at fire-sale prices, as Greece’s creditors sometimes idiotically demand. Instead, a bankruptcy court would convert debt claims that are unpayable, or whose payment would impair the long-term value of the enterprise, into equity claims whose value would depend upon restoring the underlying enterprise to health.

Greece’s problems are extreme, but by no means unique. European states in general are crippled by overleveraged, fragile capital structures. What Europe requires, in financial terms, is a means of converting some part of member states’ sovereign debt into equity. One solution would be to redenominate the debt of European sovereigns into unredeemable fiat currencies. But that is a particularly extreme solution, and would represent a large setback to the European project. What follows is a more modest proposal to equitize part of European states’ capital structures. The proposal is not original. It is an elaboration of a suggestion by Warren Mosler. It seems politically impossible. But very recently, so did outright default and/or exit of a Eurozone sovereign, yet that political impossibility suddenly looks very likely. The boundaries of the possible are very much in flux. European governance, to its deep discredit, tends to disparage populism in favor of elite technocracy. This proposal intentionally includes a strong populist element.

Without further ado, the proposal:

  1. European governments would define a new class of security: European Sovereign Equity Shares. Governments would issue and sell these securities at par. Dividends would accrue at the Eurozone inflation rate (and negative accruals could occur in the event of outright deflation). However, these would be true equity securities. The timing of any redemptions, whether of principal or accrued dividends, in part or in full, would be at the discretion of the issuing sovereign.
  2. Under certain circumstances (like the current circumstances), member states and the ECB would agree that issuance of sovereign equity would serve the economic interest of the Union. The ECB would agree to purchase up to a certain quantity of each states’ equity shares, which it would carry on its books at par. With any purchase offer, the Bank would announce a maximum balance that the ECB would be willing to accept from each state. This limit would be equal for all states in per capita terms. For example, the ECB might set the maximum equity balance might at €20000 per capita. If that announcement were made today, it would mean that Greece could issue roughly €226 billion of shares, while Germany could issue roughly €1.6T. The maximum balance per country would be set at the time of an offer, and would not automatically change with population shifts. However, up to that balance, the policy would amount to a standing offer to purchase shares. Even if a sovereign has redeemed shares, should it have the need, it may issue new shares, and the ECB would purchase them, up to the ECB’s current limit for that country.
  3. Purchase of equity by the ECB would be contingent upon member states agreeing to use the proceeds precisely as follows:
    1. First and foremost, any proceeds must be used to retire or repurchase the sovereign’s debt.
    2. Should the proceeds of any sale exceed the sovereign’s outstanding debt, the excess must be distributed directly to citizens in equal amounts.
    3. Distributions to citizens would be under analogous terms. Before receiving any cash benefit, citizens would be required to apply their allotments to retiring or defeasing outstanding debts. Only once all debts are retired would citizens receive a check, with which they could do as they please.

That’s basically it. This sounds opaque and technocratic. Why do I claim that it’s a good idea and also populist?

The reason it’s a good idea is because it does what obviously needs to be done in Europe, which is to eliminate the tyranny of zero. Suppose that Germany’s net financial position (however you want to compute that) is €30000 per capita while Greece’s is €5000 per capita, because Greeks have consistently consumed a greater fraction of their income than Germans. That’s fine and right: for whatever reason, the Greeks have saved less than the Germans, and therefore have a lesser claim on future consumption. But now suppose Germany’s net financial position is €10000 per capita while Greece’s is negative €15000. The difference in wealth, in absolute terms, is identical, but around and beneath zero all kinds of “distress costs” kick in. Loans go unpaid, interest rates spike, politics get ugly, etc. etc. (You don’t have to imagine. Just read the news.) The effect of this proposal, in practical terms, would be to shift the zero point. If Greece and Germany both issue €20000 per capita of sovereign equity, the non-equity financial position of both states shifts upwards, reproducing the first hypothetical. The operation keeps the absolute wealth difference intact but eliminates distress costs. Of course, a sovereign’s issued equity represents a liability to the ECB, so each sovereign’s overall financial position has not changed at all. But equity, redeemable at the discretion of the issuer, does not provoke distress costs, while a debt position very much does. For sovereigns as for corporates, capital structure matters in the real world. The long-term value of a distressed enterprise can increase dramatically if it is able to convert an unserviceable debt position to equity.

But why is this a populist proposal? What pisses off ordinary humans, quite legitimately, about bailouts is that they undermine the moral environment, the “karma” if you will, that we try to construct in our communities in order to preserve and sustain the social norms that is the “secret sauce” of every good society. It is corrosive if policy interventions render those who are industrious and prudent no better off than those who are reckless, indolent, or predatory. However, we needn’t (and ordinary humans don’t) demand that people who are reckless or disorganized be condemned to starvation or misery. What matters is that the industrious fare significantly better than the indolent. If an ordinary German citizen gets a €15000 check (or €15000 of burdensome personal debt forgiven) while an ordinary Greek gets nothing other than the vague knowledge that politicians have squirmed out of the debt they have accrued, that sustains the difference in reward. Ordinary people in rich countries are likely to be more open to a proposal that involves their receiving a nice check (while their counterparts in less disciplined countries get nothing at all) than they would be to a “transfers union” that implies their cutting a check to those who behaved poorly while seeming to get nothing in return.

But what about inflation? Does this just amount to a scheme to hide transfers from rich countries to poor behind a money veil? No, or not entirely. First off, many of the distress costs associated with insolvency are deadweight losses, not transfers. The benefit of preventing the burning of Athens does not impose any offsetting cost on Berliners. Shifting the zero point is just a good idea. Second, for the Eurozone as a whole, inflation need not rise at all. The ECB has the tools to combat a general inflation, if it wishes to. When inflationary pressures arise, the ECB can raise interest rates. In terms of Eurozone-wide consumption, the value of Germans’ new Euros can be sustained. The distribution of inflation rates across the Eurozone would likely be affected, in a way that disadvantages citizens of rich countries. Status quo inflation targeting across the Eurozone tends to distribute inflation towards current-account deficit countries, reducing their relative competitiveness and exacerbating the imbalance. Cash grants to citizens in rich countries reverse the maldistribution of inflation, raising income and prices in countries that are generating unsustainable current-accunt surpluses. If Germans but not Greeks receive €15000 grants, prices of German goods will rise relative to prices of Greek goods. At the margin, this will increase Germans’ propensity to spend their newfound wealth in Greece and help restore financial balance.

Further, the proposal creates a new policy tool by which countries can individually take some control over their own price level, helping remedy the “one size fits all” limitation of European monetary policy. Remember, the German government would have the right, but not the obligation, to issue sovereign equity in excess of its debt and distribute the proceeds to its citizens. To whatever degree the German polity values price stability over access to wealth on very easy terms, the German polity can choose not to issue. It loses nothing by doing this: it retains the right to issue equity and distribute the proceeds whenever it judges that its domestic economy would be helped more than harmed by a bit of “helicopter drop”. As a matter of political economy, when the ECB’s equity limits are raised due to a crisis in some corner of the Eurozone, solvent countries might wish to issue some equity and distribute the proceeds, to buy the support of citizens and sustain the sense of reward for collective prudence. But they could leave much of their capacity in reserve for a future domestic slump.

One genuine downside of this scheme is that it fails to distribute losses to foolish rich-country lenders, and therefore might encourage reckless lending to and borrowing from spendthrift countries going forward. Persistent current account imbalance is, I think, very dangerous and corrosive, and should absolutely be discouraged. Very few proposals credibly address this. Under current arrangements, trying to punish foolish lenders generates a crisis that threatens the existence of the Euro. The leading maybe-reform, a European stabilization fund financed by “Eurobonds”, would bail out creditors and impose deadweight austerity costs on debtors. It is naive to think that imposing harsh austerity on debtors will prevent intra-European debt crises going forward. In human affairs at every level, it is creditors, not debtors, who provide or fail to provide practical limits on bad lending. An individual person or government may be prudent and refuse to borrow funds they’ll be unable to invest and repay. But in any population of humans, and in most countries as governments change over time, there will always be people willing to take loans and consume the proceeds recklessly. The only way to prevent that behavior from causing systemic problems is to insist that creditors take responsibility for their loans. (Note that the roles of creditor and debtor are asymmetrical. Many humans have an innate impulse to spend recklessly that is not matched by an innate impulse to lend recklessly. Trying to punish foolish borrowing is fighting human nature in a way that insisting reckless creditors bear losses is not.)

The current proposal punishes creditors insufficiently. But it does punish them some, by reducing their relative advantage over debtors. Going forward, if it were up to me, I’d insist that bank loans to sovereigns other than a bank’s “home” sovereign carry the same risk weighting as corporate equity, and I’d tax cross-border fixed-income investment. But those are topics for another time.

This proposal would defuse the current crisis. And it would create a permanent mechanism for dealing with future crises. It does not pretend (absurdly) that interventions are “one-offs” that absolutely, positively, will never be repeated. The ECB can purchase sovereign equity whenever a systemic debt crisis threatens the Eurozone.

Enabling sovereign equity issuance would enlarge the space of macroeconomic policy options, both at the level of the Union and at the level of individual member states. Distributing the proceeds of equity sales (after debt retirement) directly to citizens means that crises get resolved in a manner that is comprehensible and fair to ordinary people. Nothing explodes. Citizens of countries that adequately discipline their governments and banks occasionally receive large checks. Citizens of less careful countries do not, and look across their borders with envy.

[1] If you don’t get this, think about it. The sine qua non distinction between debt and equity is involuntary redemption. The issuer of a debt security must redeem it for something else, either on a fixed schedule or on demand. Equity securities are redeemable only at the issuer’s discretion. Great Britain and the US finance themselves by issuing 1) fiat currency, which is plainly a form of equity; and 2) securities that convert to fiat currency on a fixed timetable, or “mandatory convertibles” to equity. In both cases, bearers have no right to demand redemption of the issuer’s paper for anything other than, well, the issuer’s paper. Just as firms that issue equity work to maintain the value of their equity despite the absence of any right to redeem, Great Britain and the US work to ensure that their paper is valuable in secondary markets by a wide variety of techniques, including taxation and the payment of interest. But all of those manipulations are at the discretion of the issuing sovereign. Great Britain and the United States have all-equity capital structures. Greece, France, and Germany finance themselves by issuing securities that are redeemable on a fixed time table for Euros, an asset which those states cannot issue at will. Greece’s sovereign debt is in fact debt, while the United States’ “sovereign debt” is a form of equity.


68 Responses to “Saving Europe with sovereign equity”

  1. JKH writes:

    Preliminary thoughts:

    Your debt/equity distinction seems parallel to the MMT theme that sovereign currency issuers don’t have to issue debt. In that light, debt is technically redundant from a capital structure perspective. So you might say they don’t issue debt, in effect. You label that equity.

    Similarly, your implicit criterion for redeemability reflects the object being exchanged in redemption. The Euro is in effect a foreign currency for all involved governments. The dollar is not for the US government. So your debt/equity distinction seems similar in that way to the MMT currency user/issuer distinction.

    However, I see nothing operationally preventing the US government from issuing similar “equity” securities as you describe.

    Then we would have intersecting distinctions – sovereign currency issuer debt as equity; and sovereign currency issuer debt and equity securities.

    Looking at your classification of US debt as equity, for example, there is no effective redemption option from the perspective of currency issuance in the sense of principal amount. But there is a redemption option from the perspective of pricing. At maturity, the nominal debt holder gets to redeem existing pricing for new pricing. The nominal equity holder would not have to do that. That’s a distinction within the currency issuer framework.

    In total, I see at least 3 different potential interpretations of equity within this subject matter:

    a) Your currency issuer as equity issuer distinction

    b) Your equity security design as a distinction within a currency user framework

    c) The “book value” of equity for any cumulative deficit spending position – which is the negative inverse of the debt issued, whether the issuer of debt is a currency user or sovereign currency issuer. Such book value is the inverse to the “net financial asset” position provided to government as per MMT. It has an interpretation, and not necessarily an unfavorable one merely because of the “negative” direction of it.

  2. JKH writes:


    “Such book value is the inverse to the “net financial asset” position provided to non-government as per MMT.”

  3. Mattay writes:

    Good post. I think this would stop the immediate crisis. But I am not sure if it would necessarily fix structural problems like higher unemployment in Greece/Spain. And if immediate disaster is merely averted but those structural problems are not fixed, public support for the Euro will continue to wane in periphery countries. And that’s a problem for European elites, if they genuinely want to preserve the EMU.

    Where else have I heard non-convertible debt or currency referred to as equity?

    Here, from Chris Cook.

  4. homunq writes:

    Truly awesome. You’ve restored my optimism about the world.

    Now, you gotta neasy solution fer climate change up yer sleeve, too?

    (I would have asked about US political deadlock, but I already have the answer for that one: )

  5. Morgan Warstler writes:

    I have been advocating the same basic idea be PITCHD politically by the quasi-monetarist crowd.

    It is the only chance they have. Mosler steals from the best! And you steal from Mosler- who is tard.

    Here’s the the plan I have pitched for two years:

    Take the newly printed money and give it to the Tea Party directly… those folks who have savings and have not gotten in over their head on a a mortgage… the savers.

    Keep printing money and giving it to them, until they finally employ all the unemployed.

    Pay off the people hurt most by inflation, and let those in debt out ONLY as everyone else continues to rise above them.

  6. JKH writes:

    “If Greece and Germany both issue €20000 per capita of sovereign equity, the non-equity financial position of both states shifts upwards, reproducing the first hypothetical.”

    I think I know roughly what you’re getting at here, but I’m having difficulty visualizing what the calculation is. E.g. a typical household net worth calculation (e.g. fed flow of funds) includes government debt as assets but not as liabilities. A different type of consolidated calculation would zero out financial assets of all types. Is there a net position calculation of this genre for which the government liability position becomes an overall net negative in the calculation (other than the government position itself, which I don’t think is what you’re referring to, or is it)?

  7. JKH writes:

    Oh … maybe you mean the international investment position (cumulative current account).

  8. […] One solution for Europe: Selling sovereign equity instead of sovereign debt — Interfluidity […]

  9. Scott Fullwiler writes:

    Good stuff, Steve! I like the way you enable Mosler’s per capita transfers without destroying the eCB’s capital and instead expanding its balance sheet. Warren’s proposals has fewer if any constraints on what the transfers can be used for, but that’s small potatoes, and your suggestions make sense given the current circumstances. You end up with Mosler’s outcome largely, too–those who have been “good” can spend the money; those that haven’t can’t.

    I find the national equity issuance idea on its own quite interesting and consistent with our thinking. It also made me think of how John Cochrane equates national debt issuance with equity issuance by companies when he’s describing his version of the fiscal theory of the price level.

  10. Fed Up writes:

    “Persistent current account imbalance is, I think, very dangerous and corrosive, and should absolutely be discouraged.”

    So how about stop issuing any debt (private or gov’t)? In most cases, is it the debt that allows the CA imbalance to build up over TIME? If there were no debt, would the currency adjust quickly/quicker and not allow a persistent current account imbalance (usually deficit)?

    “The only way to prevent that behavior from causing systemic problems is to insist that creditors take responsibility for their loans.”

    IMO, the best way is to have no debt. No debt means no debt defaults and debt repayments lowering the amount of medium of exchange. Fewer problems in the economy.

    As far as equity-financing, how do you “equity-finance” medium of exchange?

  11. Patrick writes:

    If Greece were a firm, a bankruptcy court would not sell critical assets at fire-sale prices, as Greece’s creditors sometimes idiotically demand.
    Perhaps not but private creditors might and in fact often do. Is the EU a bankruptcy court or a private creditor?

    If you think the EU is basically Germany, then ..?

  12. rsj writes:

    It’s a great post, but I’m not sure how this pencils out.

    Yes, equity does not require fixed payments, but by the same token it is not valued at par. The mechanism that equity holders have of demanding higher yields is to reprice the equity until the yields are the level demanded.

    Central banks typically used cash-flow based rather than accrual based valuation techniques, but they purchase finite lived instruments with fixed payouts.

    Your proposal still has a capital hole, but it is hidden with the use of purchase-cost valuation based on an eternal asset.

    Therefore I don’t see how you can maintain this situation apart from a ZIRP environment.

    If we are not at ZIRP, then how does the ECB sterilize the distributions? If it sells the equity, the market will not price it at par. You are back to your capital hole problem.

    If it does not sterilize the distributions, then how does it maintain a positive interest rate? IOR? In that case, the ECB’s capital position will quickly drain away.

    In other words, over the long term, I don’t think you will succeed in hiding the capital hole by valuing the equity payments at par.

    After X number of distributions and sterilizations, the ECB will run out of assets that it can sell to sterilize the transfers, that is, it will run out of accurately priced assets, and it will be left with assets that, on its own books, may be valued at par, but which cannot be sold at par to the private sector in attempts to drain excess reserves. At that point, the ECB can only grant another distribution one last time, and then on keep rates at zero or pay IOR.

    This is very similar to attempts to convert the ECB into a zombie bank, or bad bank, and the same dynamics will force the balance sheet to be brought in line with the market value of the equity. Basically when the bank runs out of fairly valued assets that it can sell.

    On the other hand, if you really believe that the equity payments will be accurately priced — that is, that they will yield regular dividends, then this is nothing more than having the ECB re-finance for the member governments, with the wealthier member states ultimately guaranteeing the obligations of the poorer states.

    It will not make fundamentally insolvent nations solvent, it will only eliminated the unstable spiral of high risk leading to a worse balance sheet and more risk.

    The underlying problem of trade and income balances will remain.

  13. Steve Randy Waldman writes:

    JKH @ 1 — Insightful as usual. Yes, the debt / equity distinction parallels the MMT currency user / currency issuer distinction. And yes, nothing prevents the US government from issuing things it calls equity securities that would be purchased by its central bank, although there is little need for it, since markets already interpret US debt as equity (they don’t behave as if there is nontrivial risk of more than a technical default, but the price of US debt does in general vary with valuation, i.e. inflation expectations). Investors in US debt assume that promised mandatory conversions to US dollars will be honored (with perhaps a small risk of political delay), and they value US dollars as traders value equity, with a small part of fundamental analysis and a large part of extrapolation from current pricing and recent history.

    You are very right to point out that US debt securities do redeem for variable prices: US debt holders face reinvestment risk that equity holders do not, as well as valuation/inflation risk (which equity holders do face). But we could imagine firms issuing mandatory convertibles with an in-kind variable dividend yield. This would generate a capital gains and losses for some holders, and enable varieties of market timing and speculation not typical of equity markets. But it wouldn’t eliminate the equity-like nature of the securities, as all redemptions (“principal” and “coupon”) would be conversions to equity. The issuer is never subject to an essential characteristic of debt: some portion of the possible state space in which the promises it has made cannot be kept and therefore the value of all claims becomes subject to unusually radical uncertainty.

    Price-stability commitments confer a bit of a debt-like quality to fiat currency. I wrote that it is “involuntary redemption” that is the sine qua non of debt, but as we remind libertarians ad nauseam the question of what is “voluntary” is a matter of degree and circumstance more than formal legal categorizations. It may be formally “voluntary”, but it is practically compulsory, if my alternative to taking a job is starvation. Similarly, fiat currency becomes debt-like when the political cost of any violation of the price stability commitment is catastrophic. Suppose a country adopted a currency board that pegged the value of its currency against the price of a bundle of commodities (via open market operations rather than a general offer to redeem). If users of the currency rely on that commitment, and if a violation of that commitment would lead to a flight from the nation’s banks, and a collapse of its financial system and government, then the currency is very debt-like, even though the issuer makes no direct promise to redeem. Alternatively, if a country’s price stability commitment is looser, if users of the currency anticipate and accept volatility in the price level path and the governance and financial system is robust to that, then the currency is equity-like. There are still costs to violating the price stability commitment, just like firm managers find their lives made less pleasant when share values fall. But as costs shade from “utterly intolerable” to “manageable”, as actions to sustain a price level commitment given trade-offs with other objectives shade from “compulsory” to “voluntary”, currency shifts from debt-like to equity-like. In the US, Great Britain, and Japan, currency is clearly very equity-like. One can imagine, however, a developing world currency issuer whose population is very sensitive to the prospect of inflation, and who would run from the currency catastrophically if there were any hint of devaluation. We further imagine that the country does not have the practical ability to coercively prevent such a run at tolerable cost. For such a country, despite its currency-issuer status, currency would be debt-like, not equity-like, and MMT-ish intuitions about currency issuers would fail to hold.

    Your (c) is very much like the equity position of a firm. The equity position of a firm has a negative sign: it is a claim against the firm and sits on the liability side of the balance sheet. But because the securities are equity, and ultimately all of a firm’s assets are offset by claims, the magnitude of that negative value is more a strength than a weakness for a firm, as the part of a firm that would not be matched by an equity-liability would otherwise be matched by a much more onerous debt liability.

    For states, the analogy breaks down a bit: Most claims against the state are held by informal equity claimants: citizens expect certain benefits and services to be provided by the state, but the state has a great deal of discretion over whether, how, and when those expectations are met. Formal financial claims against a state therefore displace more-equity-like claims rather than the less-equity-like claims displaced by equity on a corporate balance sheet. Securities like the ones I propose would be less burdensome than formal debt for a country like the US, so if the US did issue such things, the informal claims of ordinary citizens might be advantaged in the “tranche warfare” that occurs between formal financial claimants and informal equity claimants of the state.

  14. Steve Randy Waldman writes:

    Mattay — The analogy between fiat currency and equity is not new, here or elsewhere. (you’ll find it referred to or hinted in several older interfluidity posts, i’ve seen mencius moldbug make the analogy, and “fiscal theory of the price level” economists have made it since the 1990s, see e.g. Christopher Sims, John Cochrane.) Which isn’t at all to belittle the Chris Cook piece you linked, which is insightful.

  15. Steve Randy Waldman writes:

    homunq — Thanks! And thanks for the link to the collaborative document on alternative voting procedures, which I look forward to reading.

    (I don’t have very much up my sleeve re climate change, except that I’d like to see a high carbon tax fully rebated to the general public in the form of flat transfers. This undoes the regressiveness of a carbon tax, as poorer people consume less than richer people, and so pay less of the carbon tax, but receive an equal share of the rebate. But the tax has to be on carbon generally, not just a gas tax, because gasoline usage and wealth don’t correlate as much as wealth and broad carbon consumption.)

  16. Steve Randy Waldman writes:

    Morgan — I’m glad we’re on the same wavelength.

    I’m not sure I love the idea of favoring the savers, though. On the one hand, they were prudent and saved. On the other hand, they did a poor job of monitoring how their savings were invested and were dramatically bailed out by the state already to evade losses on the real projects that their deferred consumption endowed. Going forward, I think we need to do a much better job of drawing lines between modest savings, for whose stewardship savers need not take responsibility because we make an explicit policy choice to guarantee them, and larger nest-eggs for whose investment owners must take responsibility. But we failed to do that (limits on deposit insurance are ridiculously porous and were waived in the crisis), and have bailed out savers large and small, in large amounts and at the expense of everyone else. I’m unenthused about adding to that subsidy.

  17. Steve Randy Waldman writes:

    JKH @ 6 & 7 — Yes, that’s right. I’m being intentionally loose about definitions, but broadly I’m consolidating the financial positions of the private and public sector, and looking at the domestic/external balance. Internal imbalances can in theory be managed by domestic institutions and transfers, although that is not to say that domestic imbalance in the context of promiscuously international institutions can’t provoke crises that lead to external contagion.

    You’ll note that my equity proposal is designed to reduce indebtedness of both the private and public sectors. As we’ve seen in Ireland and Spain, in the context of international crises, private and public financial positions are de facto consolidated by the demands of external creditors.

  18. Steve Randy Waldman writes:

    Scott — Thanks! The balance sheet part is largely a matter of accounting formalities; the balance sheet of a fiat-issuing central bank has a very different meaning and requires different interpretation than that of a currency user. (A fiat issuing central bank cannot be illiquid, and one of the core purposes of a balance sheet is to predict the likelihood of a liquidity problem even in the context of rich financial markes. A balance-sheet-insolvent firm will be unable to raise cash and will suffer a liquidity crisis where a balance-sheet-solvent firm can borrow, but that’s irrelevant to central banks.)

    The constraint on the use of funds is very intentional. I think one of the reasons why people are very resistant to fiscal interventions, no matter how macroeconomically justified, is the sense (often justified in my view) that existing real governments will misspend and transfer wealth corruptly. Monetary interventions also involve questionable transfers, but the mechanics of those are opaque and so they are more widely tolerated. “Sound money” people, understandably in my view, want to foreclose both fiscal and monetary intervention not primarily because they disagree with the theoretical macro, but because they believe that the institutions that implement policy are not neutral, and they are more outraged by immoral and corrupt transfers than they are troubled by a sub-par economy. So I see the question of how to implement “fair” and “neutral” interventions as central, both as a political matter, and as a policy matter. (I think the sense that institutions are corrupt is ultimately very costly to a polity, in tangible economic terms as well as “spiritually”.) My proposal doesn’t entirely ensure neutrality — after all, the public debt that is extinguished represents the residuum of past transfers that may have been corrupt, and the availability of “sovereign equity” in extremis might promote corrupt public expenditure at the margin. But at least “windfall gains” to relatively disciplined polities are distributed in a way that is likely to be fair and to not create corrosive temptations for rent-seeking.

    Cochrane certainly makes the currency/equity analogy quite prominent. I’ve found the analogy a useful way to make MMT-ish intuitions comprehensible to people with a conventional finance background.

  19. Steve Randy Waldman writes:

    Fed Up — I agree, broadly: First best, to avoid bad spillovers, is to prefer explicit equity arrangements to anything that even looks like debt. Debt securities and money always blur, and things that are money-like create a sense of entitlement that often leads to poor risk management and forces a state guarantee. So if we could just ban debt and have an all equity world that would be better. Except if we did that, the quantity of investment would drop dramatically (most investment is financed by debt, not equity, and investors do not view the two forms as close substitutes). So we’d have to find some other, more transparent means of encouraging investment than the quasisubsidy implicit in the quasiguarantees that surround debt.

    The medium of exchange is, I claim, a form of equity (in the US, Great Britain, Japan, etc).

  20. Steve Randy Waldman writes:

    Patrick — In a corporate setting, private creditors can only insist that assets be liquidated at fire-sale prices when a bankruptcy court approves of that. Bankruptcy courts in practice are unpredictable things. But in theory, a court should refuse to allow such quick liquidations during a reorganization (Chapter 11 bankruptcy in the US), if allowing them would impair the long-term value of the reorganized enterprise. It doesn’t matter whether some creditors wish to “get out quick at any price”. In a reorganization, the court has a duty to maximize the value for all creditors, which means maximizing the value of the enterprise.

    In a liquidation (Chapter 7 bankruptcy), bankruptcy courts understand that the scrap value of assets is far less than its going-concern value, and are more tolerant of “fire sale” pricing. The enterprise has no long-term value; it is being liquidated, and the goal is to maximize short-term liquidation value, which is inherently impaired.

    Greece right now is undergoing a process that in theory should be like a Chapter 11 reorganization, but it lacks the protection of a bankruptcy court. It is being forced by external creditors which, for political reasons have a short time horizon, to sell assets at whatever price a quick market will bear regardless of the effect on Greece’s long-term prospects. That is, Greece’s insolvency is being treated like a liquidation when in fact it is a reorganization. That is much harsher on Greece’s long-term stakeholders than a private bankruptcy reorganization would be, and may leave the country unnecessarily crippled going forward.

    If the EU really wants to use sovereign insolvency as a means of fiscal discipline, it had better invent the equivalent of Chapter 11 bankruptcy, with provisions to protect long-term enterprise value. An ad hoc in-swoop of creditors is the worst of all possible worlds.

  21. Steve Randy Waldman writes:

    RSJ — Great points, but I think I can address them.

    The core question is the degree of the capital hole created by purchasing sovereign equity. There certainly is a subsidy implicit in purchasing equity on the generous terms that I have described: Private claimants would require a much higher rate of return than what I’ve proposed to hold Greek equity, for example, and would be unwilling to hold it at all without stronger incentives for the sovereign to redeem (in part via dividend payments or in full). But the subsidy takes the form of a submarket return, not a capital loss, if (and this is the essential point) the member state will be able to redeem the equity over the long-term.

    It’s not my intention, in proposing this, that the ECB absorb permanent losses relative to the book value of purchase. The ECB, under this plan, would be taking a simple bet: if we help the member states (as a group) through the current crisis, all member states will enjoy a real growth rate greater than zero. As long as that growth is not accompanied by a recurrence of the same unsustainable debt growth, eventually the equity claim will be small relative to GDP and the issuing member state will be able to redeem it without difficulty at the request of the ECB at some point in the indefinite future.

    If this plan is adopted without other reforms to prevent a recrudescence of debt crises, so that the ECB is required frequently to equitize member state debts, then some of the dynamics you describe will come into play. Ultimately, real economics bites. If the EU as a whole invests its real resources poorly, leaving as an accounting record bad debt, then either those debts will have to be written off or monetized with tolerance of inflation as money is issued despite a scarcity of real goods. This plan cannot prevent the real consequences of real error. But at the moment, the actual losses are affordable. Europe as a whole retains the capacity to produce goods and services at anticipated levels, but financial arrangements mean that some entities are formally insolvent and others are risk averse. So this is exactly the sort of situation where a restructuring of financial claims can restore output without requiring an sharp upshift in the price level.

    The only European country that arguably is hopelessly insolvent is Greece, which in the worst case could create a small capital hole for the ECB. But even there, if Greece is forced to adjust by virtue of an elimination of its capacity to borrow externally going forward (which should occur no matter what) but without the burden of debt service, there is little reason to think it will fail to find some means of putting its taxation and expenditure into balance and start to grow. A patient ECB can do what every major Western bank is trying to do, and grow its way out of a loss the size of Greece over time. Most of Europe doesn’t face remotely similar challenges on a forward-looking basis, especially if reforms to ensure current account balance going forward are put into place. Irish equity, Spanish equity, and French equity would not be overvalued at par, as long as equity-purchase-necessitating crises are kept rare. This equity would not be marketable, but over time it could be redeemed on request of the ECB.

    Let’s talk a bit about the mechanics that you point to. The sale of sovereign equity would dramatically increase Euro reserves, which would potentially force interbank rates to zero. Suppose that the ECB wishes to set a higher policy rate. Then it has three options: It can 1) sell assets to suck reserves back into alignment with banks’ demand at the required rate; 2) it can pay interest on reserves at the desired policy rate; or 3) it can raise reserve requirement to bring banks’ demand for reserves into alignment with supply at the desired policy rate.

    Member state equity would not be readily marketable, so this proposal constrains option (1). Depending on the overall mix of the ECB’s asset position, it might have sufficient other marketable assets with which to suck in reserves, or not. Suppose not. Then the ECB will have to rely upon other tools. But note that its situation would be similar to the status quo, under which the ECB has been forced to purchase sovereign debt from troubled states that is not marketable. I claim that in real terms, the ECB’s situation would be better, because it would have increased the likelihood that the long-term value of its assets will be good. But in the short-term, whether the ECB holds crappy Greek debt or unmarketable Greek equity, it faces a problem if it runs out of other assets to sell for reserves.

    So it might pay interest on reserves at the policy rate it desires. As you point out, over time, this might put its capital position under pressure if its policy overnight interest rate is much higher than the Eurozone inflation rate. However, if we believe that the sovereign equity represents a long-term good asset, that’s a slow burn at worst. In the US at least, the Federal Funds rate has typically been less than the consumer inflation rate. If Europe is similar, we might adopt a conservative rule and let the ECB book gains at the minimum of the policy interest rate and the Eurozone inflation rate. (On redemption, then, there would still be a gain as the accrued inflation exceeds the overnight interest.) That will leave the ECB taking net capital hits occasionally, when it has tightened the policy rate sharply so that it briefly exceeds the inflation rate. But those spikes are (at least in the US experience) very rare. If we wish to be very jealous of the ECB’s book solvency, we can let it book inflation accruals in full, and it will generally book a profit on the swap of equity for interest-paying reserves.

    In general, paying interest in reserves is not a big stress on central bank capital, because except when the yield curve is inverted, the assets it purchases as it rolls over its portfolio pay higher than the overnight interest rate. Sovereign equity would create an opportunity cost for the ECB — it would fail to realize cash flows, and realized accruals would be lower than if it had purchased government paper. But it will not create a capital hole.

    Finally, in extremis, the ECB has option (3): it can raise reserve requirements. This, as JKH helped to work out with me in the comments of the previous post, amounts to a tax whose incidence falls either on banks, borrowers, or depositors (I claim it falls on depositors). In a macro sense, this potentially creates a cost, by for example increasing the cost of bank finance (if much of the incidence is on borrowers). But if we are above the zero bound, the central bank can offset this by choosing a policy rate lower than it would have chosen without the tax. Further, the total cost to the private sector of the reserve requirement is identically the spread the central bank earns from its asset portfolio. The existence of zero-cash-flow, low-return equity in the central bank’s balance sheet reduces this spread, and therefore the total cost to the private sector of the reserve burden. A part of this “tax” won’t be paid at all in real time, but will be paid eventually when member states redeem, which will be moments when the macroeconomic burden of the tax is low.

    In sum, it really won’t be very difficult for the ECB to carry sovereign equity without surrendering control of interest rate or generating a hole in its own capital position, if equitizations are infrequent and the total value of equity on the ECB’s books grows more slowly than Eurozone GDP.

    Now suppose that Europe fails entirely to get its stuff together, and it broadly turns into pre-Euro Italy. Then, from an accounting perspective the ECB still has little problem, but it will fail to meet its macroeconomic objectives. It will be, as you put it, a zombie bad bank. Every five years the ECB buys a lot of sovereign equity to prevent yet another debt crisis. It will dutifully book gains on those assets at the (probably high) CPI rate, and its balance sheet will grow without bounds, with reserves on the liability side and very questionable equity on the asset side. If the ECB pulls a Volcker and raises the policy rate substantially higher than the inflation rate, it will take a capital hit. If it does that for a long time, it could find itself with negative book equity, but that’s not so likely. Alternatively, the ECB could do what bad central banks usually do and tolerate inflation post-monetization, which would enhance its book capital position. In either case, if Europe as a whole fails to organize its real investment reasonably, something bad will happen, either a central-bank imposed recession or a spiraling inflation, as the bank monetizes a continually growing “equity” position that everyone knows to be without real value.

    All of this is to say that sovereign equity is not a panacea. It cannot magically fix the consequences of continually squandering real resources. Sovereign equity is just a much less fragile, much less contentious substitute for status quo debt purchases by the ECB. Equity and continuously-rolled-over low-interest debt are, to a first approximation, the same thing. But the first approximation hides the instability caused by endless decision points and endless justifications for paying above-market prices on reissued debt. If Europe is to succeed, the ECB’s interventions, whether it purchases debt or equity, will serve as bridge financing over the course of a reorganization of Eurozone financial arrangements that prevents future debt crises and allows member states to grow out of past errors. If the EU fails to pull that off, sovereign equity can prevent some unnecessary distress costs and buy some time until the next crisis, but if crises recur frequently, bad things will still happen.

  22. Chris Cook writes:

    I have been advocating Sovereitgn Equity for maybe a couple of years now.

    As I have pointed out in response to Warren a couple of times, such a credit instrument already exists in the form of the UK Perpetual Annuities known as Consols which have been around for hundreds of years and actually pre-date the UK National Debt. Contrary to the informative but misleading Wikipedia Entry Consols are not a bond, which is a debt instrument, but are ‘Stock’, which is a credit instrument, and is a term dating back to national accounting by tally-sticks

    One of the refinements was to make the two halves of the stick of different lengths. The longer part was called stock and was given to the party which had advanced money or (other items) to the receiver. The shorter portion of the stick was called foil and was given to the party which had received the funds or goods..

    But I digress.

    This Consolidated Stock pays a return in perpetuity, unless the Stock is redeemed, and Consols are therefore akin to Redeemable Preference Shares in UK Plc.

    My proposal Cook’s Consol Plan for Greece would create a single continuum of Sovereign Equity to replace all existing sovereign debt, and this would have enormous benefits both in terms of funding costs and in liquidity, since all of the fragmented issues; dates and interest rates may be consolidated into a single asset class.

    Such a 21st century debt resolution and ‘consolidation’ would be a type of debt/equity swap, and several economists – including Buiter and Taleb – recognise that if debt is unsustainable then equity may be an alternative.

    During the breathing space given by such a resolution of sovereign debt to sovereign equity, it goes without saying that Greece’s economy would then have to transition to a sustainable fiscal footing so that the Greek sovereign equity has a real and sustainable basis, and Greece does not end of as a sovereign version of ‘The Producers’.

    That, of course, is another story.

  23. JakeS writes:

    I am deeply skeptical of inflation-indexed instruments (whether debt or equity), because in the presence of a large negative shock to real GDP, they will explode. And since large negative shocks to real GDP are already extraordinarily unpleasant experiences for the relevant polities, compounding them by having inflation-indexed securities go off like firecrackers all over the places strikes me as… counterproductive, shall we say. Indexing to nominal GDP preserves the inflation protection without insulating creditors from the real economic consequences of the existence of real sunk costs.

    I would further argue that while this is an interesting and instructive proposal that illustrates some of the flexibility sovereigns have in their macroeconomic planning… it is ultimately either unnecessary or impotent. If the “Hanseatic” members of the €-Mark stop pursuing irresponsible wage suppression policies, and allow current accounts to regain sustainability through greater imports from the “Mediterranean” members, then there is nothing wrong with the current situation that cannot be solved by a string of private and sovereign defaults. The ECBuBa would have to provide unrestricted liquidity to tide the bankrupts over the 18-24 months of hysterical tantrums by the private money markets that follow a sovereign default, but if unsustainable CA balances are eliminated going forward, the formerly bankrupt sovereigns would be solvent, so that would not be a problem.

    But if, going forward, Germany, the Netherlands and Austria continue to suppress domestic wages in pursuit of internal current accounts surpluses (thereby creating a €-zone demand deficit which must result in persistently unacceptable unemployment rates or unsustainable current accounts imbalances as members with more responsible full employment policies make up the demand deficit), then no amount of accounting legerdemain will prevent the €-Mark from going the way of the gold standard, Bretton Woods, the ERM and the Argentinian dollar peg.

    Because as of right now, the BuBa is attempting to get somebody who is not the BuBa to pay the cost of defending the BuBa’s currency policy. That is not only unethical in the extreme, it is, more importantly, impossible to accomplish in the real world.

    Fixed exchange rates, mercantilist wage suppression, no fiscal transfers, no sovereign defaults. Pick any three.

    As an aside, and in respect to the possible consequences to CB solvency of running policy rates above the rate of inflation: If the central bank ever permits any point on the risk-free yield curve to exceed the rate of inflation for any length of time together, then You’re Doing It Wrong. Risk-free yields in excess of the rate of inflation means printing free money to people who do nothing but stuff cash into their pillows. Cash-in-pillows does not contribute a single ball bearing to the capital accumulation of the country (except insofar as the country is at risk of an acute shortage of kindling). So it is extremely difficult to see any macroeconomic justification for subsidising it.

    – Jake

  24. Greg writes:


    If I were you I would not be glad to be on the same wavelength as Morgan Warstler. Ive followed this guys comments around the internet and he is a thug in full support of kleptocracy …….. by his guys.

  25. Scott Fullwiler writes:

    Good to see you here, Chris!

  26. JKH writes:


    “Formal financial claims against a state therefore displace more-equity-like claims rather than the less-equity-like claims displaced by equity on a corporate balance sheet.”

    I think of this area a little differently (What a surprise).

    As I noted eons ago in one of your early posts, the consolidated position of a sovereign currency issuer includes the government (treasury) balance sheet and the central bank balance sheet. I referred to this as the GCB balance sheet. The typical GCB position is net liability, composed of bank reserves, currency, and debt.

    I interpret such a GCB balance sheet also to reflect a negative equity position. This is directly analogous to negative book equity in the case of an insolvent corporation.

    Negative equity could be interpreted literally as a negative balance sheet entry below debt, zeroing out the effective net financial balance sheet of the consolidated state entity.

    Alternatively, such negative equity can be interpreted as a contingent tax asset. The state has the power to eliminate its debt through taxation, in theory at least.

    Using the latter interpretation, actual taxes that are used to retire debt at the margin also eliminate the same amount of the contingent tax asset. Contingent taxes become actual taxes. Actual taxes reduce the negative equity position of GCB, if used to pay off debt.

    Your proposal could be shoehorned conceptually and jointly into this framework at well (albeit with accompanying kicking and screaming likely). Actual equity securities issued at the margin can be used to eliminate an equivalent amount of GCB debt. At the same time, actual equity securities issued match an equivalent portion of the contingent tax asset. The contingent tax asset represents the possibility of a tax cash flow that could be used to retire the equity security. The net result is that equity securities issued also reduce the net negative equity position of GCB, if used to pay off debt.

    Moreover, these two prior points are consistent with my comment those eons ago that taxation at the margin is an infusion of equity. This again is simple bookkeeping, comparable to the case of the private sector. Revenues for a corporation are also an infusion of equity, at the margin, until expenses take some of that away.

    In this sense, “negative equity” is reconcilable with a tax asset. “Negative equity” is an equity receivable (as opposed to a recorded equity infusion), which is what a contingent tax asset is (acknowledging the state’s power to make the contingency something actual if necessary).

    This framework does not access the “informal equity claimants” piece of your view of things, which is somewhat more imaginative than my effort. Mine is a rather sterile “book value” approach to equity analysis. I personally find this drab consistency with corporate accounting to be very comfortable, and therefore I am willing to risk torment from the hobgoblins that inhabit small minds.

    That said, the sterile book value approach has something going for it in terms of keeping track of time. Actual taxation is a done deal. So is actual expenditure. So is actual debt or equity issuance. The services that are due to “informal equity claimants” are the same services that accrue to them in real time in the future, alongside the taxes and debt/equity issuance that accrue in real time as well. There is no warehouse of real services for the future. But the threat that is a contingent tax asset is always available as an asset reserve.

    I view your “informal equity claimants” as real time recipients of real time services, paying taxes in real time. These I think of as flow items, separable from the balance sheet stock condition.


  27. JKH writes:


    That’s all extendable from the case of a single sovereign currency issuer to that of a single currency issuer (ECB) with multiple sovereigns (EZ), with pro rating etc.

  28. JKH writes:

    A couple of points regarding the RSJ/SRW exchange above:

    a) The ECB balance sheet is somewhat (internally) congested now with aberrant TARGET distributions amongst constituent NCB balance sheets. The Bundesbank is substantially long TARGET balances and the central banks of Greece and Ireland are short, the last time I looked. This reflects private capital outflows from the latter two offset by (automatic) clearing of central bank reserve positions in the other direction. At the margin, the Bundesbank is funding the liquidity requirements of the other two central banks, and the EZ in total will be responsible for any consequent capital effects according to loss sharing formulae. There is a corresponding aberrant distribution of refinancing operations. The Bundesbank has shrunk its refinancing to allow for TARGET asset expansion, for example. This has been described as “crowding out”. All of which to say is that there is an extra difficulty to begin with regarding the aspect of the balance sheet room that RSJ refers to on the asset side.

    b) In the other direction, remember that the ECB still has a large chunk of currency in its balance sheet – about 850 billion EUR. As is the case with the Fed, this is a substantial shock absorber when it comes to analyzing scenarios for possible interest margin compression due to QE/(SRW equity) type costs for interest paid on reserves.

  29. RueTheDay writes:

    In general, I am a strong supporter of debt to equity conversions, be they for banks, non-financial corporations, or individuals, as a solution to the sort of problem the world faces today.

    However, I’m struggling a bit with this concept of sovereign equity issuance. I tend to associate equity with 1) ownership, which implies control and 2) a residual claim to the cash flows that are left over after operating expenses have been met and creditors serviced. It would appear that the former would not be applicable to sovereign equity, for some reason, and that the latter would be addressed by a dividend that would accrue at the rate of inflation. Thus, it seems that this would be a sort of hybrid security, analogous to Perpetual Cumulative Preferred stock. The central idea seems to be to replace bonds which are rigid in that they have fixed interest payments and must be redeemed on a regular basis with something else that is more flexible, with both a dividend and remption that are at the discretion of the issuer. However, since, as you note, fiat currency is a form of equity, it seems that there is a far simpler solution to this problem. Granted, individual EU nations like Greece cannot simply print Euros, but that’s the crux of the matter – either there needs to be a full monetary AND fiscal union which necessitates things like a central treasury, eurobonds, and harmonized taxing and spending powers or a number of countries need to leave the EU and return to their old currencies to regain control of their monetary systems. Sovereign equity seems to be another stopgap solution to avoid either end state. Perhaps if there were a strong economic argument in favor of the EU actually being an OCA, sovereign equity could be a tool for smoothing out temporary situations, but in the absence of such evidence, I keep going back to the other two solutions.

  30. […] Steve Randy Waldman, “What Europe requires, in financial terms, is a means of converting some part of member states’ sovereign debt into equity. “  (interfluidity) […]

  31. Donald Pretari writes:

    I think the answer is for the Wealthier Countries to Bail Out the Poorer Countries, & remember that the underlying idea is that countries economically intertwined are hopefully less likely to fight each other. But, of course, I must be wrong, as history never repeats itself, & Irving Fisher isn’t relevant to our current financial woes.

  32. JKH writes:


    Follow up thoughts:

    The typical consolidated government/central bank balance sheet (GCB) consists of a net “funding” profile, with a mix of bank reserves, currency, and debt.

    Consider a more streamlined case where the only type of “funding” is bank reserves.

    Reserves are characterized accurately as a liability in my view. The reason is that the GCB is obligated to “repay” (extinguish) reserves under certain circumstances. It must be willing to extinguish bank reserves in exchange for tax payments, at the option of the taxpayer acting through his/her bank.

    Reserves are the “medium of exchange” for commercial banks. When a taxpayer’s bank pays taxes with reserves, the reserve liability is extinguished by the reserve payment. Thus, the taxpayer’s bank pays reserves as the medium of exchange asset back to the issuer of reserves as a liability, extinguishing the liability in the process. In effect, GCB is short a put option on reserves, viewed both as the medium of exchange for tax payments (flow), and as the liability that is returned to the issuer (stock) as a result of the payment. The currency issuer is short a put option on the currency, in its reserve form roles as both a stock and a flow.

    The short put option obligation means that reserves are a liability for the GCB issuing them under the terms of that option. The currency issuer is short an option, and the currency issued in the form of reserves is a contingent liability because of that.

    Some people refer to reserves or the currency of a sovereign issuer as a tax credit. More properly they should be viewed as a contingent tax credit or tax asset. From the issuer’s perspective, they are a contingent tax liability. They can be used when the holder of reserves elects to use them as the medium of exchange in paying taxes.

    This does contrast with the role of reserves in the case of a currency user and its liabilities. A currency user discharges liability using currency held as an asset.

    The currency user perspective can be illustrated using the same example of tax payments. Commercial banks are currency users. They pay taxes on their own account, or for clients with reserves. A bank that pays taxes for its own account is discharging a tax liability. It uses reserves as an asset – a contingent tax asset – to discharge that liability.

    Thus, in the case of tax payments, the currency issuer erases its liability by extinguishing it in return for discharging the liability of a tax payer, while the taxpayer as a currency user discharges his tax liability using reserves as an asset conveyed in payment. The liability in the case of the currency issuer is to accept the return of the liability itself to pay taxes, thereby extinguishing it. The liability in the case of the currency user (in the case of taxes) is to discharge a tax liability by paying for it with reserves as an asset.

    Now expand the liability mix of GCB to reserves, currency, and bonds.

    Currency is redeemable for reserves.

    Bonds are redeemable, at least at maturity, for reserves. The fact that governments tend to roll into new bonds is interesting at the macro level, but is not relevant to the characteristic of redeemability at the micro level.

    So the case of reserves as a liability extends to currency and bonds as liabilities.

    Thus, the GCB short put option extends to currency and bonds – first a put of currency or bonds to bank reserves; then a put of bank reserves as the medium of exchange asset used to pay taxes, back to reserves as the GCB liability that is itself extinguished when it is presented as the asset of the taxpayer when used as tax payment.

    Now introduce GCB issued equity securities.

    The GCB is not short a put on GCB issued equities. They are not redeemable at the option of the holder for reserves or anything else, in paying taxes or for any other purpose.

    However, GCB has the option of contracting or bidding to buy back its issued equities (according to SRW guidelines?).

    Therefore, GCB may be long some type of call option on GCB issued equities (perhaps at a market price; perhaps at a designated fixed price), but it is not short a put option.

    So there is no GCB liability with respect to GCB equities. GCB issued equities are indeed equity in characteristic, free of any short put option position associated with a liability.

    The standard case of the single sovereign GCB extends the case of the single CB with multiple sovereigns. It is a matter of formulaic allocation of risk. I gloss over this for now, but it is a somewhat different view from yours regarding the nature of a liability in the case of a government in general. You differentiate according to the currency issuer/user perspective. I look past that and treat the case of the “currency user” (EZ sovereigns plus ECB) more or less the same as that of the currency issuer (US government plus Fed). That implicitly assumes some allocation options in the case of the multi-sovereign ECB, given its multiple “clients” or “users”. Then I view everything in the context of the tax related short put position – rather than the ease of availability of the currency itself. In the case of the ECB, one could view the constituent NCBs and their respective sovereigns as being short the put option with respect to accepting Euro reserves as tax payments.

    Returning to the simple case of a reserves only balance sheet, I suggested earlier that the offset would be a contingent tax asset, interpreted as negative equity. Add issued equities to this balance sheet, so that the two right hand categories are reserves and issued equities, and the left hand side is a tax asset. Then the net equity position of this balance sheet is negative equity in the amount of reserves. A gross tax asset can be netted out in the amount of issued equity. There is no contingent liability associated with issued equity, because there is no short put option associated with it. Therefore, the contingent tax asset in the same amount becomes moot. At the same time, the contingent tax asset represents a gross call on taxes, in the event the GCB wishes to call its issued equity. But such provisioning is totally at the option of the GCB, given the equity nature of the equity securities. Whereas such contingent tax provisioning is inherent in a balance sheet that has liabilities but no equity securities issued.

    This interpretation comports with the case of a corporate balance sheet that receives an equity capital infusion that is positive, but less than its starting negative book equity position. The result remains net negative book equity.

  33. […] debt-to-equity swap for the European […]

  34. Fed Up writes:

    SRW@19 said: “Except if we did that, the quantity of investment would drop dramatically (most investment is financed by debt, not equity, and investors do not view the two forms as close substitutes). So we’d have to find some other, more transparent means of encouraging investment than the quasisubsidy implicit in the quasiguarantees that surround debt.”

    I’d need to see some figures. I’m used to stocks where the company funds investment from earnings.

    And, “The medium of exchange is, I claim, a form of equity (in the US, Great Britain, Japan, etc).”

    Is it really equity if there is a bond attached?

  35. Fed Up writes:

    JKH@32 said: “[Central bank] Reserves are the “medium of exchange” for commercial banks.”

    IMO, it is a good thing when JKH and I come to the same conclusion.

    And, “When a taxpayer’s bank pays taxes with reserves, the reserve liability is extinguished by the reserve payment.”

    Let’s expand on that. When I (as a taxpayer) pay taxes using a demand deposit, my demand deposit account gets marked down and the bank’s central bank reserve account gets marked down. If that causes a shortage of central bank reserves, the central bank can replace them. Therefore, it seems to me that taxes are about the gov’t reducing the amount of medium of exchange (demand deposits or currency, if taxes are paid with currency) if the medium of exchange is considered to be “destroyed” or reducing its velocity if the medium of exchange is considered to be “saved”.

    And, “Now expand the liability mix of GCB to reserves, currency, and bonds.”

    Can that be expanded to include demand deposits?

    And, “Now introduce GCB issued equity securities.”

    Just get rid of the bonds/loans so there are only currency, central bank reserves, and demand deposits?

  36. Fed Up writes:

    SF@9 said: “I find the national equity issuance idea on its own quite interesting and consistent with our thinking. It also made me think of how John Cochrane equates national debt issuance with equity issuance by companies when he’s describing his version of the fiscal theory of the price level.”

    First glance question. What does national debt issuance have to do with equity issuance by companies? It seems to me that ends up with the problems of today:

    savings of the rich = dissavings of the gov’t (preferably with debt) plus dissavings of the lower and middle class (preferably with debt)

    IMO, is should be:

    savings of the rich plus savings of the lower and middle class = the balanced budget(s) of gov’t(s) plus dissavings of the currency printing entity with currency and no loan/bond attached

    IMO, that would give the best chances of productivity gains and other things being distributed evenly between the major economic entities and evenly in time.

    Is what everyone is asking really “if an economy needs more medium of exchange, how should that happen?

  37. Zac writes:

    Would this would for the US? ie if each state issued the ‘equity’?

    Assuming that there are political barriers to the fiscal union operating as well as it should is this a possible solution?

  38. Zac writes:

    Also, I am not sure how you rigorously you could enforce the debt repayment priorities part of the plan. Maybe with nation states, but individuals would easily be able to take out loans in anticipation of the debt relief that is just around the corner.

  39. Morgan Warstler writes:


    You make the same mistake DeKrugman makes.

    Money (monetary) doesn’t really exist for everbody. No more than Government does. Sure it might be something other than a storehouse of value, but only those who use it that way get a vote on WHAT IT IS.

    This view largely pisses in the Cheerios of macro, and it is obviously right.

    I mean C’MON! Who in their right mind thinks money theory has anything to do with the conscience of a liberal.

    That’s like Judaism being explained by the conscience of a Nazi (see Godwin).

    It requires immense suspension of disbelief yo even consume it. Money is and invention for people who need THE INVENTION,not for people who need money.

    Think of Monetary like a Wallet. If you have no money, no one cares what you think about wallets.


    You get off on being rational. So man up (see Palin). Money and government is controlled by the people in America who are both: A) likely to vote B) own stuff. They are both necessary conditions for mattering.

  40. […] Saving Europe with sovereign equity Steve Waldman […]

  41. gerold k.b. weber writes:

    Very inspiring post and discussion, thx!

    One question from an Eurozone layperson to this blogs esteemed economists and thinkers:
    Is it possible to combine the Sovereign Equity Share concept with negative interest rate money for the retirement of debt? The negative interst rate could be 1% per month like in the ‘Certified Labor Value’ money in Wörgl/Tyrol 1932/33, which was based on ideas of Silvio Gesell.

    Such ‘Freigeld’ (Gesell) or ‘Stamp Scrip’ (Irving Fisher) for debt retirement obviously has considerable advantages, as it would
    – start to ‘counterbalance’ hoarded and unproductive money
    – distribute some losses to lenders, as money paid back by borrowers loses value
    – circulate rapidly, thereby raising GDP and employment
    – have a well defined temporary character allowing to market it as a crisis instrument
    – help contain inflation, as it retires itself after 100 months

  42. Fed Up writes:

    Me@34 “SRW@19 said: “Except if we did that, the quantity of investment would drop dramatically (most investment is financed by debt, not equity, and investors do not view the two forms as close substitutes). So we’d have to find some other, more transparent means of encouraging investment than the quasisubsidy implicit in the quasiguarantees that surround debt.”

    I’d need to see some figures. I’m used to stocks where the company funds investment from earnings.”

    This is probably an extreme example, but here is what I am talking about.

    Apple: Morgan Stanley Suggests $25B BuyBack, 2.4% Dividend

    “Huberty, noting that Apple has $76 billion in cash, or $82 per share, writes that the total is far in excess of the $6 to $8 billion in annual investment the company needs to make.”

    And, “If Apple doesn’t spend, that cash pile will keep growing: “If the company does not return cash to shareholders, we expect its cash balance to grow 58% Y/Y to $94 billion by the end of CY11 and another 45% Y/Y to $136 billion by the end of CY12, mainly driven by the strong growth and profitability in the iPhone business.” Apple will generate $34 billion in free cash this calendar year, she reckons, and $42 billion next year.

    The most risky thing could do is to make a large acquisition.”

  43. Chris — Welcome!

    Commenter Mattay linked earlier to your proposal, which is insightful and definitely in the same spirit as this one, and much earlier presented. As a quibble, I’d note that consols are not “pure” equity, as coupon payments represent a firm commitment whose nonpayment would constitute default. But then nothing in this world is pure, and purity isn’t really what we’re after. If the coupon in the consols is sufficiently small, and if forward-looking measures are put into place to prevent a “producers” scenario, the likelihood of default may be so low that the debt-like coupon payments are irrelevant. The principal portion of the instrument is equity-like, redeemable only at the discretion of the issuer.

    Rolling up debt into such consols would be a good idea, if we could persuade some institution to convert past debts into such an instrument while credibly resolving the unbalanced capital flows that require some European countries to be “improvident”. (As with my scheme, a potential deficiency may be that the roller-up fails to exact sufficient costs from improvident lenders, unless it is creditors who are forced to accept a conversion of their debt to the consols.)

  44. JakeS — I agree with much of what you have to say. I also think that sovereigns should be very chary with inflation-linked debt, and that real returns on default-risk-free debt should be zero, at least at the short end of the curve.

    However, the inflation-linked sovereign equity suggested here is categorically different than inflation-linked debt, precisely because it’s equity. The trouble with inflation-linked debt is that a sovereign can easily make promises it absolutely cannot keep: it has promised returns in real terms on a fixed schedule, and it may be unable to deliver on those, or the cost of delivering on those promises may impose unjust burdens on others. With sovereign equity, though they are to be redeemed at some point in the indefinite future at an inflation-linked 0% real return, a sovereign is never forced to redeem at a time when it would be disruptive or burdensome to do so. Like Chris’ consols above, as long as the real return is made less than the likely real growth rate of the economy, eventually the size of the debt that seems so onerous becomes trivially small, and the sovereign will redeem on request during OK times. If the long-term does not yield above zero percent real growth, the sovereign will be screwed on many different dimensions, but having retired debt in favor of sovereign equity will only ease the burden, as the sovereign will never be under any obligation to redeem.

    I’m sympathetic with much of your critique of European institutions controlled by surplus nations, which are effectively if not intentionally mercantilistic and who make demands that their own policies ensure some nations will be unable to meet. Part of the motivation of this proposal was to use populism as a means of undoing that bad dynamic. To be fair to surplus country populations whose consumption was suppressed, those populations reasonably demand and should get a cash payoff. The cash payoff renders it difficult for mercantilistic governments to suppress the domestic price level and engender continued imbalance. The intention is to use populism as a foil that undoes mercantilistic wage suppression, and so allows Europe to choose fixed exchange rates, no fiscal transfers (except via relative price level shifts), and no sovereign defaults.

  45. JKH @ 26 — I’ve taken a good deal of insight from your long-ago insight that tax payments are equity infusions, which I might recast as purchases of an equity claim. I’m less attracted to the insolvent corporate analogy. After all, the economically relevant equity of a firm includes not only its equity position on conventional account books, but its position including what it would be able to raise from shareholders in a rights issue (that is, if it asked existing shareholders for proportionate equity infusions). The “book equity” of a sovereign may or may not be below zero if one excludes its capacity to draw informal equity infusions via taxation. But if one incorporates the equity infusions accessible at reasonable cost, and if the sovereign’s “hard” liabilities are just another form of equity in a malleable preference hierarchy, then it’s a very different sort of thing than a corporate with a negative book value in scrip it cannot issue with shareholders it is unable to call on.

    I’m with you (and the MMT-ers, and even conventional economists) in thinking that it is often useful to consolidate the positions of the government and central bank. GCB seems as good a term as any for that beast.

    I don’t think we’re disagreeing about anything substantive. In your terms, we can think of contingent taxes as an asset, and so the true equity position is greater than it would be in an analysis that excludes that asset. And as you say, if we added an instrument like the proposed sovereign equity, it would effectively amount to another tranche in the liability structure if the state, which already includes whatever claims taxpayers have by virtue of their payments and whatever claims holders of nominal dollar securities have (and also some claims by people holding inflation-indexed debt, a tranche which, with JakeS above, I think should be carefully limited).

    As you say, “the sterile book value” approach has value as it is more conservative than an approach that tries to value contingent tax assets and such. We design accounting standards to understate values (usually) for good reason. Under conventional public accounting, the sovereign debt position is a record of historical expenditures, which is useful to have around, and the less we rely optimistically on the value of informal equity or a contingent tax asset, the less likely we are to make errors that will force an unwanted devaluation of existing equity claims (whether in the form of debt, currency, or informal claims).

    Analytically, there’s nothing wrong with saying tax payments engender informal equity claims (as you long-ago suggested, but seem to be backing away from) and that they represent payments for services in real time. They obviously represent both. Taxpayers and bond purchasers, in aggregate, are both paying to keep the police on the street today, and paying to endow future public goods and service. As a taxpayer, I expect the state to offer me services in the future as well as services today, and to the degree those expectations, though not enforceable, are likely to be met, I have a valuable (alothough not marketable or transferable) equity claim. The state also issues informal equity claims to people who have not paid taxes (corporations issue equity sometimes without cash payment for various reasons), but that doesn’t eliminate taxpayers claims (although it does dilute them).

  46. RueTheDay — Some equity securities represent residual claims, and some equity securities come with control rights, but those characteristics are definitely not definitive of equity. Preferred shares are not residual claims and have no control rights, but they are often correctly understood to be equity, because dividend payment is unenforceable other so long as more junior classes of claimants are also unpaid. Many firms (UPS, Google, others) offer classes of stock that are residual claims on profit and/or liquidation proceeds, but whose redemption is not enforceable by shareholders and that confer no control rights. This is what you get if you buy GOOG or UPS on the stock market. Debt claimants are often negotiate much stronger control rights than those available to most equityholders by insisting on tight covenants and acceleration clauses, which constrain corporate action and make likely occasional periods where they can dictate terms to the borrower.

    The securities described would constitute a form of equity, as you suggest more like preferred equity than common stock. Euros, however fiat they may be, are not equity to individual countries. They are equity to the Eurozone as a whole, and as you suggest, if the Eurozone were willing to consolidate, with a Treasury and procedures by which internal transfers (and internal lapses disciplined), there would be no problem. Such a united Europe would be no more liable to debt crises than the US or Britain or Japan.

    But Europe is not willing to do that. This proposal is in a sense a stopgap that tries to make the best of that and inject some equity into member states’ capital structure despite the disunity.

    I think “OCA” arguments are overstated: the range of potential currency, financing, and economic regulatory arrangements is large, and there are lots of perfectly workable schemes under which heterogenous regions might share a currency. Tools other than monetary policy can be used for country- or region-specific economic policy, and controls can be designed to prevent persistent capital flow imbalance. Europe is poorly designed not just or necessarily because it is a currency union, but because it is a currency union that systematically undermines regional attempts to manage local economies by other means or prevent destructive capital flows. This proposal would push a bit in the other direction, and give nations some scope for “local monetary policy” (via a right to draw and distribute “equity infusions” in a slump). It is also intended to reduce the incentive for ex ante, and to help undo ex post, persistent capital flow imbalance.

    It might or might not be better to just eliminate the Eurozone and let individual nations issue their own currencies. That has the advantage of familiarity and simplicity.

    But there are reasons, not all of them bad, for the EU and the Eurozone, and especially given the path we are already on, it may be reasonable to try to preserve those institutions if we can reform them so that they function better, both economically and democratically. It is in that spirit that this proposal is offered.

  47. Donald — I think too much is lost when you say wealthier countries should bail out poorer countries. After all, there are poor taxpayers in Germany and rich tax scofflaws in Greece. The US doesn’t send money freely to Bangladesh to bail it out of its recurrent nonprosperity.

    The “wealth” and “poverty” of Eurozone countries are not random conditions, nor are they evidence of the moral or economic inferiority of Greeks or the hegemony of Germany. They are understandable outgrowths of economic and political choices made by various nations in the context of a flawed institutional context. We need to improve that context, or Europe will fall apart, either soon or when history does indeed repeat itself.

  48. JKH @ 32 — I have to confess I’m having a hard time completely following you. But I think you’re mistaken that the tax-extinguishing characteristic of fiat currency renders it equity. Of course, the distinction between debt and equity is always a matter of degree, not kind, just like human action is never perfectly voluntary or perfectly compulsory. But fiat currency is very equity-like, despite the state’s inviolable promise to individual entities that currency can be used to eliminate their tax liabilities.

    That promise does bind the state with respect to individuals — it would be profoundly disruptive of the state’s mission if it were to start refusing acceptance of some people’s currency and then jail them for nonpayment of taxes.

    But the promise does not meaningfully bind states with respect to its citizenship in aggregate. That is, if the state decides that it wishes not to redeem equity despite surrender of claims for tax extinguishment, it can always raise the level of taxes and spend or transfer to restore the pre-payment status quo. Alteration of the state’s tax receivables position is entirely at the state’s discretion. Which isn’t to say its choices are costless, most “voluntary” choices involve tradeoffs. But a state that wishes to maintain or expand the level of tax indebtedness in its population may do so, despite continual payments of tax. The state loses nothing it cannot choose to regain by extinguishing a tax liability.

    So I don’t think the state is meaningfully short a put option, or if it is, the good it may be forced to exchange it may recover at will, so the substantive cost of that option is very small. I don’t think the state’s willingness to accept money for taxes already leveled represents a meaningful contingent liability.

    Currency represents an asset to an individual, in part because she can use it to pay taxes, and reserves are an asset to a bank, also in part because it can satisfy tax obligations with them. But from the issuer’s perspective, being short this particular asset is more like a firm’s short equity position: It is, genuinely, a short position, but being short this particular asset does not meaningfully constrain the issuer.

    Note that for a sovereign that is not a currency issuer, the ability to tax does not prevent currency from being debt-like. For a currency-using sovereign, tax extinguishment is not necessarily reversible, and being forced to extinguish is a more meaningful liability. A currency issuer can restore the pre-extinguishment status quo by spending or transfering and then levying taxes. A currency nonissuer can levy the taxes, but it may be unable to transfer and spend (especially if it must distribute the taxes collected to external creditors). Levying taxes without offsetting disbursements may be very costly and disruptive. A currency issuer, by regulating the rate of issue, has great freedom to regulate the burden of taxation. For a nonissuer, taxation has costs that are largely beyond its control, and the prospect it may be forced to levy and extinguish taxes when doing so conflicts with its objectives represents a real burden.

    The equity instruments I proposed would not be redeemable for tax extinguishment, and so they would be a different sort of equity, a different tranche or category of liability than currency. (They could be made negotiable for tax extinguishment. Then they’d become like “Mosler bonds”, and they’d no longer be true equity. I’d oppose that.)

    I still have trouble thinking of the state as having a negative equity position as long as its involuntarily redeemable liabilities are of less value than the real assets it commands. And so long as the vast preponderance of a state’s “liabilities” are in currency it issues or something like the equity proposed here, I see the state as positively capitalized (although it may suffer from devaluations). Only if states issue liabilities that are involuntarily redeemable for something not freely issuable do I see the possibility of a meaningful negative book equity position.

    A state’s equity position may approach zero, if its core assets (its capacity to coordinate and sustain a productive economy, its legitimacy, its ability to coerce) are devalued. And fiat currency may become debt-like when those core assets are seriously threatened, because failure to sustain the market value of its “equity” may become so disruptive to its legitimacy that it is no longer voluntary. Again, the distinction between debt and equity is not a matter of legal forms, but a matter of the degree to which redemption is voluntary. That can change with circumstance.

  49. Fed up — There is lots of investment that is financed by firms internally from profits. But there is lots of investment that, under present arrangements, would not occur absent external finance. Start-up firms are not financed internally from profits. Construction of homes would be permanently depressed without external finance, unless we segue from the institution of individual homeownership to corporate management. Investment in the production of durable goods like cars from profits would be impossible without the profits, and car companies would have very little profit if all of a sudden no external finance was available to customers.

    Apple, with a gargantuan cash hoard, absolutely can finance any investment it wishes from retained earnings. But many, many other potential investors and entrepreneurs currently rely on external finance funded by the issue of debt securities.

    Again, I am with you in terms of goals: I think debt finance is very costly and dangerous, and that we absolutely should try to find ways to shift to an equity financed world, whether that takes the form of investing from past profits or externally supplied equity. But debt is popular for the reasons that it is dangerous: it finds ways to extract external guarantees (explicit or tacit), which makes it attractive for people to hold. I think we can move to an equity world if we replace this opaque, often corrupt, subsidy (not to mention the subsidy via tax deductibility) with explicitly agreed and limited encouragements of equity arrangements. But if we just pull the plug on bank or debt finance, I think there’s little question we’d have a turbulent period of underinvestment, for however short or long it takes to develop workable alternatives. Better we do the figuring now, and transition from the shitty, overindebted status quo to workable more equity-like substitutes (which might require some explicit state involvement).

  50. Zac — This sort of thing could be used to manage debt crises among US states, should we come to that.

    As far as enforcing debt-repayment prior to cash disbursal, it wouldn’t be perfect, but you could insist that formal liens be extinguished, ask creditors to report outstanding debts and withhold payment until they are paid or successfully disputed. Alternatively (or in addition) you could require recipients to legally attest to having retired or defeased substantially all outstanding debts, with civil or criminal penalties for false attestations.

    Afterwards, of course, you are right. If the factors that led to overindebtedness in the past are not remedied, a clean slate will just permit the cycle to restart. Just like for Europe as a whole, it would be important to reform institutions to discourage capital flow imbalance that inevitably becomes bad debt, if we want to prevent less geographical consumer credit crises, we have to find ways of limiting overextension of credit going forward, both by regulating supply, and by reducing demand (e.g. by reforming education finance). Sharpening lenders’ incentives not to lend when doing so will create burdens or time-inconsistent incentives for borrowers is something we have to do no matter what. But that doesn’t mean we should refuse to ameliorate the debt overhang caused by our last miserable episode, suffer human misery and huge opportunity costs because we might screw up again if we set ourselves free.

  51. gerold — There’s nothing inconsistent between this proposal and schemes to offer devaluing scrips or create negative interest rates, but they do represent very different approaches. If devaluing scrips can be used for debt retirement, that either represents a tax on creditors (who’d prefer not to accept it), or it must be redeemable by creditors for permanent money and the devaluing aspect would be largely arbitraged away. Negative interest rates could be designed to affect (nearly) all money, and then wouldn’t have this problem. Devaluing scrips or negative interest rates can be used to promote current expenditure despite the existing debt burden, as the benefit of hoarding cash to offset debt is reduced by the interest cost associated with holding cash. You can definitely create spending by turning money into a hot potato, and in a way that’s really the purpose of conventional monetary policy. But I’d much rather we promote demand for the things that money can buy rather than create conditions in which people try to avoid holding money, because I think the quality of expenditures and investments is harmed by hot potato money.

    All that said, in a world where the politically possible is very limited, I prefer reducing interest rates to zero or negative values than status quo creditor-friendly inaction. Despite strong reservations, I’m “pro” zero or negative interest rates for now.

  52. Greg — I prefer to think the best of people, and I do my best to avoid encountering evidence to the contrary.

    Morgan — Money is a very non-neutral thing, and finance is more a means through which power is exercised and hidden than the arena for rational calculation described in textbooks.

    That said, money and finance are with us and will remain important, both to the people who use them to exercise power and the people caught in that exercise of power. One way or another, it’s worth trying to put as much sugar on those Cheerios as we can, even if they are floating in a bowl of piss.

  53. rtah100 writes:

    Steve / JKH,

    Tax payments do not seem like an equity infusion to me. Surely (in a fiat money context), since they destroy money and we are contending that fiat money is equity-like, they are more analogous to the opposite of a bonus issue, i.e. a forced tendering of equity back to the issuer at par? Each remaining unit is then a slightly larger claim on the equity value and, of course, the obligatory tendering of shares helps to support demand for them.

    Or am I missing something?

  54. JKH writes:


    I think we agree broadly. The difference between the government and corporate situations insofar as negative book equity is concerned is that the government book position is sustainable largely because of the strategic tax call option. It becomes largely a matter of semantics if one wants to abandon unadjusted negative equity as terminology or accounting. The case to take into account a contingent tax asset is stronger than the analogous case for expected corporate profits or contingent rights issues. The latter valuation adjustment is done via the stock market rather than corporate balance sheet accounting. Perhaps “market” valuation of the government balance sheet is the appropriate analogy here, if that makes any sense. Still, I think sterile book value as starting point forces one to think clearly and granularly about what such an adjustment entails.

    I’m not sure if I said previously that taxes constitute equity claims. I’ll have to check that. Without checking, what I recall saying was that taxes constitute equity infusions, but without the notion of longer lived equity claims. That again would be a book value accounting perspective in which income transfers in general are transfers of equity value at the margin – which is what happens in fiscal policy as opposed to monetary policy, the latter which consists of asset swaps rather than income/equity transfers. But as you point out (and I seem to recall a dedicated post on this), there is in general incomplete accounting on the government asset side, so that there’s definitely a case for taxes paid as representing an effective longer term claim on government assets that are delivering annuity type benefits to taxpayers.

    I’m aware of several of the papers you’ve referenced regarding currency as equity (and the conflict they probably present for my view of things so far), but have not yet gone through them in detail.

    You’ve characterized the currency issuer’s arsenal as including the tools to “reverse” the impact of “tax extinguishment”. I recognize that. But there are two modes. At the operational level, the short put option on reserves I’ve referred to is easily reversed when the state buys back its own debt, injecting bank reserves. Or when in theory it can start acquiring private sector assets for the same purpose. At the strategic level, the issuer can change gears in its pace and/or direction of overall GCB liability management at its own choosing. So it can reverse any marginal put option exercise effect through fiscal easing. And that’s a very interesting point you’ve made about the comparable position of a currency user. Austerity galvanizes the impact of the put option at the strategic level of the overall GCB liability profile, restricting the user’s ability to reverse it.

    In summary, you’re quite right in noting some omissions or possible inconsistencies in my story. My focus so far has been a micro concept of “liability”, rather than the macro behaviour of the state in dealing with it, as you have described. I need to become clearer on what point I’m attempting to make there, but I think its micro operational only, without necessarily contradicting the macro behaviour you allude to.

    Your feedback is much appreciated.

  55. JKH writes:


    I think you’re making a deeper point, but as part of an answer, here is a streamlined example of the book accounting that I use for the tax analysis:

    Suppose you had a government that was in cumulative fiscal balance – no bond debt outstanding.

    Set aside real assets held by the government.

    Just consider the financial balance sheet of the government.

    So the government financial balance sheet on its own is in balance – there’s nothing there.

    Suppose its central bank had reserves and currency on the liability side, with private sector assets (e.g. loans to banks) on the asset side. Assume away for ease of exposition that there is no capital position on the right hand side of the balance sheet (nominal CB capital is normally small anyway).

    So the central bank balance sheet is in balance, with zero book equity.

    And the combined government/central bank balance sheet (GCB) is the same as the central bank balance sheet, because there’s nothing on the government financial balance sheet.

    So the GCB balance sheet is in balance, with zero equity – on a nominal, book value basis as I’ve discussed above.

    Now consider the effect of a tax at the margin.

    Bank reserves are debited. That measure of money is destroyed (along with a commercial bank deposit liability somewhere, probably).

    The offsetting entry for GCB is an equivalent increase in equity capital. Money is destroyed, and capital is created. These are both on the right hand side of the GCB balance sheet.

    In parallel, the central bank will probably lend an equivalent amount of money (created ex nihilo) to the banks in order to restore reserve levels. That is an asset swap, as usual. And the resulting balance sheet differs from the starting balance sheet by an increase in equity capital, and a matching increase in private sector assets.

    If you want to deconsolidate that back to separate G and CB entries, it looks like:

    CB reserves destroyed by tax payment

    Government account with CB credited

    Government balance sheet shows deposit with CB and matching equity

    CB restores reserves by lending to banks*

    (*Alternatively, the government can acquire a private sector asset, which puts reserves back into the system, and moves the external asset onto the government balance sheet)


    When you say “we are contending that fiat money is equity-like”, I’m not quite there yet on that score – as I’ve noted with Steve. I suppose one of my micro sticking points might be that reserves and currency are generally required for the system to function – yet in theory they can be manufactured via private sector asset swaps alone, which is a marginal state of zero equity. In general though, and usually, reserves and currency tend to be an indirect source of deficit financing offset, since the assets of the Fed for example in normal times have usually been government bonds.

    Anyway, those are just rambling thoughts for now. Not really fully integrated.

  56. Ragweed writes:

    Steve –

    Tangential to the main discussion, I think there is a lot of misunderstanding created by the use of the savers/borrowers dichotamy. I think if we adopted the terminology of lenders vs borrowers, then we have a more balanced view of the relationship, and it doesn’t carry the implication that we are robbing Grandma if we don’t bail out billion-dollar sub-prime MBS holders.

    In your response to Fed Up at 1:26AM – I wonder if the popularity of debt (and its security) is due to deeper behavioral considerations of risk aversion (I would rather forgo the chance to make $1 than loose $1) or if it is simply a political power imbalance in favor of those who have the wealth to lend (which might better explain the tax subsidies)?


  57. rsj writes:


    I am having a hard time keeping up with all of these comments. I’m also a little drunk at the moment. JKH’s point that the ECB is already devoting a substantial proportion of its assets towards non-marketable loans is also noted, but with enough stretching, room can be made for your “equity” claims. I understand your rejoinder and I agree that if we stretch far enough — e.g. increase reserve requirements, for example — then your proposal would work.

    I hope we can all agree it is ugly.

    But I can’t ignore the sense that this initiative is driven more by the particular monetarist fetish of economists than by any real economic or political purpose. It is certainly not driven by simplicity.

    To the degree that the ECB purchases non-interest bearing assets, then it is giving up interest income that would have been passed on to the member banks, and from there to the EMU member states.

    No one is fooled into thinking that this is anything other than a direct income transfer from Germany to Greece, as Germany would have received that interest income and now must either increase taxes, or reduce expenditures, or go further into debt in order to make up for the lost income.

    Moreover the rich states continue to bear the risk of default. If you say no default is possible, since the poor nations never need to make a dividend payment, then that is lost interest income. It is no different than selling eurobonds and asking Germany to make up for the interest income from its own budget in case Greece can’t make a payment.

    I can’t think of any material difference between this proposal and the euro-bond proposal, which will also fail to do what is needed. The difference, in terms of hitting the German bottom line, is more in terms of misdirection.

    What is needed are perpetual ongoing transfers from Germany to Greece if there is going to be a lasting monetary union between Germany and Greece. Same for all other nations.

    Not loans, but gifts.

    In the U.S., income is transferred from rich states to poor states on a regular basis. It must be so. This is politically acceptable because the transfers are from rich households to poor households, with the wealthy households just happening to cluster together geographically (and ethnically).

    Suppose for a moment that in the U.S., the federal government did not tax households in wealthy states and use the proceeds to pay benefit payments to households in the poorer states, but rather lent money to the poorer states. There would be a crushing debt burden. The union would not survive.

    Monetary union requires these types of fiscal unions.

    Money is a creature of the state, but the state is not a creature of money. In this sense, the ECB is a type of monument to the monetarism that ruled the economic landscape at the time the EMU was conceived.

    It is all backwards. Sometimes I think Friedman was born with his head facing inwards.

    But that was a process of the elites, and the mass of the european population acquiesced because they were not told of the costs.

    In any case, I have to wonder why you want to hide these transfers within the central bank’s balance sheet as opposed to using more transparent options.

    The first-best approach would be fiscal union. Unemployed workers, wherever they reside, obtain identical benefits that are paid for by progressive taxes on all households, wherever they reside. Same for retirement benefits, EU-wide health benefits, etc.

    Then Greece would get more money than Germany, but it would not be viewed as a tax on ethnic groups or nation states. This approach is not only the best from an economic view, but is also more stable politically.

    The second best approach — the economically stable yet politically unstable approach — would be to agree to on-going transfers from rich EU nations to poor ones.

    The third best approach — which is politically stable but economically unstable — is to lend money from the rich to the poor states.

    The worst approach, IMO, would be a combination of pseudo-hidden transfers and loans from rich EU nations to poor ones routed via the ECB. Enough transfers to antagonize, but not enough to make a difference. Plus a healthy does of lack of transparency and the use of non-elected bodies.

    Pseudo hidden, in the sense that they are in plain sight, but nevertheless conform to the economists’ paradigm that central banks are responsible for demand management.

    A paradigm believed by few outside of the profession.

    The public at large still holds elected governments responsible for job creation and the health of the economy. Few even understand what central banks do. If anything, there is a suspicion that CBs take money away from them and give it to banks.

    But as the barriers to fiscal union in the EU are political, rather than economic in nature; I have to think that this proposal is crafted to convince the wrong person. It is both economically and politically unstable.

  58. […] Saving Europe with sovereign equity – via Interfluidity- One way to think about the European financial crisis is that it is a matter of capital structure. Countries like the United States and Great Britain are equity-financed, while countries like Greece, France, and Germany are debt-financed. [1] There is no question that some European countries have very real problems. But there is also no question that no matter how badly a country may be arranged, nations cannot be “liquidated”. A “bankrupt” state must be reorganized. If Greece were a firm, a bankruptcy court would not sell critical assets at fire-sale prices, as Greece’s creditors sometimes idiotically demand. Instead, a bankruptcy court would convert debt claims that are unpayable, or whose payment would impair the long-term value of the enterprise, into equity claims whose value would depend upon restoring the underlying enterprise to health. […]

  59. rtah100 — Taxes look like an equity infusion when you look through the money to real resources. That is, to raise $100, I have to supply some quantity of goods or labor. If I net the two transaction — raise money by supplying labor, pay taxes by surrendering money — I can think of the money part as being transient, and the taxation in terms of real goods and services. I supply to government real goods and services, which it makes use of to conduct its business. In exchange, I expect the largely unenforceable but still real benefits of citizenship. In that sense, taxation looks like an equity infusion.

    Let’s look at it another way. Suppose that the government has already acquired the use of real resources by spending money into the economy. Now the government taxes back some of the money, the raising of which requires the production no new good or service. Then the government spending was itself the equity infusion. The taxation becomes a swap from a higher seniority to lower seniority form of equity. That is, I had an equity claim in the form of an explicit financial security. After taxation, I retain an equity claim, but it takes the form of an unwritten, loose claim on the benefits and services of government, rather than scrip whose exchange value the government is not obligated to, but often does support.

    You may object, quite reasonably, that “exchange” doesn’t seem right, because when I surrender currency for taxes, my claim on the governments benefits and services is no stronger than it had been prior to the exchange. I had the rights and obligations of a citizen before paying taxes, and retain those rights afterwards. But that’s a fallacy of failing to compose. In aggregate, citizens really do strengthen their claims to the benefits and services of government by surrendering taxes. Government would not be able to supply those benefits and services if it did not compel taxation, and an “optimal” government would tax only in a manner and to a degree that any new tax demanded is matched by an increase in the quality of governance, the benefits to which taxpayers in aggregate hold an equity claim.

  60. JKH — I always enjoy working through balance sheet analogies with you. You’ve offered a lot of counterintuitive insights, some of which have persuaded me, some of which still leave me scratching my chin. But I think I’ll leave this conversation here for now. I’ll look forward to resuming it down the line.

  61. Ragweed — I very much agree that “lenders / borrowers” presents a fairer and more accurate rhetorical playing field than “savers / borrowers”.

    Re: Behavioral risk aversion vs power imbalance, I’d argue that they are mutually reinforcing. Suppose people lend rather than take an equity interest because of risk aversion and/or asymmetric information, both very “natural” explanations for the popularity of debt. If the people who have lent have political power, they will strongly enforce “creditors rights”, which will reduce the risk to borrowing and reinforce its appeal to the risk averse. Even if lenders do not explicitly exercise political power, if they lend because they are risk averse, and treat loans as low risk (i.e. they do not provision for possible default), they will become vulnerable to severe misfortune if loans are not paid. If lenders as a group are politically visible, if their misfortune would disrupt the functioning of the polity, the mere fact of their situation will conjure the protection of the state. Which of course will further attract risk-averse lenders, and further discourage them from provisioning for potential default. Creditor risk-aversion + the existence of a state to which creditors are a nonmarginal group create a mutually reinforcing dynamic of risk-aversion, protection, and systemic fragility to potential default.

  62. RSJ — I think there’s going to be a lot of light between us on this one.

    Regarding our previous exchange, I think we agree as an accounting matter that central banks have the capacity to not show any capital hole if they don’t wish to. This is part and parcel of the fact that fiat money is equity. Since central banks never face a liquidity crunch, the usual function of a balance-sheet solvency analysis — to predict future illiquidity events — is short-circuited. A central bank can offset new currency issue with unrealistic marks on its assets, and no capital hole is revealed. Whether or not central bank shows a capital hole, the securities a central bank issues may gain or lose value in the open market, and there is little or no correlation between a CBs expressed capital position and the value of the scrip it issues. So ultimately, the only question that matters is whether the CB is managing its currency issue in a manner consistent with meeting its macroeconomic goals. A central bank’s formal capital position is a meaningless nullity, unless by some confidence loop it affects the value of the currency. So central bank accounting standards are ultimately determined (and constrained) instrumentally, by how accounting communications will affect the behavior on currency users. I’m sure it is true that central banks that lose confidence of investors end up with especially silly marks on their balance sheets, but again, I don’t think that central balance balance sheet strength or “accuracy” (that’s hard to define here) much correlate with the actual standing of real currencies. In addition to communicating accounting statements, central banks have a lot of tools they can use to manage the scarcity of their scrip.

    I think I’ll respond to your latest in a separate comment.

  63. RSJ — Again, your recent comment is going to highlight some pretty big differences. Re using the ECB to manage Europe’s sovereign debt crisis rather than explicit transfers, you write

    I hope we can all agree it is ugly.

    Nope. I wouldn’t have proposed it if I thought so. I think this is actually the correct, and a very elegant, solution given what Europe is and the mixed democratic legitimacy of the European project.

    It is not true, even in an integrated country like the US, that persistent transfers from some groups to others are openly tolerated despite perceived illegitimate use of the proceeds. It is certainly true that, in the US, populous states persistently make transfers to less populous states. But that is not “the persistently rich” subsidizing “the persistently poor”. It is a recognition that there are fixed costs associated with governing geography, and that if we collectively wish to “own” our scarce geographies, we have to pay those costs. Subsidies from urban to rural exist in Europe and are not broadly controversial there (though they are controversial elsewhere) in Europe’s common agricultural policy. The US does reliably offer transfers ex post to internal current account debtors, primarily via FDIC, and in the more recent era of megabanks, TBTF support. Florida, Nevada, and Arizona, were terrible current account deficit states prior to the crisis. State reimbursed defaults are our means of transfer. The United States does much countenance what are obviously persistent welfare transfers from rich to poor across state lines. Unemployment insurance is a state-by-state affair, supported by state-level taxation for the most part. The Federal government provides only catastrophic unemployment insurance with in the US, offering extended benefits in severe downturns. That is, the Federal government is kind of a reinsurer of states that pays up during nationwide shocks and no-fault “disaster area” emergencies. Its role as even catastrophic reinsurer is enormously controversial. (Republican politicians seem to hate it, and I presume they represent some substantial fraction of the polity in doing so.)

    Human beings are moral animals (and thank goodness that they are). Undoubtedly, in every political arrangement there are opaque transfers, and some of those go from rich to poor (though most of those flow uphill I suspect). No transfer union is sustainable, in the US or in Europe, which compels open and apparently permanent transfers from one group to another group without some justification for why the transfers are deserved. Greece’s enthusiasm for tax avoidance and Italy’s cultural exuberance will not fly as a justification for persistent transfers. Transfers from urban to rural are widely justifiable under existing cultural norms in Europe and America, but very few other current transfers are.

    It’s important to remember that a few years ago, several of today’s beggar countries looked like European tigers. Ireland and Spain were doing great, to those foolish enough to believe market efficiency obviated concerns about capital flow imbalance. There is no reason why Spain and Ireland, or even Greece or Southern Italy, should expect permanent poverty, and no reason why Germans and Finns(!) should sign up for permanent transfers to them. They require transfers now because of a specific historical circumstance (caused primarily by foolish lending and tacit regulatory guarantees thereof).

    I can’t think of any material difference between this proposal and the euro-bond proposal, which will also fail to do what is needed. The difference, in terms of hitting the German bottom line, is more in terms of misdirection.

    This will come back to an issue that we’ve squabbled over before, which is you don’t see a very big difference between debt and equity, whereas I am certain that, although they lie along a common continuum, the distinction ultimately represents something important and categorical.

    Yes, both debt and equity represent outlays of funds that are intended to be repaid, and yes, private sector equityholders demand compensation for the risk of nonpayment as surely or perhaps more surely than creditors, in the form of a stochastically expected cost of capital. Equity can be hard to raise.

    But once equity is raised, its effect on the financed entity is entirely different than the effect of debt finance. Debt-finance, absent perfect refinancing markets, implies that there are states of the world in which an enterprise may be forced to sacrifice long-term performance in order to satisfy the claims of creditors. Equity claims impose no such constraints. (This lack of constraint can arguably be a bad thing too — there’s a whole literature on leveraged cap structures as a means of managing agency costs — but let’s put that aside for the moment.)

    This proposal, if it would work, would do so via two basic mechanisms. The first represents a very ordinary kind of subsidy: I’m proposing that the ECB offer to refinance e.g. Greece’s debt in perpetuity at a rate of return vastly below what private market participants would demand to hold a similar security. I am suggesting that the ECB also offer e.g. Germany’s debt on precisely the same terms, but obviously the net effect of those two refinancings is a subsidy of Greece’s interest payments by Germany, as the spread between market-and ECB- terms offered to Germany is far less than the spread between market- and ECB- terms offered to Greece.

    The second mechanism, however, serves to justify this subsidy in part. I believe (and I think that the European Union should act as though believes as well) that, given time and a discontinuation of the bad capital-flow hygiene that brought Greece it where it is, there is no question that Greece can grow at a rate that will render its current indebtedness manageable, if the return demanded on that indebtedness is modest. That is, I think that a long-term, patient and unconstrained, investor should be willing to offer even Greece financing on extremely generous terms. European institutions especially should be willing to do so, because it represents a kind of Pascal’s wager for them. If, over say an 80 year time horizon, Europe’s circumstances remain so tumultuous and uninspiring that Greece’s current real debt remains burdensome, the European project is toast anyway. There is very little incremental cost to European institutions in making a long-term wager that Greece will grow in real terms over the decades, once the current unpleasantness has passed. All I’m asking is that European institutions invest in their member states as though they are long-term low risk, and on terms that are distributionally fair. That strikes me as a very justifiable sort of investment for European institutions to make.

    Your comments suggest that this proposal is intended as a form of smoke-and-mirrors, that it’s all about using the money veil to enforce transfers. But that is not at all my intent. Some things that can be thought of as monetary transfers are intended: the expected differential effect on the domestic purchasing power in Germany and in Greece, for example. But reequilibrating real exchange rates is prerequisite to the continuance of European integration. The “transfers” involved are multidimensional (Germans become wealthier when purchasing Greek goods, and poorer when purchasing German goods), and can be thought of as undoing earlier fluctuations in relative value caused by foolish capital flows.

    But overall, I do not intend this proposal to “hide” any sort of hole. People talk about “insolvency” as though that is ever a fact that must either be acknowledged or faked. The solvency of an enterprise is never a factual question (only illiquidity can be factual). Solvency or insolvency is always a conjecture, and policy can tilt that conjecture one way or another. We may wish sometimes arrange policy to tilt towards insolvency. In fact, we often wish to do so in the service of “creative destruction”, to keep incentives sharp, to avoid “zombie firms”. I think we ought to arrange policy so that Citibank’s insolvency becomes a social fact, for example. But I acknowledge that we can arrange policy in such a manner that it has a tacit asset of state support that will render it solvent for an arbitrary period. The question isn’t whether Citi is or is not insolvent. The question is whether it serves our long-term interests to provide an environment in which it suffers an overt insolvency, given different future scenarios and legitimacy concerns under the rules of the game ex ante. For Citi, I want to see an overt insolvency, for both tacit and moral/normative reasons. But I see little upside in Europe’s sovereign debt crisis to manufacturing overt insolvencies. The technocratic challenge can be met by managing preventing unbalanced intra-European debt flows going forward. That me be politically difficult, but as a technical matter it’s trivial.

    On a moral/normative level, nations don’t disappear and reconstitute as smoothly as capitalist firms. The humiliated employees of Arthur Anderson are doing fine at PwC, and though they may look back unfondly to the trauma of their uprooting, I suspect that very few harbor a generational grudge against Washington. But humiliated “bankrupt” Greeks will still be Greeks, and given the rigidities of European labor markets, most of them won’t smoothly be absorbed into the broader EU economy following an insolvency. There is no moral upside to treating a nation like a firm that deserves to be liquidated and a whole lot of terrifying downside. This is our “economic consequences of the peace” moment. Troubled European countries can be long-term solvent, given capital on generously nonburdensome terms and better financial hygiene going forward. That is what we should provide for them.

    (BTW, despite my perhaps sharp disagreement, is that how you write when you are drunk, I’d hate to face your sobriety. As always, you thoughts are smart, interesting, and much appreciated.)

  64. rsj writes:


    I enjoy the discussion. Let me try to insert your proposal into a different paradigm — one that doesn’t depend the technicalities of reserve accounting or differences between equity and debt.

    The EMU holds interest bearing assets. The ECB member states supply capital to the ECB and earn a pro rata share of the ECB’s net interest income.

    We also agree that governments are not firms, so that the decision as to which member state receives how much seignorage income is not a profit-maximizing investment decision but a political decision. But it is not a bureaucratic decision. The member governments need to sign off on the arrangement.

    Now consider two proposals.

    In the first proposal, all the EMU governments jointly guarantee and issue “euro-bonds”, using the proceeds to directly lend to Greece. Greece uses the proceeds to retire its outstanding debt and for future financing needs. It redeems the obligations at par whenever it wants, while the other nations continue to service the debt to the private sector. The ECB announces that euro-bonds are acceptable risk-free assets for purposes of determining capital requirements, repo-lending, and bank-lending.

    In the second proposal, the ECB lends to Greece on the same terms, and sterilizes the operation by selling off some of its interest bearing marketable assets. The assets that it sells off are acceptable collateral for purposes of determining risk-weighted capital requirements, and repo lending, etc. They yield the euro bond rate.

    In the first proposal, whenever Greece uses its right to defer a payment to the member states, that is a loss of interest income for them, as they must make the payment instead. In the second proposal, whenever Greece defers a payment, that is an identical loss of income, this time for the ECB, and this results in an equivalent loss of seignorage income by the member states (assuming ECB expenses remain the same).

    In both cases, the same transfers are occurring, to the penny. In both cases, Greece is re-financed at the same rate.

    Let’s push this further.

    Suppose that we are in the first case and the financing needs of Greece are proportionally larger than the financing needs of the other states.

    What ensures that the eurobonds earn a low interest rate? The ECB can guarantee this by setting a nominal rate for the bonds, but there is a risk of inflation and the ECB is mandated to control inflation. As more euro-bonds are sold, the member governments will need to drain assets from the private sector so that the ECB does not see a need to raise interest rates. Ultimately the member states are taxing their domestic populations and transferring the proceeds to Greece.

    Suppose now that there is excess asset demand so that Greece’s debt offering does not crowd out the debt offerings of member states. Then it is still the case that the member states are excessively taxing their own populations and this is what allows Greece to run deficits (even though the motivations for excess taxation may have nothing to do with Greece). Again there is a direct trade-off between the EMU wide-tax level and the deficits of Greece.

    The Maastricht treaty was introduced to avoid the free riding problem of these trade-offs, and I believe that the one size fits all nature of this treaty is why we are in trouble. California historically pays a dollar in federal taxes for every 70 cents of federal spending, while for poorer states the situation is reversed. It must be so. It has been this way for decades. The equivalent Maastricht rules would require Germany to run a surplus and Greece would be allowed to run a large deficit, with transfers from one to the other.

    Back to the two proposals, suppose now that we are in the second case:

    Greece may require more in loans than the size of the ECB’s balance sheet, in which case the ECB will need to raise reserve requirements. We agree that this is effectively a tax on the financial sector. Irrespective of the incidence of this tax, it is still a EMU-wide tax, the proceeds of which are sent to Greece. Again, same thing. It doesn’t matter how you do the accounting, or whether you like to classify one obligation as equity or debt. It is all tax and transfer, and the political opposition is due to the tax and transfers, not due to accounting classifications.

    This, I believe, is the real source of the proposal. I.e. the second tax and transfer operation is believed to be more politically acceptable than the first, even though in both cases, we are talking about equivalent tax and transfers.

    Operationally, the ECB does not have this discretion — the payout ratios and asset requirements are constrained by ECB policy which must be approved by a board of national representatives whose votes are weighed in proportion to their capital subscription — a combination of GDP and population. Nevertheless there is an assumption that the national representatives governing the ECB are more likely to voluntarily donate income streams to Greece than their elected colleagues.

    Which is why I call the proposal ugly:

    There is no reason that income transfers need to be routed via the central bank, which is a non-elected body, does not have the necessary expertise, and contains conflicts of interest that prevent it from levying the appropriate taxes on its core constituency in order to insure that Greek social spending is not reduced.

    But I see how you it might be considered clever if it would really work.

    In any case, I hope we can agree that operationally, the first model is superior to the second. There is no reason why the EU banking sector reserve demand should constrain Greek debt, when the non-financial sector’s asset demand should be the constraining factor. There is no reason to use only a dedicated funding source — e.g. seignorage income — to pay for transfers that arise out of industrial and institutional imbalances between member states.

    In terms of whether these transfers are necessary, I think they are. There are increasing return to scale industries that lead to agglomeration effects. Productive enterprises require a social eco-system of human capital, well functioning institutions, and credit relationships. By agreeing to join a currency and trade union, nations are risking the survival of these eco-systems as the most productive ones swallow the less productive ones.

    In the future, Greece may be the birthplace of some new industry — e.g. the Nokia phenomena — but until then, if Greece is to share in a currency union with Germany, then it will for the most part de-industrialize and lose its increasing return industries to Germany. This will be accompanied by gains due to industry concentration and larger market sizes within the EU as a whole, provided that appropriate transfers are put in place. These transfers should tax the Germans for the productivity gains due to larger market sizes and they should subsidize the Greeks for the resulting loss of capital (and productivity) to Germany.

    The ideal form of taxation is via an EU-wide system of income taxation and social benefit payments, not bank reserve taxes and state-to-state transfers. But the net effect of these transfers will be to tax high productivity areas and subsidize lower productivity areas.

    Just as within Germany, the wealthy industrialized south subsidizes the less productive north, or within Italy, the more productive north subsidizes the south. We cannot all work for increasing-return manufacturing firms, some of us need to work as haircutters and waiters. If the increasing-return firms concentrate in one area — and they will do so — then either there will be ongoing transfers or the economy as whole will experience recurring internal payment crises and it will shrink. I believe that an industrial economy needs these transfers as a pre-requisite for economic stability. I understand that this is not a mainstream view.

  65. RSJ — As always, a very meaty analysis. I enjoy the give and take as well.

    A few points:

    1) There are differences between the schemes you describe and the equity proposal here, and a core difference regarding how we come to the question of “fairness”. In particular, in the equity proposal, each state has the option to exactly the same per-capita cash flows. The lost seigniorage income lost by the ECB is not used to fund only Greece, but to fund all takers. Individual states make a choice of how much of that funding they wish to accept, which has domestic price level implications. If all states accept their full allotment of ECB equity purchases, nominal cash flows are equalized, and the foregone seigniorage loss is shared on a per capita basis. If the ECB chooses to increase reserve requirements as one tool by which it manages the price level, there is a tax, but the incidence of that tax, to the degree it can be described, would be better characterized in terms of class than country. That is, financial asset holders in aggregate (potentially borrowers, though I doubt it, and also potentially banks) are taxed. Perhaps that taxes Germany disproportionately since it is “rich”, but you’d have to look deeply into the meaning of rich, the distribution of wealth and character of assets held to say that. If all countries choose to accept their full equity allotment, you really have to stretch to find nation-to-nation nominal transfers. There is an EU-wide assetholder to general public transfer.

    2) If, however, some countries opt not to accept their full allotment in order to manage the domestic price level, looking at the period of equity issuance, there would be the sort of country to country transfers you describe. But you describe a kind of nationalistic worst case, where only Greece borrows, and it borrows fairly indefinitely, financed either by Eurobonds or foregone ECB seigniorage. In that case, yes, if you follow the per-period cash flows, you will find continuing net cash flows from the rest of the Eurozone to the indefinite borrower, and it is financially irrelevant whether those cash flows are laundered through the ECB or financed via Eurobonds.

    3) However, my proposal is not intended for the “worst case” you describe, and I think that here is the core of our disagreement. Meaning, while looking backwards I think Greece’s creditors have a weak case and deserve whatever haircuts can be imposed on them, going forward I don’t think anyone should be lending to Greece, whether via Eurobonds or laundered through the ECB, until Greece demonstrates its capacity to repay loans as agreed. This proposal is not intended to obscure perpetual transfers. It is intended to reorganize past indebtedness in a fashion that creates space for maximizing future welfare with as little taint as possible from past error. “Sovereign equity” is not intended as a means of arranging transfers at all. While unbalanced cash flows do occur at the time of equity issuance, those “transfers” are to be reversed, in real terms, at some point in the indefinite future. Whether or not you wish to account for the extremely below-market-rate finance, the foregone potential profits, as a transfer is a judgment call. On the one hand, the non-equity-accepting countries (the net purchasers of equity) could have driven a harder bargain, and by not doing so, they are making a transfer relative to nominal Euro maximizing baseline. On the other hand, the risks to all Eurozone countries and the continuing value of the Eurozone itself might render accepting a low return optimal for all parties, and so there might in fact be no opportunity cost. If there is a net opportunity cost, it may be borne by some countries more than others (depending on domestic choices about whether to accept equity), it may be borne by assetholders or by taxpayers (depending on very complex questions regarding the distribution of costs and benefits associated with reserve requirements, interest on reserves, taxation, inflation, etc., and policymakers’ choices going forward). But over all, the only subsidy this proposal would provide any party is the opportunity cost borne by net purchasers of the equity, as long as it is true that over an arbitrary long horizon the equity will be redeemed.

    Rereading our exchange, I think that much of our disagreement is a matter of talking past one another. What I am trying to accomplish and what you would like to accomplish are two very different things. A political union that includes widely accepted, preagreed transfers and widely shared insurance schemes that necessarily compel transfers ex post might indeed be a very wonderful thing. You are certainly right that there are many transfers, some of which are persistently attached to geography, that are widely accepted and agreed within the US, for example. There are already such transfers in Europe, too. Germany already does pay, via the common agriculture policy and EU infrastructure, green energy, and cultural grants, more than it receives as part of the union, like California. That remains (mostly) uncontroversial, and is a good thing.

    The EU’s problem now results from historical cash flows that were made formally as debt. I am with the mean Germans in that I react with outrage at the notion that because some preagreed intra-Europe transfers are wonderful and advisable that debt imbalances should be resolved ex post with transfers. Within the US, we do lots of transferring, but if California’s fiscal problems go pear-shaped, the necessary resolution process here will be unpleasant as well, and it should be. Mostly, it should be unpleasant for creditors (as it should be in Europe too). But if, as is likely, we find we cannot accept creditors bearing their own losses, the outcome of the policy process should not be a shrug and a transfer, because after all we are part of a transfers union and California has overpaid in the past. The normative context in which cash flows are made matters, and if that context cannot, as a practical matter, be respected, then we have to find a credible and sustainable set of norms and arrangements going forward.

    It is uncontroversial that FDIC has transferred lots of money to California and Nevada and Florida and Arizona in the aftermath of their unbalanced current accounts, because we had agreed and prearranged an insurance program that compelled those flows. It is uncontroversial if, as a matter of stimulus or crisis management, we agree as a polity make grants to states to address their fiscal crises. But it is and certainly should be controversial if some few states’ domestic affairs are arranged in a manner that compels transfers under duress. And though ultimately we might and probably would be forced to intervene in such a case, the right response to that situation isn’t necessarily to say “there should have been more transfers agreed in the first place, so the problem wouldn’t have arisen”. Bad debt can coexist with any level of transfers or income (and often does). The right response is to come up with a set of norms and institutions and incentives in which the transfers that are necessary are preagreed and there are sufficient incentives in place to prevent transfers that are not preagreed from being compelled.

    I don’t necessarily disagree with you on the desirability of more ongoing and agreed transfers within the European Union. But I think it’s toxic to mix that discussion with the question of how to resolve the existing crisis. We should recognize, of course, that current account imbalance may exist because transfers are necessary but have not been agreed. But current account imbalance can also exist because of mercantilistic creditors and and a kleptocratic debtor state. My proposal is not intended to allow continual borrowing: it would be attended by current account austerity, made easier by the fact that no near-term debt service would be required. Going forward, Greece should absolutely be forced to live within its means. What those means should be, given the realities of a political union and productivity differences, definitely deserves discussion, and you may be right that a wise polity will accept that persistent productivity differentials imply persistent transfers at a level higher than previously obtained.

    But that is a conversation for the future, and excuses neither creditors nor debtors of their past misjudgments.

    I think we may disagree a bit less than it seems on the long-term picture. But I am focused here narrowly on the question of reorganizing the past burden in a manner that is as fair and as respectful of the normative environment as possible without impairing the ability of states to grow forward.

    In the longer term, it would be great if the EU, with the support of its publics, were to agree on deeper integration and whatever transfers that entails. I’m sure you are right that successful industrial economies inevitably require such transfers. Reasonable people can argue over the level and terms of such transfers (and even whether they are “transfers” at all once the option value associated with “nonproductive” people and geographies is taken into account). If arranged well, transfers will help prevent debt crisis by substituting income for borrowing, and that is a practice we all need a great deal more of. But, repeating myself repeating myself, a debt crisis that has created wide disagreement along national/tribal lines is probably a bad time to have that conversation.

  66. JKH writes:

    Ex conversation:

    Marshall Auerback riffs again on the Mosler proposal:

    His description of the proposal leaves the inherent concept of negative equity as an unarticulated (but unavoidable) subliminal feature (as seems usual with this particular proposal) that results from using the ECB balance sheet as the conduit.

    The crediting of NCB accounts at the ECB would eventually result in the release of the same amount of bank reserves, and in that form act as alternative funding for cumulative EZ deficits. What is interesting about this, relative to our earlier discussion above, is that such a transfer formalizes the negative equity measure associated with that portion of cumulative deficit funding. That’s because capital (and in this case negative equity) is a formal entry on the ECB balance sheet, where it is not EZ treasury balance sheets. Yet the substance of such funding is essentially the same on either balance sheet.

    Ironically, Auerback interprets such a marginal expansion of reserves as an equity rights issue. The effect is to reverse-transform your concrete proposal for an equity security on the left hand side of the ECB balance sheet to an abstract idea for equity on the right hand side of the ECB balance sheet. Unfortunately, ECB institutional book keeping will force the opposite result. Because the EZ treasury(s) deposits and the associated reserves ultimately created are missing a matching asset (e.g. the equity securities of your proposal), they will force the capital position of the ECB to be negative. So it goes, one way or the other, when you use the ECB balance sheet as the medium for EZ funding transformation and deal with the inevitable requirement for institutional accounting reconciliation.

    Quite apart from our abstract and somewhat academic discussion around the concept of “negative equity”, your proposal is superior in my view because it deals head on and realistically with the real world requirement for coherent institutional (ECB) accounting of some sort. Such accounting is absolutely necessary, functionally, as well in order to recognize and measure the true risk and cost/return sharing dimensions for EZ members of associated institutional arrangements.

    These types of proposals would also benefit from at least some back of the envelope calculations on the potential ECB and EZ treasury(s) operations interest margin consequences and the associated presumed cost of capital benefits of risk sharing. It’s exactly the same type of analysis that is easily done in the case of the Fed’s balance sheet with respect to the risk of potential future interest margin compression coming out of QE. The Mosler version of the proposal for the ECB makes this type of analysis even more advisable because there is no corresponding and at least partially offsetting interest revenue stream coming in on the asset side of the balance sheet.

  67. Fed Up writes:

    SRW said: “Start-up firms are not financed internally from profits.”

    They should be financed with savings.

    And, “Investment in the production of durable goods like cars from profits would be impossible without the profits, and car companies would have very little profit if all of a sudden no external finance was available to customers.”

    The customers need to be more profitable so they can save up to buy a vehicle.

  68. Fed Up writes:

    JKH said: “Suppose its central bank had reserves and currency on the liability side, with private sector assets (e.g. loans to banks) on the asset side.”

    How about “Suppose its central bank had reserves and currency on the liability side, with goods/services of the economy as assets on the asset side.”?