An Italian Regulator's Risk-Sharing Plan to "Cure the Eurozone"

Marcello Minenna, a division head at the Italian securities regulator, emailed his plan to "Cure the Eurozone".

Marcello Minenna, the head of Quantitative Analysis and Financial Innovation at Consob, the Italian securities regulator, pinged me recently with his plan to save the Eurozone.

The plan requires debt guarantees with a catch: The catch is the guarantees have a price: The riskiest countries have to pony up the most for debt insurance.

His thoughts are in a downloadable PDF on Curing the Eurozone. A slightly different version can also be found on FT Alphaville: Getting to Eurobonds by reforming the ESM.

Minenna notes the "European Stability Mechanism (ESM) has subscribed capital of €704bn but only 11.4 per cent of that has been paid-in; the remainder is callable shares. Thus, the Mechanism runs a large gap between subscribed capital and paid-in capital. Should the Board of Governors call in authorized unpaid capital (€625bn), ESM members would have to quickly meet the call with additional contributions."

Minenna proposes a risk-sharing agreement whereby riskier countries pay insurance premiums to the ESM in the form of capital injections.

Cost Benefit Italian Case

For Italy, the total cost of the guarantee would be €56bn to be spread over a 10-year horizon, but starting from the third year this cost would be more than offset by the savings in interest expenditure.

Over ten years, Italy would pay an estimated €56bn to the ESM in the form of insurance premiums. The associated public investments would increase Italy’s GDP by a cumulative €150bn.

At the end of the 10th year all debt will be fully risk-shared.

"The extra payments to the ESM would be a challenge, but they would be a big improvement to the current situation, where, because of the fiscal compact, the danger of rate hikes and the over-prudential discipline on non-performing loans, finance has stopped flowing to the real economy and the public budget has lost €100bn of tax revenues from banks and businesses," claims Minenna.

Debt Mutualization

Leverage

In his email, Minenna proposed "ESM leverage capability could be used to give a financial backing to public investments within peripheral Eurozone areas, in order to benefit of large fiscal multipliers usually exhibited by less developed regions."

Issues

  1. The Maastricht Treaty which led to the creation of the Euro, does not allow such schemes. Germany has resisted all such schemes.
  2. Germany and some of its neighbours would experience a deterioration of their creditworthiness because of the joint responsibility on the shared debt of the other states.
  3. Minenna likely underestimates the amount of insurance required, perhaps by a lot, if debt debt volatility picks up.
  4. Minenna likely underestimates the amount of debt once such a scheme is hatched.
  5. Why might debt and volatility increase? Precisely because of the leverage Minenna espouses. Italy benefits only if debt or interest on debt does not soar.
  6. Minenna's solution does not fix any key fundamental problems. One interest rate policy cannot serve 19 masters. There are huge productivity differences between various Eurozone countries.
  7. Target2 is fatally flawed by design. No amount of insurance can possibly solve the fundamental point that Italy will never be able to pay creditors, primarily Germany.

Target2 Analysis

The latest numbers show Germany is owed €848.4 billion, primarily by Italy and Spain.

I struggle to see how these amounts can ever be paid back, insurance or not. If insurance is price correctly, Italy cannot afford it.

Debt Mutualization Key Points

Here are two essential points that Minenna never states explicitly.

  • What cannot be paid back, won't be paid back.
  • One way or another Germany will pay substantially.

Minenna's insurance scheme kicks the can still more, perhaps buying more time for some German politician to come into office who realizes the mathematical certainty of the above bullet points.

If Germany were to agree to an insurance scheme, we have the beginnings of debt mutualization in which debtors start defaulting on payments owed, for which insurance will never fully cover.

There are two and only two ways this ends.

  1. Germany agrees to restructure the amounts it is owed.
  2. Some country, likely Itlay, says to hell with it all, leaves the Eurozone, and starts a cascade of defaults.

If Germany were to accept Minenna's proposal, that would be a step in the direction of point number 1.

The political problem is Germany does not accept my two previous bullet points as a matter of fact.

Until Germany accepts it cannot be paid back and until a German chancellor is willing to take the heat for admitting the truth, the can-kicking insurance scheme cannot gain any traction.

As long as Germany believes it can and will be paid back in full by creditors, it is unlikely to accept any insurance schemes, debt mutualization schemes, or eurobonds.

Politically, Germany may not be willing to accept such schemes (even if it does accept my points), until it is well understood that some country is about to default.

Insurance Icing

I freely admit that Minenna seeks a solution that makes a eurozone superstate possible, whereas the Libertarian in me hopes the thing blows sky high.

Nonetheless, I honestly appraised his proposal. I think his proposal is well thought out, in general.

However, Minenna needs to explain how anything substantial can happen without a treaty change that every Eurozone country has to approve.

Even if such a thing could happen, how long would it take?

This is not a matter of me wanting one thing and him another. This is about political realities regarding German acceptance of what a genuine solution entails as well as political realities and timelines that suggest it cannot realistically happen given that it takes 100% agreement among 19 nations to do nearly anything at all.

This is yet another fundamental Eurozone flaw. Meanwhile, the political and economic clocks keep ticking.

Mike "Mish" Shedlock

By Italy paying $56 billion, spread over 10 years; Italy’s $2.3 trillion, and rapidly growing concurrently with a demographic time bomb, debt; somehow magically becomes a complete non-issue forever……

Structured mortgage products once worked the same way: Take 10,000 deadbeat mortgages, package them together, make up some obfuscations sufficiently fancy to fool the average idiot, and suddenly the mortgages are all money good…..Until they’re not anymore. Some time after bonuses have been paid out, and reelections are in the box.

There is a solution: Germany spends the money! The start of the problem is that Germany sell lots of exports and then they do not spend the money the exports bring in. So, the excess money (current account surplus) is forced into other countries primarily in the form of debt. Target2 is buy one (easy) way for this money transfer to occur. If Germany is unwilling to spend the money then they will lose it. Example of how this could work: 1) German govt notifies the public that they are piling up too much money and need to start spending it; 2) Germany makes a temporary cut to the VAT by 150 to 200 billion euros/year; Germany makes a temporary increase to govt spending by 150 to 200 billion euros per year; govt notifies the public that they will continue this temporary policy until the people start spending the excess money. The choice seems clear to me. Germany can either spend the money or lose it. All evidence is that they would prefer to lose it.

Just from first principles, if there is a clear net benefit to one actor in a purely financial transaction, then said actor is underpaying, which means net cost for the other actors (which would of course be the objective here for Southern countries, a huge subsidy). If the conclusion is that all actors benefit, something is wrong with the math. Risks and costs can't be 'disappeared', only transferred.

sounds familiar - "spending other people's money" that is, until they run out. Germany needs the money it is owed to finance its past (1.5 million) and future (1 milllion every five years) immigration. All the money that the ECB has provided as export credit guarantees to Germany (and Holland) on behalf of Italy and Spain, so that massive trade imbalances are held in the "nostro accounts" represented by Target 2 - is needed by Germany. Each immigrant requires around 50,000 a year to pay for education, health, housing, policing, "utilitying" and job training - that's a minimum and does not reflect the indirect costs of immigration as Germany has to divert resources away from servicing the indigenous German population. My guess is that direct and indirect costs are around 100,000 euros a year per immigrant. So 1.5 million times 100,000 euros = 150 billion a year now, rising to 250 billion a year in five years. the present value of that at 30 yer bund yields is of the order of 80 times that amount (30yr bund = 1 1/8%) or 8 trillion euros. That is before the ECB normalizes rates - say an increase over the next fove years of at least 2% in the refi rate and a 2% hit to eurozone GDP from the new interest burden. in short, germany is just as broke as every other EU country - its libtard socialists lie about it, in the same way. BUT, it needs the Target 2 money so Italy and Spain will have to "pony up" the export credits they think they don't ever have to pay for.

No doubts that my proposal on ESM reform based on risk-sharing is challenging…But the challenge comes mainly from the political arena …
This both bad and good… Bad because after years of risks segregation within the Eurozone we are all more and more used to German-thinking….Good because a political change will change our minds.
Reaching an agreement at the political level can change premia required by markets by dramatically changing their expectations … does anyone remember 17 years ago when the full commitment of participating governments to the Euro projects pushed investors to bet on the Germanization of sovereign yields? Then, massive convergence trades took place where market participants sold expensive Bunds and bought cheap Italian Govies making profits from convergence. And what about the effect of the Draghi announcement of the OMT?
It’s a matter of expectations…and if you think about the fact that Germany has to pay (one way or the other), may be it could be worth also for Germany to reach an agreement. What I’m proposing is less penalizing for core Eurozone countries than Euro-bond free debt mutualization proposals discussed in late 2011. I'm saying that Italy has to pay to share its risks (Eurobonds do NOT provide for these payments) and the net benefit comes from yields convergence and large fiscal multipliers of public investments.
As soon as the new ESM will start, the portion of public debt expiring each year will be re-issued with risk-sharing clauses providing for a re-distribution of risks across Eurozone governments; at most risk perception could worsen on outstanding (non-refinanced) Govies as they are not assisted by such clauses. But, with proper provisions, also this can be managed: these are hold-to-maturity bonds, whose depreciation wouldn’t affect the interest expenditure for the Italian Treasuries provided that selective default is forbidden.
With regard to risk-shared Govies my estimates of the amount of insurance required assume yields convergence. That’s true. After all, an agreement across Eurozone partners in the direction of a debt mutualization CAN DO this. And in the long term also EU treaties should be revised in a similar perspective, for instance allowing the ECB partial deficit monetization.
Let’s not fool ourselves. Either risks are shared or the EU Monetary Union is destined to disintegrate because it will remain the last viable option for Southern countries of the south (pushed by a Germany that is now in danger of being trapped in its own orthodoxy). What I propose instead is an agreement that provides for a temporary application of the subsidiarity principles provided by the EU treaties: Germany will have to accept a normalization of its credit standing (PLEASE DON’T TELL ME THAT GERMAN NEGATIVE RATES ARE NORMAL!) to guarantee a viable future for itself and for the other Eurozone countries. In exchange for this, along with insurance-based contribution paid by risky countries, risk sharing clauses will have to prohibit the possibility of converting government bonds into a new national currency, thus making the option of exiting from the euro worthless.
What Mish says is true ... we are 19 different countries ... but sharing risks is the first step to truly re-align our diversities. It was exporting risk with vendor financing and then with deleveraging that Germany managed to increase its productivity ... and forced peripheral countries like Italy to devalue the work to try to recover land in an area where there are no plus the adjustments made possible by exchange rate movements ... it’s time for Germany to recover some of the risk it has exported ... Personally, I am tired of the pro-German mainstream, according to which the evils of the periphery are due exclusively to fiscal indiscipline . Let's stop segregating the risks and let's see ... and if the Italian economy re-starts (really) it will be able to repay the Target 2 deficit ... I say: LET'S GIVE US A CHANCE.

@gstegen
Germans already spend more than Italians. What Germans spend or not spend, is exactly zero business of anyone but themselves, including the German government.

Besides, Germans, in aggregate, are spending; albeit backhandedly and involuntarily, as is the case with most spending done by productive people these days. They’re spending on Italian debt. And on salaries, perks and prostitutes for banksters, politicians and other genuinely worthless, unproductive and useless rabble.

Take the involuntary part out; as in, attempt to reinstate some semblance of freedom; and Germans won’t spend their money on that. Which very directly solves the problem of Italy having too much debt. And the problem of banksters now gaining increasing influence and status, even in Germany proper.

@m_minenna
Thanks for posting!

You probably know more about what it takes to save the Monetary Union than almost anyone. And what you are proposing, may be the most politically palatable means of doing just that.

But why? It’s an economically unworkable system. And not because it pits Germany against Italy, nor North against South, nor Core against Periphery. But simply because structural risk sharing, risk mutualization, in any form; including to the extent already baked into the EU/EMU; is by it’s very nature a subsidy: Paid to the reckless, by the prudent. Central banks providing “liquidity” assistance is no different; whether their domain covers an individual country, as does the Fed, or a bloc, as is the case with the ECB.

The mere existence of forced, structural transfer mechanisms; from those who happened to win the lottery to those who didn’t; or from those who toiled away in a coal mine amassing a valuable pile of coal, to those who spent their time at Bunga Bunga parties and are now about to freeze to death; the two of which are fundamentally impossible to differentiate even in theory, by the way; does nothing but provide an ever increasing incentive to join the Bunga Bunga crowd, and an ever decreasing one to toil away prudently.

And it’s not as if Germany consists of a monolithic borg of toilers, and Italy of BungaBunga’ers. Both have plenty of both. But because of the implicit risk sharing, backstopping, guarantees, transfers etc., already baked into the EU/EMU, as well as individual country political arrangements, the BungaBunga'ers have steadily gained ground, with every single, whether well intentioned or not, move towards making “the financial system” more “stable” and less prone to the periodic collapses that would otherwise correct over extensions and excessive imbalances.

More specifically, your (almost certainly correct) observation that German vendor provided financing, to entice non-German buyers to buy German product, lies at the core of the problem, illustrates the problem of risk sharing/mutualization perfectly. As it is the (even if only implicit) risk sharing baked into "The System” already, which allows vendors to be so reckless about verifying the credit worthiness of their customers. Or, in practice (if a bit oversimplified), which allows reckless German actors in the financial sector, to profitably insert themselves into and obtain a cut of the value added by prudent German producers. By way of offering to underwrite said vendor financing, without first doing sufficiently prudent due dilligence. Safe in the knowledge that someone, somewhere who is solvent, will be forced by structural arrangements beyond his control, to “save the system,” or even simply “preserve faith in the system,” by providing a de facto backstop, once the poorly vetted, less than credit worthy customer ends up defaulting.

The ones losing out in this whole mess, are not “Italians” in aggregate; but rather the prudent Italian, as well as prudent German, producers who seriously vet their customers for credit worthiness before/if extending credit. And who are hence left at a competitive disadvantage. And insidiously, increasingly so, as by being prudent hence solvent, they are ultimately the ones tasked by “the system” to make the otherwise insolvent and reckless ones whole again. IOW, they are the ones who ends up paying for the cost of the misallocations that reckless vendor financing allowed to happen.

Aggregating what started as reckless vendor financing deals between individual firms, viaTarget2 imbalances, up to the national level, and then attempting to deal with them there; just further blunts incentives to be prudent. By distributing losses even wider.

It’s already silly, and economically destructive enough, to assume, a priori as seems to be the official German stance, that the balances are to be paid by “Italy,” as in realistically, young Italians who had no say in the matter, via them being overtaxed their entire lives and those of their children and grandchildren……. for the level of services they receive for their tax Euros. Rather than via the individual obligations being defaulted on, then resolved/erased via bankruptcy proceedings, by the individual firms owing individual vendor financiers. So that the individual imprudent decisions come back, as directly as possible, to haunt the specific actors that made the deals, and who hence profited from them.

Trying to cast the net even wider, in an ever more widespread search of patsies, in order to keep a fundamentally dysfunctional system afloat, will just end up accelerating the shift from prudence to recklessness, hence ultimately the economic decay. Italy, like anyone else, needs productive actors creating value. Ditto for Germany. An integral, and no less important than the immediate creation itself, component of that, is that both needs a mechanism for destruction: In order to, as precisely, quickly and efficiently as possible; destroy those actors and processes which do not contribute to value creation. Not kick the can down the road and mutualize the losses those guys incur; by effectively saddling the productive with the cost of backstopping them. All in order to save an abstract, artificial “system,” which is simply assumed to be above rational critique.

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