Pay It Forward: Emergency Eurozone Liquidity Without Begging the ECB

The severity of the financial crisis is down to savers no longer “knowing”* what saving goods (especially bonds) are worth. While the crisis reflects major underlying problems, its immediate escalation is simply a draining away of liquidity from almost all saving goods. The one exception – so far – is money.

A holder of an Italian or Spanish government bond knows that it is backed by a promise made on behalf of million of taxpayers. Yes, both economies (as with all others in the developed world) are mired in difficulties of some description or other. But this diagnosis is not entirely new. Have Italian and Spanish workers all suddenly become less productive? No. Has the word of their sovereigns become questionable all of a sudden. No.

For all the theory directed towards macroeconomics, what causes a recession to occur after a period of growth is confidence. Factors of production – land, labour and capital – do not undergo sudden changes. Yes there are recurrent supply shocks, such as rising commodity prices, wars and natural disasters. But nobody is arguing that any of these is to blame for the current crisis.

Meanwhile, very many people recognise that confidence is key. Keynes talked of animal spirits, and this concept has recently made a comeback in the English language. Behavioural economics has never been more influential.

Yet this level of understanding among policymakers has not unlocked the present conundrum. The more savvy do realise that the key to de-escalating the Eurozone financial crisis is to furnish savers with a saving good whose worth they “know”*. So far, this has prompted calls for the provision of more money (ie ECB intervention). It is beyond the scope of this note to detail the difficulties of such a proposal – suffice to say there are major political impediments.

But as I argued recently (“Dear Mario: A Plan for Italy”**), formal ECB-driven quantitative easing (QE) is not required. No ECB intervention is needed for eurozone sovereigns to issue an instrument whose worth can never be in doubt. Previously this instrument was a government bond, although in this emergency savers now question whether distressed sovereigns are capable of honouring their promises. So a new instrument must be established.

This instrument is a Tax Credit. What distinguishes this from a conventional bond is that the worth of a Tax Credit (to a taxpayer in the year of exercise) is self-evident. This worth is independent of what other savers think or how they behave; it does not rely on a sovereign being in rude financial health in the future. A Tax Credit resembles money much more than it does a bond.

Whereas formal QE cannot be achieved by Italy or Spain (without abandoning the euro) – and might not even be feasible for the ECB given its political environment – Tax Credits can be issued by any sovereign unilaterally with immediate effect simply by offering to subscribe a sum of government bonds in exchange for another sum of Tax Credits exercisable in the future.

Whereas savers (who cannot know for sure what government bonds are worth) demand very high yields to hold bonds issued by distressed sovereigns, they would not have this concern about Tax Credits. Like money, their liquidity is as assured as taxes being levied. Consequently, the terms of the exchange would reflect a much lower (truly risk-free) rate of return: the opportunity cost of holding a Tax Credit (for the taxpayer) is the liquidity premium (on account of the delay before its exercise, at which date it is a cash equivalent).

The government would announce an auction/exchange date together with the sum of Tax Credits being offered (with different years of exercise). Using a risk-free rate of return to accrue value, a maximum exchange rate would be set. E.g. up to EUR110 of 10Y Tax Credits could be offered for EUR100 of 5Y bonds. (My previous note goes into more detail about pricing; the idea would be to offer Tax Credits whose present value corresponds with the surrendered bond par). Italy is running a primary surplus of around 1% of GDP – which, with debt of say 120% of GDP, suggests that paying average interest of 0.8% would mean the government would only need funding for bond repayment. While a yield of 80 basis points is probably ambitious, issuing Tax Credits holds out hope of reducing interest costs towards this breakeven level.

By staggering supply, the government could allow the price of Tax Credits to be bid higher as bondholders compete to exchange bonds for risk-free instruments. The higher the price of Tax Credits, the greater the saving for the sovereign. But by offering present value up to the bond par, this is achieved without imposing a haircut on bondholders, and without resorting to coercion or default. In this way, the sovereign sends a credible signal that it intends to honour its promises, which should encourage bonds to trade back up towards par. Conventional borrowing (bond issuance) would then fall back to affordable levels. (Returning to conventional bond issuance at some stage is desirable as it imposes greater discipline.)

Even with this level of generosity to bondholders (certainly in comparison to market prices), the sovereign would save itself a potentially considerable amount of interest over coming years – and also has the opportunity of postponing refinancing needs too. These two factors mean government – not bond vigilantes – can set the terms of necessary austerity. Restoring financial and economic health is not a given with such an emergency scheme – but by greatly boosting domestic liquidity and investor confidence while reducing interest costs, at least recovery would be back within governments’ sights.

*I use quotation marks in order to set aside wider questions of value and purchasing power, since these important ideas are not necessary in de-escalating the current crisis.

** Also available in the FT Long Room and at


2 Responses to “Pay It Forward: Emergency Eurozone Liquidity Without Begging the ECB”

  1. RebelEconomist Says:

    Nice try, but I don’t think it would make much difference. The tax credits would effectively subordinate the remaining bonds, and make default on them even more likely. And then there is always a chance that the government would refuse to accept tax credits as full settlement of its tax demands anyway.

    • eg221 Says:

      Thanks – correct that it is not a free lunch, but cannot see why default probability should increase as you suggest. I suppose you could, in static terms, seek to argue that default probability should not lessen, but even this neutral stance is to ignore the possibility of drastically reducing the issuer’s cost of finance. There should be a cash saving. Moreover, the sovereign could schedule its receipt of tax credits until after average bond maturity (tempered by the increase in liquidity premium demanded to hold longer-dated tax credits), and thereby buy itself time in which to refinance any outstanding bonds. It is not implausible to expect all bondholders to surrender their bonds in return for tax credits, in which case default probability is technically extinguished. This method (prepayment of tax) was the original means by which the English Crown financed itself, before the Bank of England came on the scene…Personally I cannot see what is preferable about issuing IOUs instead of simply issuing tax credits. Any ideas?

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