As someone who knows a little about monetary theory, banking, and government finance, it is frustrating to listen to the news reports and to read about the Euro crisis. Let me set out some observations.
First, the Euro was created as a credit unit managed by the European Central Bank. The governments of 17 European countries adopted it as their legal tender and discontinued their previous legal tender systems. The European Central Bank (ECB) was incorporated with a charter that made monetary value stability, in terms of what the Euro can buy in the future, its only objective. The ECB does not have additional political mandates, like the U.S. Federal Reserve, such as to promote economic growth or employment.
There are four distinct problems today in the “eurozone,” which does not encompass all of the European Union, but certainly affects all of the others, like Britain and Poland, which continue to use their older national currencies.
Distinguish among
- The accounting unit itself, “Euro.”
- Maintenance of the payments system using the Euro as a medium of exchange.
- The solvency of banks, which are central to the payments system, that unwisely invested in the government bonds denominated in Euros.
- The solvency of governments that issued bonds in Euro units. Those governments must somehow continue to borrow, both to keep on financing deficits and to pay off maturing bonds.
These are four entirely distinct issues, although the news reports do not make any distinctions. Because of the “money illusion” between credit markets, government accounting, and payments for goods and services, with banks at the center, the news reporters focus on the crisis as if the problem were the single currency instead of the foolishness of governments and bankers.
The crisis in Greece made the news when it became clear that government was insolvent. It has bonds maturing soon and it cannot pay principal and interest. Because of the distortion based on the Basel III Accords, designating government bonds as risk-free assets, not requiring any capital reserves, it was quickly discovered that major banks all over Europe and in the United States faced a massive solvency crisis as well.
One of the first victims was Jon Corzine and MF Global, which had invested heavily in the bonds of fiscally weak EU governments, because they paid higher yields. Those bonds were understood to be weak and were selling at slight discounts – as junk bonds ought to do – except former Governor and Senator Corzine, a man of great faith in the power of governments, believed his investments were safe and sound. After all, did not the Basel III Accords make them solid investments? Would governments allow them to fail?
At least MF Global was not linked into the EU payments system, as most major European banks seem to be. The failure of the payments system would be a major crisis for the entire world, and a disaster for Europe, so the European banks, and politicians, are working very hard for a massive bail out.
The German chancellor is not quite willing simply to coerce the ECB to bail out the banks, as the Federal Reserve chairman did do. The ECB was not given any charter to be a bail out agency, but the Federal Reserve since 1913 has always been a bail out agency; it was founded for that explicit purpose. (The corruption of Corzine and his managers, embezzling funds, is not the issue.)
The Fallacy of “Fiscal Union”
There is confusion in the news reports about items 3 and 4 in the list above. In a classical economic system that used gold coins as money, and both taxes and government bonds were denominated in gold coins, the integrity of the coins, and banks that operated with gold coins as accounting units, was never threatened when a government could not collect sufficient taxes to pay off maturing bonds. (The crude method of debasing or clipping coins is another story.)
Any banker who owned such bonds would, of course, take a hit, but like any other bad debt, it would be written off. The bank might become insolvent and have to close. The banker, like Jon Corzine, might go to jail for losing depositors’ money; customers might be shafted, like MF Global’s customers, but the payments system based on the coins would not be jeopardized.
The bankrupt government would keep on collecting taxes in gold coins and paying soldiers and police salaries, although it would not be able to run a fiscal deficit because nobody would trust it to sell honest bonds.
The irony of the situation is that if Greece had a government running a fiscal surplus, it could repudiate all its bonds and laugh at the bankers who had bought them. But Greece has to keep on borrowing because it runs a fiscal deficit. Beggers cannot be choosers.
If Greece had had its own national currency, based on a gold standard, it would already have “gone off” and devalued. But there is no way Greece can go off the Euro standard and start now to issue a new fiat currency. Who would use it, even in Greece? Who would buy Greek government bonds promising only to repay in those new, politicized accounting units? According to the news, even now in Athens people are bank-running to have Euros under their beds. Trust in the ECB is greater than their trust in the Greek government.
What is different in Europe today is the Euro payments system is jeopardized because it is a pyramid of bank credit based on government bonds. Saving the payments system is the really important task since all economic activity and growth depends on it. Modern society can not be maintained on barter.
To save the payments system, saving the banks seems to be necessary. The political drama is all about preserving the ability to borrow for the governments of Greece, Italy, Spain, and Portugal, and to pay off their bonds as they mature. This is basic for saving the banks, who own the bonds.
The fallacy of “fiscal union” is that it confuses the Euro, the accounting unit, with the overspending (or under-taxing) of the governments whose bonds are exposed as junk. The complaint about lacking a “fiscal union” is that Greece has no power to increase taxes in Germany or France to pay its debts. With the Euro, like the gold standard case above, the insolvent governments cannot resort to printing-press inflation to keep going. “Fiscal union” is a fancy name for a systemic “Robin Hood” solution.
The German chancellor and French president are trying to devise a way to bail out the insolvent governments because they want to save their own banks. They need to save their banks in order to save the payments system, and themselves. The common Euro currency itself is not a problem – the Euro is just the accounting unit. The “problem” is that it cannot be debased to make the junk bonds payable, as some hypothetical national Greek currency could have been ["coin-clipped"].
The Proposal for Joint EU Bonds
Since Greece cannot tax Germans, and since Germans do not feel like taxing themselves to bail out the Greek government, the gimmick in the news is for (1) the entire European Union to issue bonds and (2) give the money to the Greek, Italian, Spanish, and Portugese governments, but only if (3) those irresponsible politicians give up their “sovereignty” to bureaucrats in Brussels and submit to fiscal austerity.
This would bail out the banks, which is why it is the preferred political solution. It would preserve the payments system, which is why it is necessary. But the cries about “democracy” and “sovereignty” are loud and emotionally attractive. What is at stake is 100 years of European social welfare and labor union dominance, finally crashing into the stone wall of economic reality.
Consider the alternatives, which nobody wants to discuss because millions of innocent people would suffer and the EU, as well as much of the world, would probably face a massive credit collapse. Since the world is a single capital market, neither the United States nor Brazil/Russia/India/China would get out of it unharmed.
Let the bonds default?
Assume the banks could be compensated separately, or penalized separately, which is a huge political assumption. In the defaulting countries, pensioners and government workers then would not be paid more than tax collectors could gather at the point of a gun. Civil disorder might follow, and economic activity would certainly be disrupted. Thousands of people would try to emigrate. Ayn Rand fans might look approvingly at the logical consequences of the collapse of a parasite state, which might describe Greece and others, but the other European countries would not welcome large-scale immigration by economic refugees.
Compensate the Banks Separately?
There might be no justice in compensating the bankers who made stupid investments under the rules of the Basel III Accords in junk government bonds, but depositors and creditors of those banks are not to blame, and the payments system is administered by the banks. Perhaps the banks could be taken over by their governments and merged with the postal savings (giro) system.
The bank bail out in Ireland a few years ago tried something like this, but the debts almost overwhelmed the Irish government. It was given some assistance by the EU and Ireland seems to be recovering. But the problem in Ireland pales in comparison with the banking crisis in the rest of Europe if Italy and Spain go under – and the fear this problem might expand has caused the capital markets to choke. The United States is enjoying a flood of frightened capital, which is one reason U.S. government bonds are paying negative real interest rates.
Break Up the Euro Zone, or At Least Expel Greece and a Few Others?
This idea solves no problem, and is not different in substance from either of the two previous suggestions. Hyperinflation would hit Greece within a day of the attempt to introduce a new currency there, and no Greek government bonds would be purchased by any private investor. The bank runs in Greece show what the people think about it.
Was the Single Currency a Mistake?
There is an interesting question in economics about what might be the size of an “optimal currency area,” and how it would work with floating exchange rates among regional currencies – not just “national” currencies. Much of this analysis looks at labor markets and natural resource markets and considers how local conditions might make different circumstances work better. An exchange rate that devalues can make labor cheaper, due to money illusion, and an economy mostly based on exports of natural resources might want some local immunity from shifts in world demand or supply conditions that can cause wide price swings in commodity markets.
In macroeconomics, if central banks can control money and credit, and national governments can finance deficit budgets without depending on free international capital markets, sometimes a serious social crisis can be manipulated to create different winners and losers. Politicians and socialists love this idea because it gives so much power to the governing elite.
The real question, of course, in any social crisis is why the situation needing “management” arose in the first place? And why are the losers almost always the weakest and least powerful in society – as the politicians and fat cats get away with it?
In the Euro crisis, it would be good if a result can be found to cushion the punishment of the innocent, and instead ruin the lives of the political leaders who created the insolvent governments in the first place. The most likely result, however, will be the opposite. The bad judgment of the European bankers will probably become as profitable as the bad judgment on Wall Street did when the housing bubble collapsed.
Of course, Wall Street a century ago created the Federal Reserve to ensure that happy outcome. We shall see if the European Central Bank holds fast, or caves under the pressure to pollute the Euro.
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