How the paper money experiment will end

A paper currency system contains the seeds of its own destruction. The temptation for the monopolist money producer to increase the money supply is almost irresistible. In such a system with a constantly increasing money supply and, as a consequence, constantly increasing prices, it does not make much sense to save in cash to purchase assets later. A better strategy, given this senario, is to go into debt to purchase assets and pay back the debts later with a devalued currency. Moreover, it makes sense to purchase assets that can later be pledged as collateral to obtain further bank loans. A paper money system leads to excessive debt.

This is especially true of players that can expect that they will be bailed out with newly produced money such as big businesses, banks, and the government.

We are now in a situation that looks like a dead end for the paper money system. After the last cycle, governments have bailed out malinvestments in the private sector and boosted their public welfare spending. Deficits and debts skyrocketed. Central banks printed money to buy public debts (or accept them as collateral in loans to the banking system) in unprecedented amounts. Interest rates were cut close to zero. Deficits remain large. No substantial real growth is in sight. At the same time banking systems and other financial players sit on large piles of public debt. A public default would immediately trigger the bankruptcy of the banking sector. Raising interest rates to more realistic levels or selling the assets purchased by the central bank would put into jeopardy the solvency of the banking sector, highly indebted companies, and the government. It looks like even the slowing down of money printing (now called “QE tapering”) could trigger a bankruptcy spiral. A drastic reduction of government spending and deficits does not seem very likely either, given the incentives for politicians in democracies.

So will money printing be a constant with interest rates close to zero until people lose their confidence in the paper currencies? Can the paper money system be maintained or will we necessarily get a hyperinflation sooner or later?

There are at least seven possibilities:

1. Inflate. Governments and central banks can simply proceed on the path of inflation and print all the money necessary to bail out the banking system, governments, and other over-indebted agents. This will further increase moral hazard. This option ultimately leads into hyperinflation, thereby eradicating debts. Debtors profit, savers lose. The paper wealth that people have saved over their life time will not be able to assure such a high standard of living as envisioned.

2. Default on Entitlements. Governments can improve their financial positions by simply not fulfilling their promises. Governments may, for instance, drastically cut public pensions, social security and unemployment benefits to eliminate deficits and pay down accumulated debts. Many entitlements, that people have planned upon, will prove to be worthless.

3. Repudiate Debt. Governments can also default outright on their debts. This leads to losses for banks and insurance companies that have invested the savings of their clients in government bonds. The people see the value of their mutual funds, investment funds, and insurance plummet thereby revealing the already-occurred losses. The default of the government could lead to the collapse of the banking system. The bankruptcy spiral of overindebted agents would be an economic Armageddon. Therefore, politicians until now have done everything to prevent this option from happening.

4. Financial Repression. Another way to get out of the debt trap is financial repression. Financial repression is a way of channeling more funds to the government thereby facilitating public debt liquidation. Financial repression may consist of legislation making investment alternatives less attractive or more directly in regulation inducing investors to buy government bonds. Together with real growth and spending cuts, financial repression may work to actually reduce government debt loads.

5. Pay Off Debt. The problem of overindebtedness can also be solved through fiscal measures. The idea is to eliminate debts of governments and recapitalize banks through taxation. By reducing overindebtedness, the need for the central bank to keep interest low and to continue printing money is alleviated. The currency could be put on a sounder base again. To achieve this purpose, the government expropriates wealth on a massive scale to pay back government debts. The government simply increases existing tax rates or may employ one-time confiscatory expropriations of wealth. It uses these receipts to pay down its debts and recapitalize banks. Indeed the IMF has recently proposed a one-time 10-percent wealth tax in Europe in order to reduce the high levels of public debts. Large scale cuts in spending could also be employed to pay off debts. After WWII, the US managed to reduce its debt-to-GDP ratio from 130 percent in 1946 to 80 percent in 1952. However, it seems unlikely that such a debt reduction through spending cuts could work again. This time the US does not stand at the end of a successful war. Government spending was cut in half from $118 billion in 1945 to $58 billion in 1947, mostly through cuts in military spending. Similar spending cuts today do not seem likely without leading to massive political resistance and bankruptcies of overindebted agents depending on government spending.

6. Currency Reform. There is the option of a full-fledged currency reform including a (partial) default on government debt. This option is also very attractive if one wants to eliminate overindebtedness without engaging in a strong price inflation. It is like pressing the reset button and continuing with a paper money regime. Such a reform worked in Germany after the WWII (after the last war financial repression was not an option) when the old paper money, the Reichsmark, was substituted by a new paper money, the Deutsche Mark. In this case, savers who hold large amounts of the old currency are heavily expropriated, but debt loads for many people will decline.

7. Bail-in. There could be a bail-in amounting to a half-way currency reform. In a bail-in, such as occurred in Cyprus, bank creditors (savers) are converted into bank shareholders. Bank debts decrease and equity increases. The money supply is reduced. A bail-in recapitalizes the banking system, and eliminates bad debts at the same time. Equity may increase so much, that a partial default on government bonds would not threaten the stability of the banking system. Savers will suffer losses. For instance, people that invested in life insurances that in turn bought bank liabilities or government bonds will assume losses. As a result the overindebtedness of banks and governments is reduced.

Any of the seven options, or combinations of two or more options, may lie ahead. In any case they will reveal the losses incurred in and end the wealth illusion. Basically, taxpayers, savers, or currency users are exploited to reduce debts and put the currency on a more stable basis. A one-time wealth tax, a currency reform or a bail-in are not very popular policy options as they make losses brutally apparent at once. The first option of inflation is much more popular with governments as it hides the costs of the bail out of overindebted agents. However, there is the danger that the inflation at some point gets out of control. And the monopolist money producer does not want to spoil his privilege by a monetary meltdown. Before it gets to the point of a runaway inflation, governments will increasingly ponder the other options as these alternatives could enable a reset of the system.

This article was previously published at


Today’s wealth destruction is hidden by government debt

Still unnoticed by a large part of the population is that we have been living through a period of relative impoverishment. Money has been squandered in welfare spending, bailing out banks or even — as in Europe — of fellow governments. But many people still do not feel the pain.

However, malinvestments have destroyed an immense amount of real wealth. Government spending for welfare programs and military ventures has caused increasing public debts and deficits in the Western world. These debts will never be paid back in real terms.

The welfare-warfare state is the biggest malinvestment today. It does not satisfy the preferences of freely interacting individuals and would be liquidated immediately if it were not continuously propped up by taxpayer money collected under the threat of violence.

Another source of malinvestment has been the business cycle triggered by the credit expansion of the semi-public fractional reserve banking system. After the financial crisis of 2008, malinvestments were only partially liquidated. The investors that had financed the malinvestments such as overextended car producers and mortgage lenders were bailed out by governments; be it directly through capital infusions or indirectly through subsidies and public works. The bursting of the housing bubble caused losses for the banking system, but the banking system did not assume these losses in full because it was bailed out by governments worldwide. Consequently, bad debts were shifted from the private to the public sector, but they did not disappear. In time, new bad debts were created through an increase in public welfare spending such as unemployment benefits and a myriad of “stimulus” programs. Government debt exploded.

In other words, the losses resulting from the malinvestments of the past cycle have been shifted to an important degree onto the balance sheets of governments and their central banks. Neither the original investors, nor bank shareholders, nor bank creditors, nor holders of public debt have assumed these losses. Shifting bad debts around cannot recreate the lost wealth, however, and the debt remains.

To illustrate, let us consider Robinson Crusoe and the younger Friday on their island. Robinson works hard for decades and saves for retirement. He invests in bonds issued by Friday. Friday invests in a project. He starts constructing a fishing boat that will produce enough fish to feed both of them when Robinson retires and stops working.

At retirement Robinson wants to start consuming his capital. He wants to sell his bonds and buy goods (the fish) that Friday produces. But the plan will not work if the capital has been squandered in malinvestments. Friday may be unable to pay back the bonds in real terms, because he simply has consumed Robinson’s savings without working or because the investment project financed with Robinson’s savings has failed.

For instance, imagine that the boat is constructed badly and sinks; or that Friday never builds the boat because he prefers partying. The wealth that Robinson thought to own is simply not there. Of course, for some time Robinson may maintain the illusion that he is wealthy. In fact, he still owns the bonds.

Let us imagine that there is a government with its central bank on the island. To “fix” the situation, the island’s government buys and nationalizes Friday’s failed company (and the sunken boat). Or the government could bail Friday out by transferring money to him through the issuance of new government debt that is bought by the central bank. Friday may then pay back Robinson with newly printed money. Alternatively the central banks may also just print paper money to buy the bonds directly from Robinson. The bad assets (represented by the bonds) are shifted onto the balance sheet of the central bank or the government.

As a consequence, Robinson Crusoe may have the illusion that he is still rich because he owns government bonds, paper money, or the bonds issued by a nationalized or subsidized company. In a similar way, people feel rich today because they own savings accounts, government bonds, mutual funds, or a life insurance policy (with the banks, the funds, and the life insurance companies being heavily invested in government bonds). However, the wealth destruction (the sinking of the boat) cannot be undone. At the end of the day, Robinson cannot eat the bonds, paper, or other entitlements he owns. There is simply no real wealth backing them. No one is actually catching fish, so there will simply not be enough fishes to feed both Robinson and Friday.

Something similar is true today. Many people believe they own real wealth that does not exist. Their capital has been squandered by government malinvestments directly and indirectly. Governments have spent resources in welfare programs and have issued promises for public pension schemes; they have bailed out companies by creating artificial markets, through subsidies or capital injections. Government debt has exploded.

Many people believe the paper wealth they own in the form of government bonds, investment funds, insurance policies, bank deposits, and entitlements will provide them with nice sunset years. However, at retirement they will only be able to consume what is produced by the real economy. But the economy’s real production capacity has been severely distorted and reduced by government intervention. The paper wealth is backed to a great extent by hot air. The ongoing transfer of bad debts onto the balance sheets of governments and central banks cannot undo the destruction of wealth. Savers and pensioners will at some point find out that the real value of their wealth is much less than they expected. In which way, exactly, the illusion will be destroyed remains to be seen.

This article was previously published at


The errors of Keynes

The Austrian School of economics has provided the world with devastating critics of Keynes’s magnum opus The General Theory of Employment, Interest and Money (TGT) for a long time. Friedrich A. von Hayek, Jacques Rueff, Henry Hazlitt, Murray Rothbard, Ludwig Lachmann, Ludwig von Mises, and William Hutt have already provided important arguments against Keynes and Keynesianism.

Now we can add a new name to that distinguished list. In 2012, Juan Ramón Rallo has published a new Austrian critique of TGT in Spanish with the title Los Errores de la Vieja Economía (The Failure of the Old Economics) in honor of Hazlitt’s work The Failure of the ‘New Economics’.

In Hazlitt’s time, Keynes’s program was still revolutionary and described by Hazlitt as a kind of “New Economics” that broke with the insights of classical economics and especially with Say’s Law. Now, Keynesianism is mainstream. Keynesianism, and especially its main idea that spending reduces unemployment, is still taught in universities, applied by grateful politicians, and prominently defended by the 2008 Nobel Prize winner Paul Krugman.

Indeed, the immediate political response to the current financial crisis in the Western World was inspired by TGT. A second Great Depression was to be prevented and Keynes’s insights applied. Governments engaged in loose monetary policy combined with fiscal stimulus in response to what, through Keynesian eyes, appeared to be a bubble caused by reckless speculation, which was in turn inspired by animal spirits. Thus, even if Rallo’s book were just a summary of the old arguments against TGT, the moment for publication would be more than appropriate, since the ideas of the past are still the praxis of the present.

Yet, Los Errores de la Vieja Economía is much more than a summary and synthesis of the old arguments by the aforementioned Austrian authors. Rallo builds upon, combines, and develops these arguments in a systematic way. Most importantly, he adds his own innovative ideas to develop a devastating case against TGT.

Rallo’s critique of TGT employing Austrian theory is rigorous, systematic and exhaustive. Significantly, Keynes’s ideas are not twisted or distorted. The absence of strawman arguments makes Rallo’s attack against the core of Keynesian beliefs stronger than most. Rallo also does not search for terminological contradictions and inconsistencies. In this sense, Rallo’s critique is more profound and devastating than for example the parts of Henry Hazlitt’s brilliant critique that emphasize Keynes’s inconsistencies, imprecision, and explanatory fuzziness. Rallo has a great and genuine interest in giving a clear and coherent picture of Keynes’s reasoning and presents Keynes in the most favorable light.

Let’s have a look of some of Rallo’s arguments, beginning with Keynes’s famous critique of Say’s Law. Keynes’s distorted version of Say’s Law in TGT states that supply creates its own demand. Rallo vindicates Say’s Law in its original version: in the long run, the supply of a good adjusts to its demand. Ultimately, goods are offered to buy other goods (money included). One produces in order to demand, which implies that a general overproduction is impossible.

Say’s Laws leads us straight forward to the most innovative argument in Rallo’s book that addresses the old argument against hoarding. Even harsh critics of Keynes, for example from the monetarist or neoclassical camp, admit that Keynes was at least right in that hoarding is a destabilizing and dangerous activity.

Rallo, however, proves and emphasizes the social function of hoarding. To demand money is not to demand nothing from the market. Hoarding is the natural response of savers and consumers to a structure of production that does not adjust to their needs. It is a signal of protest to entrepreneurs: “Please offer different consumer and capital goods! Change the structure of production, since the composition of offered goods is not appropriate.”

In a situation of great uncertainty, it is even prudent to hoard and not immobilize funds for the long run. Rallo provides us a visual example. Let’s assume that uncertainty increases because people expect an earthquake. They start to hoard, i.e., they increase their cash balance, which gives them more flexibility. This is completely rational and beneficial from the point of view of market participants. The alternative is to immobilize funds through government spending. The public production of skyscrapers is not only against the will of the more prudent people; it will also prove disastrous if the earthquake is realized.

Hoarding is an insurance against future uncertainties. Rallo argues that, if the demand for money increases (liquidity preference increases) due to the precautionary motive, short-term market rates of interest tend to fall, while long-term rates increase. People invest more short term and less long term in order to stay liquid. This leads to an adjustment of the structure of production. More resources will be used for the production of the most liquid good (i.e., gold in a gold standard), and for the production of consumer goods. The structure of production shifts toward shorter and less risky processes reducing longer and riskier ones. Hoarding, therefore, does not cause factors of production to be idle that shouldn’t be. Factors are just shifted toward gold production and shorter-term projects. Rallo insists that it is not irrational to hoard. Indeed, when long-term projects are maintained and economic conditions change, projects might have to be liquidated suddenly. For example, the earthquake would destroy the skyscraper in progress.

It should be noted that most Austrians do not hold a hybrid liquidity preference / time preference theory of interest. For Rallo the interest rate, or the structure of interest rates, is determined both by time preference and liquidity preference. Most Austrians defend the pure time preference theory of interest. My own position on this question can be found in this article co-authored with David Howden. Due to uncertainty an actor prefers to be liquid rather than illiquid. Due to time preference an actor prefers to be liquid rather sooner than later. Therefore, the yield curve tends to be upward sloping. When uncertainty increases, the yield curve tends to get steeper. In a financial crisis, however, another effect tends to prevail over this tendency. When society is in general illiquid, the high demand for short-term loans, the scramble for liquidity, tends to cause a downward sloping yield curve.

Idle resources are another important topic in Rallo’s book since Keynes recommends inflation in the case of idle resources. Rallo asks why factors are unemployed and comes to the result that their owners demand a price for their services that is higher than their discounted marginal value product. In these circumstances, inflation implies a redistribution in favor of the owners of those factors, or a frustration of attempts to restructure, i.e., the economy suffers from forced saving or capital consumption.

In contrast, when factors of production adjust their prices, i.e., wages fall back to their discounted marginal value product, aggregate demand does not fall as Keynes suggests. On the contrary aggregate demand increases, because total production increases.

Rallo goes relentlessly after other Keynesian concepts. The famous “investment multiplier” requires idle resources of all factors of production. More precisely, for Keynes to be right you need voluntary unemployment of all factors of production plus idle capacity in consumer goods’ industries. If there is no voluntary unemployment of all factors, government stimulation of new projects will lead to bottlenecks as factors are bid away from profitable investment projects. If all types of factors are idle, but there is no capacity in consumer goods industries, then government stimulus will raise prices of consumer goods and lead to a shortening of the structure of production. If, however, there is a general idleness of factors and idle capacities in consumer goods industries, why is there no voluntary agreement between owners of factors of production and entrepreneurs?

Another important Keynesian idea that Rallo tackles is the famous liquidity trap. A liquidity trap exists when, in a depressed economy, interest rates are very low. In such a situation Keynes regards monetary policy as useless, because speculators will just hoard newly produced money. Speculators will not invest in bonds because they are at maximum prices and will fall when interest rates finally rise. At this point monetary policy becomes impotent. Public spending becomes necessary to stimulate aggregate demand.

Rallo shows that after an artificial boom, in a situation where there are many malinvestments and a general over-indebtedness in the economy, there is indeed almost no demand for loans even at very low interest rates. We are actually faced with an illiquidity trap, as agents struggle to improve their liquidity. They want to reduce their debts and not take on more loans. The monetary policy of low interest rates actually worsens the situation, because with low interest rates, there is no incentive to prepay and cancel debts (because their present value is raised). The solution to this situation of general uncertainty is hoarding, stable institutions, the liquidation of malinvestment and the reduction of debts.

High uncertainty does not imply high unemployment, since even under high uncertainty the reduction of prices for services of factors of production renders profitable new projects. Under high uncertainty, these projects will be gold production (in a gold standard) and the short-term production of consumer goods.

As Rallo points out in contrast to TGT, it is not aggregate supply or aggregate demand that is important, but their composition. If, in a depression with a distorted structure of production, in a liquidity trap situation, aggregate demand is boosted by government spending, the existing structure cannot produce the goods that consumers want most urgently. The solution is not more spending and more debts, but debt reduction and the liquidation of malinvestments to make new and sustainable investments feasible.

In contrast, for Keynes, the problem is always insufficient demand. So what can we do if consumers and investors do not buy the goods of that companies offer, but instead hoard? Well, Keynes recommends lowering taxes and interest rates, to devalue the currency, or that the government buys the products for consumers. But, why, asks Rallo, should consumers and investors buy goods they don’t want?

Keynes’s answer is that otherwise unemployment will increase. Rallo responds astutely: but if a person is forced to buy with his salary something that he does not want, why shall this person work at all? The alternative to forced buying is to lower wages to their discounted marginal value product, which increases production and demand. As Rallo points out, society does not get richer if the government induces or forces people to buy goods they don’t want. Thus, for Rallo the essence of TGT is the following: when people do not want to buy what is produced, the government should force them to act against their will.

The insights from Rallo’s book presented here are only a small selection. Rallo also offers an analysis of Keynes’s main definitions and the theoretical errors behind them, such as their pro-consumption bias. He provides an Austrian analysis of financial markets, discussing the interrelations between the yield curve, interest rates, the discount rate, the structure of investment, the liquidity trap and the stock market. He analyzes real and nominal wages, business cycles, political implications, and intellectual predecessors of Keynes’s TGT using Austrian theory. Also very useful is Rallo’s guide for readers of TGT that makes reading and spotting Keynes’s main mistakes, chapter by chapter, easy and efficient. As a plus, at the end of the book, Rallo also provides a critique of the IS-LM model developed by John Hicks and Franco Modigliani which formalized Keynes’s theory and is still taught at universities around the world.

Rallo’s book on Keynes’s TGT is full of brilliant insights and provides the most powerful and complete case against Keynes currently available. The well-written Los Errores de la Vieja Economía will be the future reference for scholars and layman alike looking for errors in Keynes’s thinking and today’s policies. The main downside of the book is that it is written in Spanish. Hopefully, the work will be available in other languages soon.


The myth of austerity

Many politicians and commentators such as Paul Krugman claim that Europe’s problem is austerity, i.e., there is insufficient government spending. The common argument goes like this: Due to a reduction of government spending, there is insufficient demand in the economy leading to unemployment. The unemployment makes things even worse as aggregate demand falls even more, causing a fall in government revenues and an increase in government deficits. European governments pressured by Germany (which did not learn from the supposedly fateful policies of Chancellor Heinrich Brüning) then reduce government spending even further, lowering demand by laying off public employees and cutting back on government transfers. This reduces demand even more in a never ending downward spiral of misery. What can be done to break out of the spiral? The answer given by commentators is simply to end austerity, boost government spending and aggregate demand. Paul Krugman even argues in favor for a preparation against an alien invasion, which would induce government to spend more. So the story goes. But is it true?

First of all, is there really austerity in the eurozone? One would think that a person is austere when she saves, i.e., if she spends less than she earns. Well, there exists not one country in the eurozone that is austere. They all spend more than they receive in revenues.

In fact, government deficits are extremely high, at unsustainable levels, as can been seen in the following chart that portrays government deficits in percentage of GDP. Note that the figures for 2012 are what governments wish for.

The absolute figures of government deficits in billion euros are even more impressive.

A good picture of “austerity” is also to compare government expenditures and revenues (relation of public expenditures and revenues in percentage).

Imagine that a person you know spends 12 percent more in 2008 than her income, spends 31 percent more than her income the next year, spends 25 percent more than her income in 2010, and 26 percent more than her income in 2011. Would you regard this person as austere? And would you regard this behavior as sustainable? This is what the Spanish government has done. It shows itself incapable of changing this course. Perversely, this “austerity” is then made responsible for a shrinking Spanish economy and high unemployment.

Unfortunately, austerity is the necessary condition for recovery in Spain, the eurozone, and elsewhere. The reduction of government spending makes real resources available for the private sector that formerly had been absorbed by the state. Reducing government spending makes profitable new private investment projects and saves old ones from bankruptcy.

Take the following example. Tom wants to open a restaurant. He makes the following calculations. He estimates the restaurant’s revenues at $10,000 per month. The expected costs are the following: $4,000 for rent; $1,000 for utilities; $2,000 for food; and $4,000 for wages. With expected revenues of $10,000 and costs of $11,000 Tom will not start his business.

Let’s now assume that the government is more austere, i.e., it reduces government spending. Let’s assume that the government closes a consumer-protection agency and sells the agency’s building on the market. As a consequence, there is a tendency for housing prices and rents to fall. The same is true for wages. The laid-off bureaucrats search for new jobs, exerting downward pressure on wage rates. Further, the agency does not consume utilities anymore, leading toward a tendency of cheaper utilities. Tom may now rent space for his restaurant in the former agency for $3,000 as rents are coming down. His expected utility bill falls to $500, and hiring some of the former bureaucrats as dish washers and waiters reduces his wage expenditures to $3,000. Now with expected revenue at $10,000 and costs at $8,500 the expected profits amounts to $1,500 and Tom can start his business.

As the government has reduced spending it can even reduce tax rates, which may increase Tom’s after-tax profits. Thanks to austerity the government could also reduce its deficit. The money formerly used to finance the government deficit can now be lent to Tom for an initial investment to make the former agency’s rooms suitable for a restaurant. Indeed, one of the main problems in countries such as Spain these days is that the real savings of the people are soaked up and channeled to the government via the banking system. Loans are practically unavailable for private companies, because banks use their funds to buy government bonds in order to finance the public deficit.

In the end, the question amounts to the following: Who shall determine what is produced and how? The government that uses resources for its own purposes (such as a “consumer-protection” agency, welfare programs, or wars), or entrepreneurs in a competitive process and as agents of consumers, trying to satisfy consumer wants with ever better and cheaper products (like Tom, who uses part of the resources formerly used in the government agency for his restaurant).

If you think the second option is better, austerity is the way to go. More austerity and less government spending mean fewer resources for the public sector (fewer “agencies”) and more resources for the private sector, which uses them to satisfy consumer wants (more restaurants). Austerity is the solution to the problems in Europe and in the United States, as it fosters sustainable growth and reduces government deficits.

Lower GDP?

But does austerity not at least temporarily reduce GDP and lead to a downward spiral of economic activity?

Unfortunately, GDP is a quite misleading figure. GDP is defined as the market value of all final goods and services produced in a country in a given period.

There are two minor reasons why a lower GDP may not always be a bad sign.

The first reason relates to the treatment of government expenditures. Let us imagine a government bureaucrat who licenses businesses. When he denies a license for an investment project that never comes into being, how much wealth is destroyed? Is it the expected revenues of the project or its expected profits? What if the bureaucrat has unknowingly prevented an innovation that could save the economy billions of dollars per year? It is hard to say how much wealth destruction is caused by the bureaucrat. We could just arbitrarily take his salary of $50,000 per year and subtract it from private production. GDP would be lower.

Now hold your breath. In practice, the opposite is done. Government expenditures count positively in GDP. The wealth destroying activity of the bureaucrat raises GDP by $50,000. This implies that if the government licensing agency is closed and the bureaucrat is laid off, then the immediate effect of this austerity is a fall in GDP by $50,000. Yet, this fall in GDP is a good sign for private production and the satisfaction of consumer wants.

Second, if the structure of production is distorted after an artificial boom, the restructuring also entails a temporary fall in GDP. Indeed, one could only maintain GDP if production remained unchanged. If Spain or the United States had continued to use their boom structure of production, they would have continued to build the amount of housing they did in 2007. The restructuring requires a shrinking of the housing sector, i.e., a reduced use of factors of production in this sector. Factors of production must be transferred to those sectors where they are most urgently demanded by consumers. The restructuring is not instantaneous but organized by entrepreneurs in a competitive process that is burdensome and takes time. In this transition period, when jobs are destroyed in the overblown sectors, GDP tends to fall. This fall in GDP is just a sign that the necessary restructuring is underway. The alternative would be to produce the amount of housing of 2007. If GDP did not fall sharply, it would mean that the wealth-destroying boom was continuing as it did in the years 2005–2007.


Public austerity is a necessary condition for private flourishing and a rapid recovery. The problem of Europe (and the United States) is not too much but too little austerity — or its complete absence. A fall of GDP can be an indicator that the necessary and healthy restructuring of the economy is underway.

This article was previously published at


The danger of external debts

Economists and journalists often point to the danger of external public debts — in contrast to internal debts, which are regarded as less troublesome. Japan is a case in point. Japan has an enormous public-debt-to-GDP ratio of more than 200 percent. It is argued that the high ratio is not a problem, because the Japanese save a lot and government bonds are held mostly by Japanese citizens; it is internal debt.

In contrast, Spain with a much lower public-debt-to-GDP ratio (expected to be at 80 percent at the end of this year) is regarded as more unstable by many investors. One reason given for the Spanish fragility is that about half of Spanish government bonds are held by foreigners.[1]

At first sight, one may doubt this line of reasoning. In fact, as an individual living in Spain, I do not care if I get a loan from a Spanish or a German friend. Why would the Spanish government be different? Why care if loans come from Spaniards or from Germans?

Governments are ultimately based on physical violence or the threat of physical violence. The state is the monopolist of violence in a given territory. And in violence lies the difference. Internally held debts generate income for citizens, which can be taxed by the threat of violence. This implies that part of the interest paid on internal debt flows back to the government through taxes. Interest paid on external debt, in contrast, is taxed by foreign countries.

There is another, even more compelling, reason why the monopoly of violence is important: I can force neither my Spanish nor my German friend to roll over his loan to me when it comes due. While the government cannot force individuals outside its territory to roll over loans, it can force citizens and institutions within its jurisdiction to do so. In a more subtle form, governments can pressure their traditional financiers, the banks, to roll over public debts.

Banks and governments live in a relationship akin to a symbiosis. Governments have granted banks the privilege to hold fractional reserve and have given them implicit and explicit bailout guarantees. Further support is provided through a government’s controlled central bank, which may help out in times of liquidity problems. In addition, governments control the banking system through a myriad of regulations. In return for the privilege to create money out of thin air, banks use this power to finance governments buying their bonds.

Due to this intensive relationship and the government’s monopoly of violence, the Japanese government can pressure its banks to roll over outstanding debt. It can also pressure them to abstain from abrupt selling and encourage them to take even more debt onto their books. Yet the Japanese government cannot force foreigners to abstain from selling its debt or to accumulate more of it. Here lies the danger for governments with external public debts such as the Spanish one.

While Spanish banks and investment funds will not flush the market with Spanish government bonds, foreign institutions may well do so.[2] The Spanish government cannot “persuade” or force them not to do so as they are located in other jurisdictions. The only thing that the Spanish government can do — and the peripheral governments are actually doing — is to pressure politicians in fellow countries to pressure their own banks to keep bonds on their books and roll them over.

External public debts also pose a danger for the US government. Foreign central banks such as the Bank of China or the Bank of Japan hold important sums of US government bonds. The threat, credible or not, to throw these bonds on the market may give their governments, especially the Chinese one, some political leverage.

What about a Trade Deficit?

In regard to the stability of a currency or the sustainability of government debts, the balance of trade (the difference between exports and imports of goods and services) is also important.

An export surplus (abstracting from factor income and transfer payments) implies that a country accumulates foreign assets. As foreign assets are accumulated, the currency tends to be stronger. Foreign assets can be used in times of crisis to pay for damages. Japan again is a case in point. After the earthquake in March 2011, foreign assets were repatriated into Japan, paying for necessary imports. Japanese citizens sold their dollars and euros to repair damage at home. There was no need to ask for loans denominated in foreign currencies, thereby putting pressure on the yen.

Japan’s export surpluses manifest themselves also on the balance sheet of the Bank of Japan. The Bank of Japan has bought foreign currencies from Japanese exporters. These reserves could be used in a crisis situation to reduce public debts or defend the value of the currency on foreign exchange markets. In fact, the net level of Japan’s public debts falls 20 percent taking into account the foreign exchange reserve holdings of the Bank of Japan (over $1 trillion). Thus, export surpluses tend to strengthen a currency and the sustainability of public debts.

On the contrary, import surpluses (abstracting from factor income or transfers) result in net foreign debts. More goods are imported than exported. The difference is paid for by new debts. These debts are often held in the form of government bonds. A country with years of import deficits is likely to be exposed to large holdings of external public debts that may pose problems for the government in the future as we have discussed above.

The balance of trade may also be an indicator for the competitiveness of an economy, and, indirectly, for the quality of a currency. The more competitive an economy, the more likely the government can support its fiat currency by expropriating the real wealth created by this competitive economy and will not get into public-debt problems. Further, the more competitive the economy, the less likely that public-debt problems are solved by the production of money.

While an export surplus is a sign of competitiveness, an import surplus may be a sign of a lack thereof. Indeed, long-lasting import deficits may be the sign of a lack of competitiveness, and often go hand in hand with high public debts, exacerbating the lack of competitiveness.

Economies with high and inflexible wages — as in southern Europe — may be uncompetitive, running a trade deficit. The uncompetitiveness is maintained and made possible by high government spending. Southern eurozone governments hired people into huge public sectors, arranged generous and early retirement schemes, and offered unemployment subsidies, thereby alleviating the consequence of the unemployment caused by inflexible labor markets. The result of the government spending was therefore not only a lack of competitiveness and a trade deficit but also a government deficit. Therefore, large trade and government deficits often go hand in hand.

In the European periphery, imports were paid with loans. The import surplus cannot go on forever, as public debts would rise forever. A situation of persisting import surpluses such as in Greece can be interpreted as a lack of political will to reform labor markets and to regain competitiveness. Therefore, persisting import surpluses may cause a currency or public-debt sell-off. In this sense, the German export surplus supports the value of the euro, while the periphery’s import surplus dilutes its value.

In sum, high public (external) debts and persisting import surpluses are signs of a weak currency. The government may well have to default or to print its way out of its problems. Low public (external) debts and persisting export surpluses, in contrast, strengthen a currency.


[1] Another important reason is that the Spanish government cannot use the printing press at its will, because it is shared by other Eurozone governments that might protest. Japan, however, controlls its central bank and thereby the printing press.

[2] It should be noted that ever more new Spanish debt is held exclusively by Spanish banks, because other investors are progressively less interested in financing a government that simply refuses to enact real and effective austerity measures.

This article was previously published at


Passing the bailout buck

Recently, there has been an intense debate in Europe on the TARGET2 system (Trans-European Automated Real-time Gross Settlement Express Transfer System 2), which is the joint gross clearing system of the eurozone.[1] The interpretation of this system and its balances has provoked divergent opinions. Some economists, most prominently Hans-Werner Sinn, have argued that TARGET2 amounts to a bailout system. Others have vehemently denied that. Jürgen Stark of the European Central Bank (ECB) even said that some commentators could lose their reputation as serious academics by claiming that TARGET2 functions as a bailout system.

Indeed, TARGET2 debits and credits have been built up since the beginning of the financial crisis. While peripheral countries accumulated TARGET2 debits, in April 2012 TARGET2 claims of the Bundesbank amounted to almost €644 billion. That is almost €8,000 per German.

But does TARGET2 really amount to an undercover bailout system for unsustainable living standards in the periphery? Let us start our analysis with a simple example of two individuals using a bank to clear their payments.

Figure 1

Person A sells a good or service to person B for €100. In international trade terms, A has a current account surplus while B has a current account deficit. A receives a claim or credit against the bank of €100 when the payment is made (the broken line in figure 1). B has a debt and owes the bank €100. The debt relationships are shown by solid arrows pointing in the direction of the debtor.

A now has some money saved in his bank that he may plan to use, for instance, for retirement. B has to produce something of value to be able to pay back his debt. A will finally be paid by B’s production of real goods (that may maintain him at retirement).

For A it is important that the bank’s loan to B is secured by a good guarantee or collateral such as a high-quality security or real estate. In the absence of collateral for B’s loan, problems arise if B does not pay his debt because he dies or for other reasons. If the bank does not hold other property to make up for the bad loan, A will be left with a claim against a bankrupt bank.

Of course, if the bank has the privilege of printing (legal-tender) bank notes, the bank will not go bankrupt but can pay back A. But A will then be paid back merely in paper, a worthless claim in our scenario, because B has not produced anything and has died. So what should A buy with the newly printed paper? A’s standard of living will fall at retirement as his wealth is based just on paper.

Let us now assume that A lives in Germany and B lives in Spain. Furthermore, we introduce Commerzbank as A’s German bank, and Banco Santander as B’s Spanish bank. In addition, we add the two national central banks and the ECB.

Figure 2

We again assume that A exports goods worth €100 to B. When the payment is made, A receives a claim against Commerzbank. A’s bank account increases €100. B gets a €100 loan from Banco Santander (alternatively he could run down his deposit account at Banco Santander). Commerzbank gets a claim against the Bundesbank (or reduces its refinancing from it), while Banco Santander increases its refinancing with the Bank of Spain (or reduces its excess reserves).

On the level of central banks, the Bundesbank receives a credit against the ECB while the Bank of Spain gets a debit. Underlying this procedure is an import of goods to Spain that has been financed by Banco Santander creating new money in form of a loan to B. The money creation results in TARGET2 debits for the Bank of Spain and TARGET2 credits for the Bundesbank.

Let us compare the TARGET2 method with the financing of imports in a gold standard. In both systems, import surpluses may be financed by capital imports, i.e., A or Commerzbank buys a bond from B. If there is no private capital financing in a gold standard, the import must be paid by transferring gold. In contrast, in the Eurosystem, import surpluses can simply be financed by producing claims against the ECB. Instead of gold, the Bundesbank receives TARGET2 credits. While in a gold standard, the payment of imports (if not financed by private loans) is limited to the outflow of gold, there is no limit for TARGET2 credits, i.e., the import surpluses may be financed without any limit by the creation of Euro claims.

How do TARGET2 debits and credits disappear? The balances disappear if A imports from B or if B sells a bond to A or borrows from him on the private market. There is nothing to assert against financing the import surplus through private loans or bonds. TARGET2 debits, however, are not private loans but amount to public central-bank loans. Without TARGET2, someone in the Spanish economy would have had to find private investors to finance the trade deficit paying potentially high interest rates, especially if no high-quality collateral for such loans can be provided.

In this sense, the TARGET2 system indeed amounts to a bailout of an uncompetitive economy with too high prices. Thanks to this bailout mechanism, the country does not have to deregulate labor markets, and reduce government spending to adjust prices relatively but can continue its spending spree and maintain its uncompetitive internal structure.

But are the TARGET2 debits and credits really never settled? Surprisingly, there is indeed neither a limit for the TARGET2 bailouts, nor are the accounts ever settled. In contrast, in the Federal Reserve System debits are backed by gold certificates and each year balances are settled. If the Federal Reserve Bank of Richmond has a debit with the Federal Reserve Bank of New York, the former settles its account sending gold certificates to the latter.[2]

The Eurosystem not only allows the financing of import surpluses via money creation; it also enables “capital flights.” In the current situation, a default of the Greek government would bankrupt its banking system. In order to prevent losses, Greek depositors have sent and are sending their money from accounts at Greek banks to accounts of banks in Germany and other countries. Through this transfer, the Greek bank loses reserves while the German one increases its reserves. The Greek bank increases refinancing from its national central bank (i.e., receives newly created money) while the German bank can decrease it loans from the Bundesbank. The Bundesbank earns a TARGET2 credit, the Bank of Greece a TARGET2 debit. If the Greek government defaults, and the Bank of Greece default on its debits, losses mount for the ECB. Thus, the risk of a Greek default is now shared by German savers through the TARGET2 credit.

What Is the Essence of TARGET2 Balances?

TARGET2 credits ultimately represent claims of savers, while TARGET2 debits represent debts of companies, governments, and individuals. TARGET2 accounts are just a consequence of an ongoing redistribution and of bailouts. For instance, TARGET2 accounts may mirror the tragedy of the euro, i.e., the monetization of government deficits. Take the following example. A Spanish bank creates new money to buy a Spanish government bond. This allows the Spanish government to maintain its government spending and to delay reforms of the labor market. It may increase public-sector wages and unemployment benefits. The competitiveness of the Spanish economy is hampered due to too high wages resulting in a trade deficit: a Spanish minister buys a German car. In the beginning, the trade deficit may be financed by private entities, for instance, by loans from German banks to Spanish banks. Yet after some time the Spanish banks will run out of good collateral. The increasing government debts and the overindebtedness of the private sector reduce the quality of Spanish debt as collateral. At some point, private investors do not want to continue to finance Spanish banks and the Spanish trade deficit because they do not have good collateral (we are already beyond this point). Yet thanks to TARGET2 the party can continue. Spanish banks can use bad collateral (Spanish government bonds) and refinance with the Bank of Spain, which accepts Spanish government bonds as collateral for new loans. As a result of this indirect monetization of government bonds, TARGET2 debits to the ECB increase. Bad risks (collateral) are shifted to the Eurosystem and socialized. TARGET2 thereby allows to finance the trade deficit through public central bank loans.

Not only public debts may be monetized through the Eurosystem and their risk socialized through TARGET2 but also private debts. This possibility augmented importantly in February 2012, when the ECB allowed national central bank on their own risk to determine eligible collateral for central-bank loans.[3] Depending on the exact collateral rules, a Spanish bank may now loan to a Spanish company to import from Germany. The Spanish bank may take the loan to the importer as collateral for a new loan from the Bank of Spain (of course, applying a haircut). In this way, the private loan (in this case used for consumption), has been monetized. As an effect there will be also TARGET2 debits for the Bank of Spain and TARGET2 credits for the Bundesbank.

What Are the Risks Exactly for a TARGET2 Credit Country Such as Germany?

If Greece leaves the euro, it most probably will not pay its debits to ECB with gold or hard assets. The ECB will suffer a loss, and through its capital contribution 27 percent of such a loss falls on the Bundesbank. If more countries leave the euro, the loss is correspondingly higher. In the opposite case of a German exit of the euro, the Bundesbank will suffer important losses if the new German currency appreciates as the Bundesbank’s main assets are now TARGET2 credits denominated in euros. Moreover, the remaining eurozone countries might resist paying for the TARGET2 credits.

But is the liquidation of TARGET2 credits a real loss? If we take our initial example of the two individuals with a clearing bank, the conclusion is straightforward. If B defaults, the bank goes bankrupt and A loses his savings. The same happens in the case of the Eurosystem. If the peripheral governments default, their banks default, their national central banks default and the ECB goes bankrupt. The Bundesbank then has a TARGET2 claim on the bankrupt ECB and goes bust too. Commerzbank loses its claims on the Bundesbank (or is not refinanced anymore) and defaults as well. Then the German saver is left with nothing but empty hands. The purpose of the visible bailouts of peripheral countries such as Greece is to maintain the illusion that no losses are to be suffered for savers in Germany and other countries.

But can the ECB or the Bundesbank really go bankrupt? Can they not always pay, just by printing more money? It is true that the ECB can always pay its bills by producing money. However, creating money does not take away the fact that the wealth is gone when the periphery defaults. It is like B not paying with real goods because he dies. A may receive new paper money from his bank, but this will not feed him through retirement. Unfortunately, as long as the European periphery remains uncompetitive relative to Germany, nothing will be produced to settle the German TARGET2 credits. Most likely, their real value is gone forever. To think that they will represent real wealth is an illusion that will be ended in one of three possible ways. The first is the already-mentioned inflation when the ECB just prints money to keep the system afloat.

Second, in the case of a peripheral default, the quality of the assets of the ECB is impaired, its capital consumed. The ECB loses options to reduce the quantity of money in circulation and defend the value of the euro. The ECB simply has no good assets to sell; they have evaporated. There is the danger that the confidence in the currency evaporates also, first on international currency markets and later internally. The value of the currency may collapse and the wealth illusion of currency holders and savers ends.

Third, another alternative is to recapitalize the ECB by transferring high-quality assets to it. The ECB can then use these assets to maintain confidence in the currency and defend its value. The recapitalization, of course, requires also an expropriation of wealth holders in Germany and other countries. After default and inflation, fiscal expropriation means an alternative end to the wealth illusion.

TARGET2, Eurobonds, European Stability Mechanism: What Is the Difference?

Eurobonds are jointly issued and guaranteed by all 17 eurozone members but have been very controversial. For instance, Eurobonds have been vehemently resisted by the German government until today. However, TARGET2 has not been resisted by the German government. TARGET2 is just the reflection of a substitute bailout. When governments issue bonds bought by their banks leading to a trade deficit, the result is a TARGET2 debit. The TARGET2 imbalances are just a sign of euros created in the periphery used to pay for goods from abroad.

The European Stability Mechanism (ESM) is another substitute for Eurobonds, as the ESM may grant loans to struggling governments issuing bonds guaranteed collectively. The difference between the three is merely of degree. There is more parliamentary control for Eurobonds or the ESM. In the ESM, creditor countries have more control over bailouts than with Eurobonds. Interest rates differences are also more pronounced with the ESM than with Eurobonds. The ECB wants to shift the bailout burden from TARGET2 to the ESM. Governments prefer to hide the losses on taxpayers as long as possible and prefer the ECB to aliment deficits. However, all three devices serve as bailout systems and form a transfer union.

[1] The best short introduction and analysis of TARGET2 may be found in Stefan Homburg, “Anmerkungen zum Target-2-Streit,” Wirtschaftsdienst, volume 91, numer 3 (2011): pp. 536–530. Our analysis and graphs follow Homburg’s line of argumentation closely.

[2] At least these rules appear in the Federal Reserve accounting manual. It seems, though, as if the Fed has suspended settlements ultimately. See Michiel Bijlsma and Jasper Lukkezen “Target-2 of the ECB vs. Interdistrict Settlement Account of the Federal Reserve” (2012).

[3] Jens Weidmann criticized the change in collateral rules and demanded collateral for TARGET2 debits in March 2012. However, only central banks and governments could provide good collateral such as gold for TARGET2 debits. Most banks have no good collateral left. Otherwise they would have used it to refinance themselves on the private markets and not through the Eurosystem with its low collateral standards.

This article was previously published at


Is there no escape from the euro?

As I discussed recently, the costs and risks of maintaining the eurozone system are already immense and rising. So is an exit possible? Intuitively, the exit from the euro should be as easy as the entrance. Joining and leaving the club should be equally simple. Leaving is just undoing what was done before. Indeed, many popular articles discuss the prospects of an exit of countries such as Greece or Germany.[1] However, other voices have rightly argued that there are important exit problems. Some authors even argue that these problems would make an exit from the euro virtually impossible. Thus, Eichengreen (2010) states, “The decision to join the euro area is effectively irreversible.” Similarly, Porter (2010) argues that the large costs of an exit would make it highly unlikely. In the following we address the alleged exit problems.

Legal Problems

The Maastricht Treaty does not provide for a mechanism to exit the European Monetary Union (EMU). Thus, several authors maintain that an exit from the euro would constitute a breach of the treaties (Cotterill 2011, Procter and Thieffry 1998, Thieffry 2011, Anthanassiou 2009).[2] In an ECB working paper from 2009 Anthanassiou claims that a country that exits the EMU would have to leave the EU as well. As the Lisbon Treaty allows for secession from the EU, withdrawal from the EU would be the only way to get rid of the euro.

The solution to this legal problem could be an exit from both the EMU and EU with an immediate reentering of the EU. This procedure could be negotiated beforehand. In the case of a net contributor to the EU budget such as Germany, the country would probably not face any problem getting immediately readmitted to the EU.

In any case, the referral to the Maastricht Treaty when discussing the legal possibility of exit is intriguing, because the Maastricht Treaty, especially the “no-bailout clause,” has been violated through the bailouts of Greece, Ireland, and Portugal. The European Financial Stability Facility effectively serves to guarantee debts of other nations, not to mention the plans to introduce eurobonds.

In addition, the European Central Bank has violated the spirit of the Maastricht Treaty by purchasing debt of troubled nations. It seems to be a justification, if not an obligation, to leave the euro after the conditions for its existence have been violated.[3] Indeed, the German Constitutional Court ruled in 1993 that Germany could leave the euro if the goals of monetary stability were not attained (Scott 1998, p. 215). After the last couple of years, it is clear that the eurozone and the euro are far from stable. Apart from these considerations it should be noted that a sovereign state can repudiate the treaty (Deo, Donovan, and Hatheway 2011).

Another legal problem results from the possible redenomination of contracts in the wake of an exit from the euro. A government may redenominate euro contracts into the new currency (applying lex monetae — the state determines its own currency). It may do so without problems if the contracts were contracted in its territory or under its law. But what about private and public bonds issued in foreign countries? How would foreign courts rule (Scott 1998, p. 224)?

Imagine a German company that sold a bond in Paris. Will the bond be paid back in euros or in the new currency if Germany leaves the euro? The French court would probably decide that it can or must be paid back in euros.[4] Possibly also the European Court of Justice would rule on such issues. Thus, in the case of an exit, there would be some uncertainty caused by court settlements. There may be one-time losses or profits for the involved parties. However, it is hard to see why these court rulings would constitute important disturbances or insurmountable obstacles for a euro exit.[5]

Introduction Costs

An exit from the euro may imply the issuing of a new national currency. This involves the costs of printing new notes, melting new coins, exchanging vendor machines, etc. There are also logistic costs exchanging the new currency against the old one. These costs are not higher than the costs of introducing the euro. The costs for introducing the euro in Austria have been estimated at €1.45 billion euros or around 0.5 percent of GDP.[6]

Wage Inflation and Higher Interest Rates

Sometimes it is argued that peripheral countries with uncompetitive wages could just exit the euro and magically solve all their problems. Greece, for instance, suffers from too-high wages mainly because there is no free labor market. Labor unions have caused wages to be too high. The resulting unemployment had been attenuated by government deficit spending and debt accumulation made possible by the Eurosystem. The Greek government employed people at high wages, paid unemployment benefits and retired people early with high pensions.

As strong labor unions prevent wages from falling to recuperate competitiveness, some people recommend that Greece exit the euro, depreciate the currency, and thereby increase competitiveness. This argument contains a problem. If labor unions remain strong, they may simply demand wage increases to compensate for higher import prices (Eichengreen 2010, p. 8). Such a compensatory increase in wages would eliminate all advantages from depreciation.[7] The exit would have to be accompanied by a reform of the labor market in order to improve competitiveness. In any case, after an exit from the EMU, the Greek government could no longer use EMU monetary redistribution and deficit spending to push up wages artificially.

Similarly, an exit without further reforms could lead to a repudiation of government debt. This would imply higher interest rates for the government in the future (Eichengreen 2008, p. 10). An accompanying reform of fiscal institutions such a constitutional limits for budget deficits could alleviate this problem.

The End of Monetary Redistribution between Countries

Some countries benefit from the monetary setup of the EMU. They pay lower interest rates on their debts than they otherwise would. If a country like Greece exits the euro and repays its debts with a devalued new currency, it will have to pay higher interest rates for its debts.

In addition, countries such as Greece could no longer benefit from the monetary redistribution. The Greek government, and indirectly part of the Greek population, benefits from the high Greek deficits and the flow of new money into the country. This process allowed Greece to finance an import surplus and standard of living it would not have achieved otherwise. At least in the short term, an exit from the euro would, ceteris paribus, mean a deterioration of artificially high living standards. In other words, after an exit from the EMU, the size of its public sector and standard of living would likely fall as the EMU subsidies end. These redistribution costs only apply to countries that have been on the receiving end of the redistribution. For fiscally sounder countries, the opposite reasoning applies.

Trade Losses

Some authors argue that European trade would collapse in the wake of a euro exit. Trade barriers would be re-erected. In any case there could be an appreciation of the new currency like a new deutschemark (DM). In a UBS research paper, Flury and Wacker (2010, p. 3) estimate that the new DM would appreciate about 25 percent.

In contrast to another UBS research paper (Deo, Donovan and Hatheway 2011) that comes up with horrific costs of a euro break up,[8] we do not regard such trade barriers as very likely for several reasons. First, such barriers would be an economic disaster for all involved parties and would lead to a severe and long depression and a reduction of living standards. Second, net contributors to the EU, such as Germany, could still use their contributions to the EU budget as a negotiating card to prevent such barriers. Third, trade barriers are a blatant violation of EU treaties. Fourth, tariffs could provoke severe tensions between nations, possibly leading to war.

Political Costs

Sometimes it is maintained that an exit implies high political costs. Most importantly, an exit could trigger the dissolution of the euro.[9] The disintegration of the EMU could endanger the development of a federal European state. At least, it would mean an important blow to the “European project.” It could mean the end of the EU as we know today. The EU could “degenerate” into a free-trade zone.

Politicians of the exiting country would lose influence on the policies of other EMU countries. The politicians of the exiting country would also lose appreciation of other EMU politicians and in the mainstream media that has supported the euro staunchly. However, for supporters of a free-trade zone in Europe, these political costs imply immense benefits. The danger of a federal European state would disappear for now.

Procedural Costs and Capital Flows

An exiting nation has to print new notes, mint new coins, reprogram automatic teller machines, and rewrite computer code (Eichengreen 2008, p. 17).[10] This takes time. The case of machines may not be tragic, because, during the transition period, old machines may be in use without chaos. A public parking place using euro coins will not bring the economy down.

The notes-and-coins problem has a fast solution, because on both the country’s origin is visible. Coins have a country-specific image and notes bear a country-specific letter. In a German exit from the euro, all German coins and notes would be redenominated into the new currency and later gradually exchanged into the new notes and coins.[11] Of course, the transition period would involve some checking costs as people have to look at the symbols when transacting in cash.

The most severe problem of a euro exit — one that according to Eichengreen (2010) would pose “insurmountable” barriers — is capital flows when the option of exiting is discussed.[12] Such a discussion takes time in democracies. During this time there may be important capital inflows and outflows.[13]

Let us first discuss the problem of capital outflow such as in the case of an exit of Greece with no accompanying reforms. If Greek senior politicians seriously discuss an exit from the euro, Greek citizens will expect a depreciation of the new currency, a new drachma. Greek citizens will transfer their euros held at Greek banks to accounts in other EMU countries. They will probably not turn in their euro notes to be exchanged for the new drachmas voluntarily.

Greek citizens may also acquire other currencies such as Swiss francs, US dollars, or gold to protect themselves from depreciation. In this way Greece could practically be immunized against the new drachma even before its introduction. As a consequence, the Greek banking system may get into liquidity and solvency problems. Meanwhile, Greek citizens would continue to transact in euros held outside Greek jurisdiction.

This is the so-called “problem” of capital outflows. Yet these outflows are not a problem for ordinary Greek citizens. For them these outflows are a solution to the problem of an inflationary national currency. Moreover, capital outflows are already occurring. The discussion in parliament of a Greek exit would only speed up what is happening already.

The opposite reasoning applies when a more solvent country like Germany discusses an exit from the eurozone. If people expect an appreciation of a newly introduced currency, there would be capital inflows into Germany. The money supply of euros within Germany, which would later be converted into a new currency, would increase. Prices of German assets (e.g., housing and stocks) would increase in advance of the actual German exit, benefitting the current owners of such assets.

A Systemic Banking Crisis

Finally, there may be negative feedback for the banking system as there will most likely be losses for banks both domestic and foreign.[14],[15] Eichengreen (2010) fears the “mother of all financial crises.” Due to connectivity, it does not matter if Germany or Greece leaves the euro. If Greece leaves the euro and pays back its government bonds in a depreciated new currency or defaults outright, there will be losses for European banks that could get into solvency problems. Similarly, if Germany leaves the euro, the implicit guarantee and support to the Eurosystem will disappear. The result may be a banking crisis in Greece and other countries. The banking crisis might negatively affect German banks.[16] The banking crisis would also negatively affect sovereigns, due to possible bank recapitalizations. Other countries may be regarded as possible defaulters or exit candidates leading to higher interest rates on public debts. A systemic financial crisis infecting weak governments would be likely (Boone and Johnson 2011).

Recently, the IMF suggested that European banks face €300 billion in potential losses and urged the banks to raise capital.[17] We should emphasize that the problem of bank undercapitalization and bad assets (most importantly, peripheral government bonds) does already exist in the EMU and will deteriorate without an exit.

It is almost impossible to leave the euro without already-unstable structures collapsing. Yet this collapse would have the beneficial effect of quickly purging unsustainable structures. Even if there are no exits from the euro, the banking problem exists and will have to be solved sooner or later. Potential bank insolvency should therefore be no argument against an exit.[18] In the EMU taxpayers (mostly German) and inflationary measures by the ECB are momentarily containing the situation. An exit would speed up a restructuring of the European banking system.

At this point I would like to give the following recommendation for a solution of the banking crisis. There are important free-market solutions to bank-solvency problems.[19]

  1. Banks with nonviable business models should be allowed to fail, liberating capital and resources for other business projects.
  2. A debt-to-equity conversion may put many banks on a healthy basis.[20]
  3. Banks may collect private capital by issuing equity, as they are already doing.

A free-market reform has important advantages:

  1. Taxpayers are not hurt.
  2. Unsustainable banking projects are resolved. As the banking sector is oversized, it would shrink to a more healthy and sustainable level.
  3. No inflationary policies are used to sustain the banking system.
  4. Moral hazard is avoided. Banks will not be bailed out.

The Problem of Disentangling the European Central Bank

The Eurosystem consists of the ECB and national central banks. The task of disentangling is facilitated because national central banks still possess their own reserves and have their own balance sheets. Scott (1998) argues that this setup may have been intentional. Countries wanted to retain the possibility of leaving the euro if necessary.

On January 1, 1999, the ECB started with capital of €5 billion. In December 2010 the capital was increased from €5.76 billion to €10.76 billion.[21]

Only part of all EMU reserve assets have been pooled in the ECB, making a disentangling easier. On January 1, 1999, national central banks provided €50 billion in reserve assets pro rata to their capital contribution (Procter and Thieffrey 1998, p. 6). National central banks retained the “ownership” of these foreign reserve assets and transferred the management of the reserves to the ECB. (Scott 1998, p. 217). In the case of an exit, both the return of the contribution to the ECB’s capital and the foreign assets transferred to the Eurosystem had to be negotiated (Anthanassiou 2009).

Similarly, there is the problem of TARGET2 claims and liabilities. If Germany had left the EMU in March 2012, the Bundesbank would have found TARGET2 claims denominated in euros of more than €616 billion on its balance sheet. If the euro depreciated against the new DM, important losses for the Bundesbank would result.[22] As a consequence, the German government may have to recapitalize the Bundesbank. Take into account, however, that these losses would only acknowledge the risk and losses that the Bundesbank and the German treasury are facing within the EMU. This risk is rising every day the Bundesbank stays within the EMU.

If, in contrast, Greece leaves the EMU, it would be less problematic for the departing country. Greece would simply pay its credits to the ECB with the new drachmas, involving losses for the ECB. Depositors would move their accounts from Greek banks to German banks leading to TARGET2 claims for the Bundesbank. As the credit risk of the Bundesbank would keep increasing due to TARGET2 surpluses, the Bundesbank might well want to pull the plug on the euro itself (Brookes 1998).[23]

Intellectual honesty requires us to admit that there are important costs to exiting the euro, such as legal problems or the disentangling of the ECB. However, these costs can be mitigated by reforms or clever handling. Some of the alleged costs are actually benefits from the point of liberty, such as political costs or liberating capital flows. Indeed, other costs may be seen as an opportunity, such as a banking crisis that is used to reform the financial system and finally put it on a sound basis. In any case, these costs have to be compared with the enormous benefits of exiting the system, consisting in the possible implosion of the Eurosystem. Exiting the euro implies ending being part of an inflationary, self-destructing monetary system with growing welfare states, falling competitiveness, bailouts, subsidies, transfers, moral hazard, conflicts between nations, centralization, and in general a loss of liberty.


  • [1] Reiermann (2011) discusses rumors of a possible Greek exit. Desmond Lachman (2011) maintains that Greece exit from the eurozone is inevitable. Feldstein (2010) recommends that Greece take a “holiday” from the euro. Johnson (2011) and Roubini (2011) recommend that Greece leave the euro and default. Alexandre (2011) and Knowles (2011) wonder how a Greek exit could be achieved. Edmund Conway (2011), on the contrary, thinks that Germany should leave the eurozone. David Champion (2011) also considers the possibility of a German exit.
  • [2] Smits (2005, p. 464) writes, “There is no legal way for a separate exit from the eurozone. So, an intention to give up the single currency can only be realized by negotiating an exit agreement, or, failing successful conclusion thereof, leaving [the EU altogether] after the two-year notice period.”
  • [3] Anthanassiou (2009, p. 19), in contrast, argues that no country can leave the eurozone in protest.
  • [4] Mann (1960) maintains that if it is unclear which currency should be applied, the courts should use the law specified in the contract. So if the bond of the German company is sold in Paris under French law, the contract would be paid in euros. Porter (2010, p. 4) reaches the same conclusion.
  • [5] Thieffry (2011, p. 104) fears a “serious legal dislocation of government bond markets and a long period of uncertainty.” Problems for irresponsible governments to finance deficit spending might actually be seen as advantageous.
  • [6] See Newsat (2001).
  • [7] The argument of increased competitiveness via depreciation has more fundamental problems (Rallo 2011, p.158). While it is important to lower some prices vis-à-vis the foreign world (e.g., wages in some sectors), depreciation lowers all prices to the same extent. Moreover, it makes imports more expensive. If a country has to import commodities and goods that are later exported, the depreciation may not increase competitiveness at all.
  • [8] The authors estimate the costs for “weak” countries to leave between €9,500 and €11,500 per person and €6,000 to €8,000 per person for “strong” countries. The authors contrast these numbers with the relatively small cost of €1,000 per German in the case of a 50 percent haircut on Greek government debt. These estimations neglect some important benefits of exit and exaggerate the costs. For instance, they do not take into account the long-term costs of a fiscal union, nor the higher inflation. Moreover, they assume that the “strong” leaving country would have to “write off its export industry” and civil disorder in weak countries, while the possibility of such disorder it actually higher staying within the eurozone.
  • [9] On the history of the political project of the euro as a means toward a central European state see Bagus (2010).
  • [10] Flury and Wacker (2010) estimate one year of transition to fully establish the new currency.
  • [11] An alternative solution would be to stamp all notes in the exiting country within a short period of time. Yet, there is the problem of massive inflow of notes or a population that does not bring in their notes to be stamped due to fear of future depreciation. Thus, we regard the exchange of notes bearing the national letter more practical, even though some of the notes are circulating in other EMU countries.
  • [12] Smith (2005, p. 465) points to the instability caused by speculations about an exit: “even the threat of withdrawal will affect the euro stability and may lead to speculation against the single currency.” Scott (1998, p. 211) argues that speculation on which country is to leave may lead to a breakup of the eurozone.
  • [13] Porter (2010, p.6 ) depicts the following scenario: If Germany is expected to introduce a strong currency. banks will transfer deposits to Germany. They could lend at the marginal lending rate of their central banks and deposit at the Bundesbank. The Bundesbank balance sheet would expand substantially. Porter suggests a surprise shut down of the TARGET2 system.
  • [14] Another alleged problem is contagion. If one country leaves the eurozone, investors may sell the debt of other weak EMU governments and their banks triggering more exits. The contagion problem does not concern us here, because we want to discuss the possibility of exit. If exit is possible and desirable, contagion is no insurmountable problem but may even be recommendable.
  • [15] As Porter (2010, p. 5) points out, an exit would result in a currency mismatch of many companies and banks. Suddenly they would have assets or debts denominated in a foreign currency with a changing value resulting in windfall profits or losses. As Germany has a net foreign-asset position and an exit would likely lead to an appreciation of the new German currency, losses would result. The losses would damage balance sheets.
  • [16] Flury and Wacker (2010) discuss this and other problems related to a German exit from the euro.
  • [17] See Reddy (2011).
  • [18] One may also ask whether a country should have rejected the possibility of secession from the Soviet Union in fear of banking problems.
  • [19] For a detailed plan and critique of the 2008 bailouts, see Bagus and Rallo (2011).
  • [20] Ideally, this conversion would be voluntary. If bank creditors are unwilling to convert their investments into equity, the bank would have to be liquidated with high losses due to fire sales. Thus, there is an incentive for creditors to convert bank debts into equity, if the business model is be viable. Doing so they can prevent the higher losses from a liquidation. On the contrary, Buiter (2008) has suggested an involuntary, across-the-board debt-equity conversion. This measure is unnecessary if we allow for bank failures.
  • [21] The Bundesbank capital share is 27.1 percent. The paid up capital is €1.4 billion. (The Bundesbank’s capital share is 18.93 percent including both eurozone and noneurozone members.)
  • [22] A depreciation of the euro implies a loss of almost €100 billion.
  • [23] Note that the claims or liabilities in the TARGET2 system are not against other national central banks, but a single net bilateral position is established vis-á-vis the ECB only (Whittaker 2011). See also Bundesbank (2011b, p. 34).


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The Fed’s swap bailout of the eurozone

On Tuesday, March 26, 2012, I was invited by Ron Paul and his staff to assist a meeting of the Domestic Monetary Policy and Technology Subcommittee of the House Committee on Financial Services. The title of the hearing was “Federal Reserve Aid to the Eurozone: Its Impact on the U.S. and the Dollar.”

Unfortunately, Ben Bernanke had not come to the hearing, being busy with propaganda lectures in favor of the Fed. Instead, two of his colleagues, Mr. William C. Dudley (president and chief executive officer, Federal Reserve Bank of New York) and Dr. Steven B. Kamin (director, Division of International Finance, Board of Governors of the Federal Reserve System), showed up to answer the committee’s questions on currency swaps with other central banks.

The hearing dealt mainly with the Fed’s currency swap with the ECB, which amounts to a covert bailout of European banks.

But why did European banks need help from the Fed in the first place? European banks had borrowed dollars short term in international wholesale markets and lent these dollars for the long term to US companies or households. The maturity mismatch is highly risky, because once a bank cannot renew its short-term debts it becomes illiquid.

We approached such a situation last year. European banks had been pressured by their governments to buy their governments’ debts. Italian banks are loaded with Italian government bonds, Spanish banks with Spanish bonds and so on. As the sovereign-debt crisis increased once again in the summer of 2011 with governments short of collapsing, European banks had increasing difficulties renewing their short-term dollar loans. As the ECB can only print euros, not dollars, European banks got nervous. While US banks did not want to lend to European banks anymore, in September 2011, the Fed stepped in and bailed out European banks through currency swaps. Through the swaps, the Fed assumed its role as the international lender of last resort.

During the financial crisis between 2007 and 2009, the Fed had bailed out European banks mainly through direct loans to subsidiaries in the United States. In order to conceal the bailouts, the Fed now uses mainly currency swaps. In the swap, the Fed sells dollars to the ECB and buys them back later at the same price, receiving interests. This construction resembles a dollar loan to the ECB at about 0.6 percent (0.5 percent above the federal-funds rate). The ECB can then use these dollars to lend them to troubled European banks.

At the hearing the Fed officials did not deny the obvious: the bailout of European banks by the Fed. Rather, they claimed that the bailout was basically a free lunch for US taxpayers, as they would get an almost-risk-free benefit in the form of the interest on the swap.

Further, the Fed officials maintained that the bailout was necessary because a default of European banks would cause stress in financial markets. Through the interconnectivity of financial markets, US banks would get into problems; lending to US households and companies would be affected negatively.

Lastly, they made assurances that the Fed will end the swap-bailout policy once it becomes imprudent and the costs and risks of such a policy exceed the benefits for the US public.

Let’s have a look at these startling arguments.

First, there ain’t no such a thing as a free lunch; not even for the Fed, the ultimate money producer. Just remember that US banks did not want to lend to European banks, because they regarded it as too risky. Even the central-bank swap is not risk free. It is true that the Fed has locked in the exchange rate and expects to get back the same amount of dollars plus interest. Yet there remains counterparty risk: what if the ECB, goes bust? Then the creditors, including the Fed, will take over the ECB’s assets. Creditors would receive assets such as Greek government bonds, or loans to Portuguese banks. These banks depend on ECB liquidity lines and are collateralized by bonds issued by the Portuguese government, which also depends on the ECB to support it.

In the end, the ECB balance sheet is backed to a large extent by bonds from insolvent governments that are only kept afloat thanks to the ECB’s promises to keep printing money and the pledged support of German taxpayers.

While an ECB bankruptcy does not seem imminent, the ECB has increased its capital to make good for potential losses already back in 2010, and the Bundesbank increased its provisions for losses in 2011. In the mean time, the ECB has bought even more Greek government debt. The ECB is probably one of the most highly leveraged banks in history.

Of course, the Fed hopes that eurozone governments will always recapitalize the ECB if it is necessary, so that ultimately taxpayers return the dollars to the Fed. But what if Germany leaves the eurozone? While this is unlikely in the short term, the possibility exists for the long run. Then southern European governments will default on their debts — and take their banks and the ECB down with them. Then who will pay back dollar swaps to the Fed?

The swap is also no free lunch as opportunity costs are involved. By abstaining from producing dollars and lending them to the ECB, the US-dollar money supply would be smaller and backed by better-quality assets (not indirectly by Greek government bonds). The dollar production also implies a redistribution toward the first receivers of the new dollars, the ECB, European banks, and their borrowers (mainly irresponsible and insolvent governments) to the detriments of the last receivers, mainly US citizens, who are confronted with a debased dollar.

There are other opportunity costs. The Fed could have produced the same amount of dollars and not invested in the central-bank swaps. These swaps earn very low interest. Instead of the swaps, the Fed could have purchased other assets, like stocks of Apple or gold, which may rise more in value.

One cost of the swap operation acknowledged by the officials in the hearing is the moral hazard created. Banks and governments worldwide may expect that the Fed will come to save them, too, especially if they are well connected with the US financial system. So why be prudent?

The highest cost of the swaps, though, may be something else. Through the swaps, the Fed is helping the ECB to bail out European banks that finance insolvent and irresponsible governments. The Fed is indirectly bailing out countries like Greece, Portugal, and Spain, debasing the dollar. Thanks to the bailouts, the political project of the euro continues. Without the swaps, some European banks might have failed, and with them their sovereigns. Thanks to the swaps, the eurozone stays intact.

The project of the euro leads to an ever-increasing rescue fund, and gradually toward a fiscal union and more centralization. A European financial government and the European super state, which would most likely abolish tax competition in Europe, are on the horizon. The highest cost of the Fed policy, therefore, may be liberty in Europe.

The Fed officials also made clear that they think the swap arrangement benefits the US public by keeping stress away from US banks and financial markets. The Fed does not want stock markets to fall or interest rates to increase. For them, low interest rates are the panacea for all economic ills. However, having artificially low interest rates climb back to more normal levels is no disaster. Sustainable investments are always restricted by real savings. Lowering interest rates does not increase the amount of real savings at all. Moreover, an important feature of a market economy is that people take responsibility for their actions. If US banks have granted loans to European banks and governments, they should assume the losses from their risky behaviour.

Finally, the Fed claims to be prudent. But how can the Fed know the point at which it is no longer prudent to bail out foreign banks? How can it know when the costs of the bailouts start to exceed the benefits to the US public? How can they know what is best for the United States? Interpersonal-utility comparisons are arbitrary. Thanks to the bailouts, some banks may win, some stock owners may win, but at the cost of liberty in Europe and to the detriment of dollar users. Moreover, bailouts produce moral hazards, crises, and losses for individuals in the future. Yet the Fed claims to know what to do: social engineering at its best — or, as Hayek would put it, a fatal conceit on the part of central (banking) planners.

In sum, the Fed has assumed the task of bailing out the financial industry and governments worldwide by debasing the dollar. Fed officials claim to know that the bailout-swaps are basically a free lunch for US taxpayers and a prudent thing to do. Thank God the world is in such good hands.

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Why is there a euro crisis?

On Thursday, October 28, 2011, prices of European stocks soared. Big banks like Société Générale (+22.54%), BNP Paribas (+19.92%), Commerzbank (+16.49%) or Deutsche Bank (+15.35%) experienced fantastic one-day gains. What happened?

Today’s banks are not free-market institutions. They live in a symbiosis with governments that they are financing. The banks’ survival depends on privileges and government interventions. Such an intervention explains the unusual stock gains. On Wednesday night, an EU summit had limited the losses that European banks will take for financing the irresponsible Greek government to 50 percent. Moreover, the summit showed that the European political elite is willing to keep the game going and continue to bail out the government of Greece and other peripheral countries. Everyone who receives money from the Greek government benefits from the bailout: Greek public employees, pensioners, unemployed, subsidized sectors, Greek banks — but also French and German banks.

Europeans politicians want the euro to survive. For it to do so, they think that they have to rescue irresponsible governments with public money. Banks are the main creditors of such governments. Thus, bank stocks soared.

The spending mess goes in a circle. Banks have financed irresponsible governments such as that of Greece. Now the Greek government partially defaults. As a consequence, European governments rescue banks by bailing them out directly or by giving loans to the Greek government. Banks can then continue to finance governments (the loans to the Greek government and others). But who, in the end, is really paying for this whole mess? That is the end of our story. Let us begin with the origin that coincides with beneficiaries of the last EU summit: the banking system.

The Origin of the Calamity: Credit Expansion

When fractional-reserve banks expand credit, malinvestments result. Entrepreneurs induced by artificially low interest rates engage in new investment projects that the lower interest rates suddenly make look profitable. Many of these investments are not financed by real savings but just by money created out of thin air by the banking system. The new investments absorb important resources from other sectors that are not affected so much by the inflow of the new money. There results a real distortion in the productive structure of the economy. In the last cycle, malinvestments in the booming housing markets contrasted with important bottlenecks such as in the commodity sector.

The Real Distortions Trigger a Financial Crisis

In 2008, the crisis of the real economy triggered a banking or financial crisis. Artificially low interest rates had facilitated excessive debt accumulation to finance bubble activities. When the malinvestments became apparent, the market value of these investments dropped sharply. Part of these assets (malinvestments) was property of the banking system or financed by it.

As malinvestments got liquidated, companies went bust and people lost their bubble jobs. Individuals started to default on their mortgage and other credit payments. Bankrupt companies stopped paying their loans to banks. Asset prices such as stock prices collapsed. As a consequence, the value of bank assets evaporated, reducing their equity. Bank liquidity was affected negatively too as borrowers defaulted on their bank loans.

As a consequence of the reduced bank solvency, a problem originating from the distortions in the real economy, financial institutions almost stopped lending to each other in the autumn of 2008. Interbank liquidity dried up. Add to this the fact that fractional-reserve banks are inherently illiquid, and it is not surprising that a financial meltdown was only stopped by massive interventions by central banks and governments worldwide. The real crisis had caused a financial crisis.

Conditions for Economic Recovery

Economic recovery requires that the structure of production adapt to consumer wishes. Malinvestments must be liquidated to free up resources for new, more urgently demanded projects. This process requires several adjustments.

First, relative prices must adjust. For instances, housing prices had to fall, which made other projects look relatively more profitable. If relative housing prices do not fall, ever more houses will be built, adding to existing distortions.

Second, savings must be available to finance investments in the hitherto neglected sectors, such as the commodity sector. Additional savings hasten the process as the new processes need savings.

Lastly, factor markets must be flexible to allow the factors of production to shift from the bubble sectors to the more urgently demanded projects. Workers must stop building additional houses and instead engage in more-urgent projects, such as the production of oil.

Bankruptcies are an institution that can speed up the process of relative price adjustments, transferring savings and factors of production. They favor a rapid sale of malinvestments, setting free savings and factors of production. Bankruptcies are thus essential for a fast recovery.

A Fast Liquidation Is Inhibited at High Costs

All three aforementioned adjustments (relative prices changes, increase in private savings, and factor-market flexibility) were inhibited. Many bankruptcies that should have happened were not allowed to occur. Both in the real economy and the financial sector, governments intervened. They support struggling companies via subsidized loans, programs such as cash for clunkers, or via public works.

Governments also supported and rescued banks by buying problematic assets or injecting capital into them. As bankruptcies are not allowed to happen, the liquidation of malinvestments was slowed down.

Governments also inhibited factor markets from being flexible and subsidized unemployment by paying unemployment benefits. Bubble prices were not allowed to adjust quickly but were to some extent propped up by government interventions. Government sucked up private savings by taxes and squandered them maintaining an obsolete structure of production. Banks financed the government spending by buying government bonds. By putting money into the public sector, banks had fewer funds available to lend to the private sector.

Factors of production were not shifted quickly into new projects because the old ones were not liquidated. They remained stuck in what essentially were malinvestments, especially in an overblown financial sector. Factor mobility was slowed down by unemployment benefits, union privileges, and other labor market regulations.

Real and Financial Crisis Trigger a Sovereign-Debt Crisis

All these efforts to prevent a fast restructuring implied an enormous increase in public spending. Government spending had already increased in the years previous to the crisis thanks to the artificial boom. The credit-induced boom had caused bubble profits in several sectors, such as housing or the stock market. Tax revenues had soared and had been readily spent by governments’ introducing new spending programs. These revenues now just disappeared. Government revenue from income taxes and social security also dropped.

With government expenditures that prolong the crisis soaring and revenues plummeting, public debts and deficits skyrocketed.[1] The crisis of the real and financial economy led to a sovereign-debt crisis. Malinvestment had not been restructured, and losses had not disappeared, because government intervention inhibited their liquidation. The ownership of malinvestments and the losses resulting from them were to a great part socialized.

Sovereign-Debt Crisis Triggers Currency Crisis

The next step in the logic of monetary interventionism is a currency crisis. The value of fiat currencies is ultimately supported by their governments and central banks. The balance sheets of central banks deteriorated considerably during the crisis and with them the banks’ capacity to defend the value of the currencies they issue. During the crisis, central banks accumulated bad assets: loans to zombie banks, overvalued asset-backed securities, bonds of troubled governments, etc.

In order to support the banking system during the crisis and to limit the number of bankruptcies, central banks had to keep interest rates at historically low levels. They thereby facilitated the accumulation of government debts. Consequently, the pressure on central banks to print the governments’ way out of their debt crisis is building up. Indeed, we have already seen quantitative easing I and quantitative easing II enacted by the Fed. The European Central Bank also started buying government bonds and accepting collateral of low quality (such as Greek government bonds) as did the Bank of England.

Central banks are producing more base money and reducing the quality of their assets.

Governments, in turn, are in bad shape to recapitalize them. They need further money production to stay afloat. Due to their overindebtedness, there are several ways out for governments negatively affecting the value of the currencies they issue.

Governments may default on debts directly by ceasing to pay their bonds. Alternatively, they can do so indirectly through high inflation (another form of default). Here we face a possible feedback loop to the banking crisis. If governments default on their debts, banks holding these debts are affected negatively. Then another government’s bailout may be necessary to save the banks. This rescue would likely be financed by even more debts calling for more money production and dilution. All this reduces the confidence in fiat currencies.


After crises of the real economy, the financial sector and government debts, the logic of interventionism leads us to a currency crisis. The currency crisis is just unfolding before our eyes. The crisis has been partially concealed as the euro and the dollar are depreciating almost at the same pace. The currency crisis manifests itself, however, in the exchange rate to the Swiss franc or the price of gold.

When currencies collapse, price inflation usually picks up. More units of the currency must be offered to acquire goods and services. What had started with credit expansion and distortions in the real economy, then, may well end up with high price inflation rates and currency reform.

It is now easy to answer our initial question: Who is paying for the mutual bailouts of governments and banks in the eurozone? All holders of euros, via a loss of purchasing power.

Instead of allowing the market to react to credit expansion, governments increased their debts and sacrificed the value of the currencies we are using. The remedy to the distortions caused by credit expansion would have been the fast liquidation of malinvestments, banks, and governments. As the innocent users of the currencies are paying for the bailouts, it is difficult not to be a liquidationist.

[1] The tremendous increase in public debts after a banking crisis is typical. Carmen Reinhardt and Kenneth Rogoff write in This Time Is Different (2009), p. xxxi: “On average government debt rises by 86 percent during the three years following a banking crisis.”

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Preparing for Euro breakup

In this essay we evaluate the alleged costs of a euro exit and propose practical steps to make a withdrawal from the euro as smooth as possible.

The costs of remaining within the euro are very high. These costs do not only include the costs of the open bailouts and guarantees for the rescue funds. The euro is a misconstruction as several independent governments can finance their deficits through one (central) banking system. The incentive is to run higher deficits than other states of the EMU. The setup of the Eurosystem made interest rates converge and enabled monetary redistribution. Due to its incentives there is a tendency for price inflation.

To save the euro the ECB will have to be highly inflationary in the future. The ECB will have to keep accepting or buying governments bonds and finance the rescue funds. Within the EMU the incentives to reduce deficit spending are diminished. There is a general tendency for the size of government to increase due to this inflationary deficit spending. Most likely, only a centralization of some sort (fiscal union) will be able to save the euro at this point with its current members. The growing size of government and the centralization imply a loss for individual liberty for citizens of governments that remain within the euro. Lastly, the redistribution may cause conflicts between nations and disturb the harmonious cooperation in Europe.

The problems of a euro exit have been largely exaggerated. Introduction costs, wage inflation, trade losses, political costs, legal problems, procedural costs, banking crisis, costs of disentangling of the ECB, pose important but no insurmountable problems. With accompanying measures and careful negotiation these problems are all solvable.
We found three ways to exit.

First, redenomination of all contracts and deposits into a new national currency. Coins and notes bearing the national symbol are exchanged gradually into the new currency preferably at a 1:1 exchange rate. In order to prevent disturbing flows of capital a “provisional” redenomination allowing for democratic discussion is found as the most elegant way.

Second, issue of a parallel national currency. This national currency may be backed by government or central bank assets preferably gold and would compete with the euro.

Third, currency competition. All legal tender laws are abolished. Gradually, citizens will start using more stable currencies and possibly adopt commodity based means of payment.

It is essential to accompany an exit from the euro with supporting reforms to alleviate transition costs. The sovereign debt and euro crisis is foremost a crisis of the state that has grown to a dimension that threatens the stability of the euro currency. Accompanying measures must roll back the state. In order to introduce a new currency with success it is essential that the new currency is expected to be less inflationary than the euro.

As a banking reform will be necessary in any case, an exit from the euro should be used to thoroughly reform the banking and monetary system putting them finally on a sound basis. Moreover, the public deficits should be eliminated, old public debt restructured, public assets privatized, markets deregulated and made flexible, and taxes lowered.

I recently presented these ideas to the European Parliament in a conference sponsored by the EFD group (starting from 41:20):