“The issuer’s promise” is a phrase I have used recently to describe the backing for fiat currencies. The purpose of this article is to define it further, given that it is increasingly likely to be challenged in the foreign exchange markets with respect to the euro.
To begin we need to define the principal difference between gold and a fiat currency. Gold has no price when it is used as money, other than what it is exchanged for in goods. Uniquely as money, it was in demand everywhere by all societies to settle their own domestic and foreign trade. Fiat money is only used to settle transactions in the jurisdiction to which it relates, and foreigners who end up with it exchange it for their own fiat money, because out of jurisdiction it is not money.
There are three basic exceptions to this rule. The dollar, through its original gold convertibility became a substitute for gold, and still enjoys an international role as a result of that legacy. A second exception is when governments intervene and build up holdings of foreign fiat money. And the third is when ownership of foreign currencies accumulates for speculative purposes. Otherwise, outside its jurisdiction a fiat currency has no useful value.
Its validity is based on a promise by the issuing central bank and the relevant government that it actually has value. The value of that promise is subjectively assessed in foreign exchange markets, where dealers compare fiat currencies. The result is that the purchasing power of a fiat currency can diminish substantially in foreign exchanges before disrupting its domestic monetary role. The dollar, for example, has lost most of its purchasing power since it became completely disconnected from gold in 1971, but Americans still think automatically “I have 10 bucks to spend: what shall I buy?” rather than “I must get rid of these 10 bucks before they lose yet more value”.
We all think like that with our respective fiat currencies, and the moment we don’t marks the start of a collapse in confidence in the issuer’s promise. This could be the euro’s Achilles Heel, because there is no identifiable government actually prepared to stand behind the European Central Bank, and as the crisis intensifies, there is a growing risk the promise will be found wanting by the eurozone’s own citizens.
Fiat money is managed by neoclassical economists at central banks who think they understand price theory. The euro is in danger of a sudden collapse, and it is not clear that the powers-that-be in the ECB understand this. It is not even clear if they understand that hyperinflation is not, as the term in modern usage suggests, an accelerating rise in the price of goods. Instead it is a collapse in the value of fiat money that arises from a reassessment of the issuer’s promise by domestic users.
The euro’s future is essentially tied to a collection of disparate governments. If any of them leaves, it risks bringing on a collapse in its value that is completely beyond the control of the ECB.
This article was previously published at GoldMoney.com.
On Thursday the European Central Bank’s Mario Draghi was moved to defend the euro, after Spain’s government bond yields rose dramatically through the 7% level. And when Valencia asked the central government for a bailout, followed by indications that other cities and regions have similar problems, it became clear that Spain is in deep trouble. We have got used to the concept of too-big-to-fail; now we have too-big-to-rescue.
We normally talk about Spain and also Italy in terms of government debt and budget deficits, forgetting they are only part of the problem. To these must be added regional and local governments, nationalised and subsidised industries, and off-balance sheet guarantees for other entities. Forget, for the moment, future health and welfare costs, which statistically dwarf everything: they are not the immediate problem. This still leaves us with rescues, without even considering commercial banks, amounting to perhaps between two and four times the headline government debt. People think Spain can be rescued, but when you take everything into account, including the prospect of a policy-induced slump from macro-economic mistakes, it is simply too big.
The failure to face up to financial reality is essentially political. Spain’s President of the Government, Mariano Rajoy, was elected with a clear majority last November, and has failed to cut spending. Instead of reducing the burden of the public sector on the economy, he has chosen to penalise the productive private sector through extra taxation. If anyone had an opportunity to face up to reality with an electoral mandate it was Rajoy, but he failed to do so either because he deemed it politically impossible or because he is simply too weak.
Perhaps it is political reality: this is certainly echoed in all the other crisis-hit states. France’s electorate has cut out any argument by electing a socialist president intent on increasing both public spending and taxes at the same time. The result is that Europe faces economic collapse sooner than it might otherwise, escalating the burden principally on Germany of bailing out impecunious states.
Germany is becoming isolated, and no longer is Chancellor Merkel able to pretend that, deo volente, it will come right in the end. Instead Germany faces a crippling bill, now recognised by the rating agencies. In a GoldMoney podcast released last Wednesday, Philipp Bagus estimated the total cost to Germany to be four times her total tax revenues. That implies personal taxes of over 100% of private sector income. How do you carry your electorate along with you, simply to keep the euro project alive, with that sort of cost?
You cannot. Bagus sees no alternative to money-printing, and that is effectively what Draghi now says he is prepared to do; but unlike other fiat currencies, the euro has no single government backing it. Therefore the effect on the euro of Draghi’s money printing could be catastrophic.
It would be quite an event. We have not seen a major fiat currency collapse in recent decades, though there are those in Germany who remember the misery it brings. The speed at which the euro weakens could be very surprising indeed.
This article was previously published at GoldMoney.com.
When currencies and monetary arrangements have broken down it has always been because the currency issuer can no longer fight the lure of the seigniorage to be gained by over issue of the currency. In the twentieth century this age-old impulse was allied to new theories that held that economic downturns were caused or exacerbated by a shortage of money. It followed that they could be combated by the production of money.
Based on the obvious fallacy of mistaking nominal rises in wealth for real rises in wealth, this doctrine found ready support from spendthrift politicians who were, in turn, supported by the doctrine.
Time and again over recent history we see the desire for seigniorage allied with the cry for more money to fight a downturn pushing up against the walls of the monetary architecture designed to protect the value of the currency. Time and again we see the monetary architecture crumble.
The classical gold standard
At the start of the twentieth century much of the planet and its major economic powers were on the gold standard which had evolved from the 1870s following Britain’s lead. This was based on the twin pillars of (1) convertibility between paper and gold and (2) the free export and import of gold.
With a currency convertible into gold at a fixed parity price any monetary expansion would see the value of the currency relative to gold decline which would be reflected in the market price. Thus, if there was a parity price of 1oz gold = £5 and a monetary expansion raised the market price to 1oz = £7, it would make sense to take a £5 note to the bank, swap it for an ounce of gold and sell it on the market for £7.
The same process worked in reverse against monetary contractions. A fall in the market price to 1oz = £3 would make it profitable to buy an ounce of gold, take it to the bank and swap it for £5.
In both cases the convertibility of currency into gold and vice versa would act against the monetary expansion or contraction. In the case of an expansion gold would flow out of banks forcing a contraction in the currency if banks wished to maintain their reserve ratios. Likewise a contraction would see gold flow into banks which, again, in an effort to maintain their reserve ratios, would expand their issue of currency.
The gold standard era was one of incredible monetary stability; the young John Maynard Keynes could have discussed the cost of living with Samuel Pepys without adjusting for inflation. The minimisation of inflation risk and ease of convertibility saw a massive growth in trade and long term cross border capital flows. The gold standard was a key component of the period known as the ‘First era of globalisation’.
The judgement of economic historians Kenwood and Lougheed on the gold standard was
One cannot help being impressed by the relatively smooth functioning of the nineteenth-century gold standard, more especially when we contemplate the difficulties experienced in the international monetary sphere during the present century. Despite the relatively rudimentary state of economic knowledge concerning internal and external balance and the relative ineffectiveness of government fiscal policy as a weapon for maintaining such a balance, the external adjustment mechanism of the gold standard worked with a higher degree of efficiency than that of any subsequent international monetary system
The gold exchange standard and devaluation
The First World War shattered this system. Countries printed money to fund their war efforts and convertibility and exportability were suspended. The result was a massive rise in prices.
After the war all countries wished to return to the gold standard but were faced with a problem; with an increased amount of money circulating relative to a country’s gold stock (a problem compounded in Europe by flows of gold to the United States during the war) the parity prices of gold were far below the market prices. As seen earlier, this would lead to massive outflows of gold once convertibility was re-established.
There were three paths out of this situation. The first was to shrink the amount of currency relative to gold. This option, revaluation, was that taken by Britain in 1925 when it went back onto the gold standard at the pre-war parity.
The second was that largely taken by France between 1926 and 1928. This was to accept the wartime inflation and set the new parity price at the market price.
There was also a third option. The gold stock could not be expanded beyond the rate of new discoveries. Indeed, the monetary stability which was a central part of the gold standard’s appeal rested on the fixed or slow growth of the gold stock which acted to halt or slow growth in the currency it backed. So many countries sought to do the next best thing and expand gold substitutes to alleviate a perceived shortage of gold. This gave rise to the gold exchange standard which was put forward at the League of Nations conference in Genoa in 1922.
Under this system countries would be allowed to add to their gold reserves the assets of countries whose currency was convertible into gold and issue domestic currency based on this expanded stock. In practice the convertible currencies which ‘gold short’ countries sought as reserves were sterling and dollars.
The drawbacks were obvious. The same unit of gold could now have competing claims against it. The French took repeated advantage of this to withdraw gold from Britain.
Also it depended on the Bank of England and Federal Reserve maintaining the value of sterling and the dollar. There was much doubt that Britain could maintain the high value of sterling given the dire state of its economy and the dollar was weakened when, in 1927, the Federal Reserve lowered interest rates in order to help ease pressure on a beleaguered sterling.
This gold exchange standard was also known as a ‘managed’ gold standard which, as Richard Timberlake pointed out, is an oxymoron. “The operational gold standard ended forever at the time the United States became a belligerent in World War I”, Timberlake writes.
After 1917, the movements of gold into and out of the United States no longer even approximately determined the economy’s stock of common money.
The contention that Federal Reserve policymakers were “managing” the gold standard is an oxymoron — a contradiction in terms. A “gold standard” that is being “managed” is not a gold standard. It is a standard of whoever is doing the managing. Whether gold was managed or not, the Federal Reserve Act gave the Fed Board complete statutory power to abrogate all the reserve requirement restrictions on gold that the Act specified for Federal Reserve Banks (Board of Governors 1961). If the Board had used these clearly stated powers anytime after 1929, the Fed Banks could have stopped the Contraction in its tracks, even if doing so exhausted their gold reserves entirely.
This was exacerbated in the United States by the Federal Reserve adopting the ‘real bills doctrine’ which held that credit could be created which would not be inflationary as long as it was lent against productive ‘real’ bills.
Many economists, notably Ludwig von Mises and Friedrich von Hayek, have seen the genesis of the Depression of the 1930s in the monetary architecture of the 1920s. While this remains the most debated topic in economic history there is no doubt that the Wall Street crash and its aftermath spelled the end of the gold exchange standard. When Britain was finally forced to give up its attempt to hold up sterling and devalue in 1931 other countries became worried that its devaluation, by making British exports cheaper, would give it a competitive advantage. A round of ‘beggar thy neighbour’ devaluations began. Thirty two countries had gone off gold by the end of 1932 and the practice continued through the 1930s.
Bretton Woods and its breakdown
Towards the end of World War Two economists and policymakers gathered at Bretton Woods in New Hampshire to design a framework for the post war economy. Looking back it was recognised that the competitive devaluations of the 1930s had been a driver of the shrinkage of international trade and, via its contribution to economic instability, to deadly political extremism.
Thus, the construction of a stable monetary framework was of the most utmost importance. The solution arrived at was to fix the dollar at a parity of 1oz = $35 and to fix the value of other currencies to the dollar. Under this Bretton Woods system currencies would be pegged to gold via the dollar.
For countries such as Britain this presented a problem. Any attempt to use expansionary fiscal or monetary policy to stimulate the economy as the then dominant Keynesian paradigm prescribed would eventually cause a balance of payments crisis and put downward pressure on the currency, jeopardising the dollar value of sterling. This led to so called ‘stop go’ policies in Britain where successive governments would seek to expand the economy, run into balance of payments troubles, and be forced to deflate. In extreme circumstances sterling would have to be devalued as it was in 1949 from £1 = $4.03 to £1 = $2.80 and 1967 from £1 = $2.80 to £1 = $2.40.
A similar problem eventually faced the United States. With the dollar having replaced sterling as the global reserve currency, the United States was able to issue large amounts of debt. Initially the Federal Reserve and Treasury behaved reasonably responsibly but in the mid-1960s President Lyndon Johnson decided to spend heavily on both the war in Vietnam and his Great Society welfare program. His successor, Richard Nixon, continued these policies.
As dollars poured out of the United States, investors began to lose confidence in the ability of the Federal Reserve to meet gold dollar claims. The dollar parity came under increasing pressure during the late 1960s as holders of dollar assets, notably France, sought to swap them for gold at the parity price of 1oz = $35 before what looked like an increasingly inevitable devaluation. Unwilling to consider the deflationary measures required to stabilise the dollar with an election due the following year, President Nixon closed the gold window on August 15th 1971. The Bretton Woods system was dead and so was the link between paper and gold.
Fiat money and floating exchange rates
There were attempts to restore some semblance of monetary order. In December 1971 the G10 struck the Smithsonian Agreement which sought to fix the dollar at 1oz = $38 but this broke down within a few months under the inflationary tendencies of the Federal Reserve. European countries tried to establish the ‘snake’, a band within which currencies could fluctuate. Sterling soon crashed out of even this under its own inflationary tendencies.
The cutting of any link to gold ushered in the era of fiat currency and floating exchange rates which lasts to the present day. Fiat currency gets its name because its value is given by governmental fiat, or command. The currency is not backed by anything of value but by a politicians promise.
The effect of this was quickly seen. In 1931 Keynes had written that “A preference for a gold currency is no longer more than a relic of a time when governments were less trustworthy in these matters than they are now” But, as D R Myddelton writes, “The pound’s purchasing power halved between 1945 and 1965; it halved again between 1965 and 1975; and it halved again between 1975 and 1980. Thus the historical ‘half-life’ of the pound was twenty years in 1965, ten years in 1975 and a mere five years in 1980”
In 1976 the pound fell below $2 for the first time ever. Pepys and Keynes would now have been talking at cross purposes.
Floating exchange rates marked the first public policy triumph for Milton Friedman who as long ago as 1950 had written ‘The Case for Flexible Exchange Rates’. Friedman had argued that “A flexible exchange rate need not be an unstable exchange rate” but in an era before Public Choice economics he had reckoned without the tendency of governments and central banks, absent the restraining hand of gold, to print money to finance their spending. World inflation which was 5.9% in 1971 rose to 9.6% in 1973 and over 15% in 1974.
The experience of the era of floating exchange rates has been of one currency crisis after another punctuated by various attempts at stabilisation. The attempts can involve ad hoc international cooperation such as the Plaza Accord of 1985 which sought to depreciate the dollar. This was followed by the Louvre Accord of 1987 which sought to stop the dollar depreciating any further.
They may take more organised forms. The Exchange Rate Mechanism was an attempt to peg European currencies to the relatively reliable Deutsche Mark. Britain joined in 1990 at what many thought was too high a value (shades of 1925) and when the Bundesbank raised interest rates to tackle inflation in Germany sterling crashed out of the ERM in 1992 but not before spending £3.3 billion and deepening a recession with interest rates raised to 12% in its vain effort to remain in.
Where now?
This brief look back over the monetary arrangements of the last hundred years shows that currency issuers, almost always governments, have repeatedly pushed the search for seigniorage to the maximum possible within the given monetary framework and have then demolished this framework to allow for a more ‘elastic’ currency.
Since the demise of the ERM the new vogue in monetary policy has been the independent central bank following some monetary rule, such as the Bank of England and its inflation target. Inspired by the old Bundesbank this is an attempt to take the power of money creation away from the politicians who, despite Keynes’ high hopes, have proved themselves dismally untrustworthy with it. Instead that power now lies with central bankers.
But it is not clear that handing the power of money creation from one part of government to another has been much of an improvement. For one thing we cannot say that our central bankers are truly independent. The Chairman of the Federal Reserve is nominated by the President. And when the Bank of England wavered over slashing interest rates in the wake of the credit crunch, the British government noisily questioned its continued independence and the interest rate cuts came.
Furthermore, money creation can reach dangerous levels if the central bank’s chosen monetary rule is faulty. The Federal Reserve has the awkward dual mandate of promoting employment and keeping prices stable. The Bank of England and the European Central Bank both have a mandate for price stability, but this is problematic. As Murray Rothbard and George Selgin have noted, in an economy with rising productivity, prices should be falling. Also, what ‘price level’ is there to stabilise? The economy contains countless different prices which are changing all the time; the ‘price level’ is just some arbitrarily selected bundle of these.
An extreme example, as noted by Jesús Huerta de Soto, is the euro. Here a number of governments agreed to pool their powers of money creation and invest it in the European Central Bank. The euro is now widely seen to be collapsing. So it may be, but is this, as is generally assumed, a failure of the architecture of the euro itself?
Let us remember that the purpose of erecting a monetary structure where the power to create money is removed from government is to stop the government running the printing presses to cover its spending and, in so doing, destroy the currency.
The problem facing eurozone states like Greece and Spain is presented as being that they are running up debts in a currency they cannot print at will to repay these debts. But is the problem here that these countries cannot print the money they need to pay their debts or that they are running up these debts in the first place? The solution is often offered that either these countries need to leave the euro and adopt a currency which they can expand sufficiently to pay their debts or that the ECB needs to expand the euro sufficiently for these countries to be able to pay their debts. But there is another solution, commonly called ‘austerity’, which says that these countries should just not run up these debts. As de Soto argues, the euro’s woes are really failures of fiscal policy rather than monetary policy.
It is thus possible to argue that the euro is working. By halting the expansion of currency to pay off debts and protecting its value and, by extension, preventing members from running up evermore debt, the euro is doing exactly what it was designed to do.
There is a growing clamour inside Europe and outside that ‘austerity’ alone is not the answer to the euro’s problems and that monetary policy has a role to play. The ECB itself seems to be keen to take on this role. But it is simply the age-old idea, based on the confusion between the real and the nominal, that we will get richer if we just produce more money. Germany is holding the line on the euro but history shows that far sounder currency arrangements have collapsed under the insatiable desire for a more elastic currency.
REFERENCES
ANDERSON, B.M. 1949. Economics and the Public Welfare – A Financial and Economic History of the United States 1914-1946. North Shadeland, Indiana: Liberty Press
BAGUS, P. 2010. The Tragedy of the Euro. Auburn, Alabama: Ludwig von Mises Institute.
CAPIE, F., WOOD, G. 1994. “Money in the Economy 1870-1939.” The Economic History of Britain since 1700 vol. 2: 1860-1939. Roderick Floud and D.N. McCloskey, ed. Cambridge: Cambridge University Press, pp. 217-246.
DRUMMOND, I. 1987. The Gold Standard and the International Monetary System 1900-1939. London: Macmillan
FRIEDMAN, M. 1950. “The Case for Flexible Exchange Rates” Essays in Positive Economics. 1953. Friedman, M. Chicago: University of Chicago Press, pp. 157-203.
HOWSON, S. 1994. “Money and Monetary Policy in Britain 1945-1990.” The Economic History of Britain since 1700 vol. 3: 1939-1992. Roderick Floud and D.N. McCloskey, ed. Cambridge: Cambridge University Press, pp. 221-254.
HUERTA DE SOTO, J. 2012. “In defence of the euro: an Austrian perspective”. The Cobden Centre, May 29th
KENWOOD, A.G., LOUGHEED, A.L. 1992. The Growth of the International Economy 1820-1990. London and New York: Routledge
KINDLEBERGER, C.P. The World in Depression 1929-1939. London: Pelican
MYDDELTON, D.R. 2007. They Meant Well – Government Project Disasters. London: Institute of Economic Affairs
ROTHBARD, M. 1963. America’s Great Depression. BN Publishing
SAMUELSON, R.J. 2010. The Great Inflation and its Aftermath – The Past and Future of American Affluence. New York: Random House
SELGIN, G. 1997. Less Than Zero – The Case for a Falling Price Level in a Growing Economy. London: Institute of Economic Affairs
TIMBERLAKE, R. 2008. “The Federal Reserve’s Role in the Great Contraction and the Subprime Crisis”. Cato Journal, Vol. 28, No. 2 (Spring/Summer 2008), James A. Dorn, ed. Washington DC: Cato Institute, pp. 303-312.
VAN DER WEE, H. 1986. Prosperity and Upheaval – The World Economy 1945-1980. London: Pelican
The eurozone continues to keep us in suspense in the wake of the French elections, and pending the second Greek election in as many months, the underlying financial deterioration is accelerating. Funds are being withdrawn from banks in troubled countries, rapidly depleting their capital. At the same time collateral held against loans is often over-valued, so write-offs that should have been taken have not. The predictable result is a developing run on both individual banks and whole national banking systems.
It should be noted that there are two reasons depositors are fleeing banks: fear that the bank itself is insolvent, and fear that the relevant government might impose restrictions on the movement of money. Fear of bank insolvency is driving funds out of Spanish banks, while fear of government restrictions is driving funds out of Greek banks. To deal with these problems they must be recognised as distinct and different.
A potential banking crisis, as that faced by Spain, requires two further considerations. The first, of providing liquidity, has been addressed by the European Central Bank through its long-term refinancing operation (LTRO); but this is a stop-gap measure and requires the second consideration to be addressed: the reorganisation and recapitalisation of the banks. And here, the cost for Spain is impossible to meet at a time when she faces a combination of deteriorating government finances and escalating borrowing costs.
Greece’s difficulties are even greater, given that depositors are trying to discount the possibility she may leave the euro entirely and introduce exchange controls to manage a new drachma. The virtually unanimous consensus among Keynesians and monetarists is that such a move is both inevitable and desirable, but public opinion in Greece is increasingly in favour of sticking with the euro. Call it the difference between macro-economic theorising and on-the-ground micro-economic reality. For the fact of the matter is that neoclassical solutions that rely on devaluation as an economic remedy provide only temporary relief at best at greater eventual cost, and exiting the euro is neither a legal nor a practical option.
That is the monetary reality behind the eurozone’s crisis. The solution is not to ease the pressures on governments to address their excessive spending: if anything this pressure needs to be intensified, a point well made in a recent Cobden Centre article by Jesús Huerta de Soto. And the idea that more money should be made available for profligate governments through multi-government sponsored bond issues should be firmly rebutted. The banks, which should be allowed to fold, should be removed from the system in a controlled manner, that is to say that the ECB and the national central banks must devise a solution, perhaps a good bank/bad bank division, to give depositors sufficient confidence to keep their funds in the system.
Unfortunately, the political tide is running strongly against this two-pronged approach, with the developing rebellion against “austerity” from all European politicians, and the Keynesian and monetarist pressures from everyone else to reflate increasing. The chances of the ECB properly ring-fencing funds to deal with the banks and stopping them being used to prop up eurozone governments are becoming more remote by the day.
This article was previously published at GoldMoney.com.
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.
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.
This article was previously published at mises.org.
Greece has now defaulted, and other eurozone governments as well as agencies such as the International Monetary Fund, European Central Bank and European Investment Bank have retrospectively inserted themselves as senior creditors, a precedent that should be of great concern and which has profound implications for private sector banks.
Furthermore, when a state defaults it is only a small part of the whole story, because governments today are major participants in their economies. The consequences of a central government default extend to state guarantees for other entities and related businesses: in the case of Greece its default has altered the assumptions behind all non-central government public-sector loans, such as railway bonds. And the private sector not directly dependent on government subsidies or contracts is also affected by the prospect of excessive taxes.
For this reason, the consequence of Greece’s default goes considerably beyond the loans directly involved, and all other eurozone nations are in a similar position. The headline numbers are a fraction of the total involved.
This brings us to a fundamental truth. Government debt is the basis for fiat money systems. This basis is now being questioned. It is the key component of the capital held by banks, as well as cash and deposits at central banks – both of which are also government creations ultimately backed by government debt. Ever since gold was legislated out of the monetary system, confidence has become totally dependent on the validity of government debt.
The insolvent position of a number of eurozone nations invalidates the general assumption that government paper provides a solid foundation for eurozone banks. That the stronger euro-countries can underwrite the weak is now also doubtful. The precedent that has been set by the retrospective interposition by governments and their agencies as senior creditors undermines the value of government debt even further for private-sector banks, who become junior creditors. It is not surprising that they have re-deposited the bulk of the money lent to them by the ECB with the ECB itself. Euros held at the ECB only give refuge from exposure to specific government paper and is the best of a bad choice. Banks outside the region are exercising the option of opting out altogether.
It may seem unnecessary to question the very basis of the European financial system in this way. But this is bound to be debated in boardrooms across the entire banking network, inside and outside the euro area, and banks will react. It is also the underlying reason why the situation remains so precarious regarding Europe’s debt crisis. The way Greece’s default has been handled brings an increased risk of capital flight from the region at the worst possible time. Funding for all eurozone nations has become a lot more difficult. The ECB will come under growing pressure to not only rescue banks, whose balance sheets are imploding, but also to directly bail out governments as well.
Because of the systemic role of government debt, the crisis can be expected to spread rapidly from the insolvent weaker euro-nations to all the others. In short, the mishandling of Greece’s debt problems has made things worse.
This article was previously published at GoldMoney.com.
In this video Philipp Bagus, Assistant professor of Economics at Madrid’s Universidad Rey Juan Carlos and author of The Tragedy of the Euro and Alasdair Macleod of the GoldMoney Foundation talk about the eurozone facing the problem that is characterised in the “tragedy of the commons” analogy. Bagus explains this phenomenon by way of an example of overfished and over-exploited oceans due to a lack of property rights on oceans. In Europe, governments run larger deficits than their “competitors” in order to externalise the costs to all users of the currency. Knowing these incentives, the Stability and Growth Pact was put in place as per the early 1990s Maastricht Treaty, capping budget deficits at 3% of GDP and the debt to GDP level at 60%. However there was no enforcement of these rules which is why there have already been more than 80 infringements to this stability pact without any repercussions.
They talk about possible solutions to the euro crisis. Bagus points out that there are basically three different ways to go about it. Firstly, governments could make drastic cuts in public spending and privatise public assets in order to balance their budgets. However, there will be – and is – strong political resistance to such proposals. Secondly, the eurozone could disintegrate, driven by a reluctance of German citizens to pay for other countries’ expenditures. And lastly, central banks and governments could decide to print their way out of the crisis, leading to high inflation.
Bagus says that as long as the incentive for running deficits exists there won’t be an increase in countries’ savings rates. Macleod points out that there is great institutional resistance to breaking up the euro. Bagus explains that the official opinion towards the euro is positive in Germany; however the sentiment on the streets looks quiet different. But as long as there is no political party devoted to this issue this mood is not likely to gain traction at least as long as inflation remains moderate.
Amid the ongoing expansion of the money supply and persistent deficits, Bagus can’t see the dollar gaining in value over the medium to long term. He also says that ECB policies are a lot more pragmatic than the ones undertaken by the US Federal Reserve. Talking about sound money, Bagus explains different ways to go about its introduction. One way would be to back all the money in existence by gold, adjusting the price of gold accordingly. Another would be to take away legal tender laws and have competing currencies. However this would require the governments to impose dramatic reforms, which is partly why they will oppose such measures.
This interview was recorded on November 15 2011 in Madrid.
The markets are telling us that there is a painful abscess in Europe, with the Euro at its core.
We believe it is driving Germany and France a little mad, and that they are abusing their European partners as a result. They are about to commit an injustice which will strip away the profound goodwill which they have built up over 50 years, and they risk tearing Europe apart.
All our European friends are today irritated by Britain’s refusal to come with them. Not for the first time we are the odd man out, and being pointed at by the shallowest politicians in Europe. It’s OK. We can live with a little name-calling for the moment, and we look forward to quietly rebuilding our friendships with every one of you in the future. We hope it will be soon, although we fear it may not be.
You are right. Our British financial system contributed – in part – to the mess we are in. But you are wrong as to the reason and the solution.
What really happened is that over a period of years the political classes in New York and Europe (including the British) worked together to hold down the cost of credit. Ever since 2001 western politicians suppressed the will of the market to enter into a mild recession. What is this ‘market will’? It is the combined message from a thousand million transactions a day, expressing the free choices of 400 million people. Looming recession is the evidence that free people think it sensible to cut back a bit.
In 2001/2 that’s what western people chose to do. But the politicians wanted them to go on spending. “Put off recession to ensure re-election” said their advisors. How? By making central bank money available cheaply to the banks.
Of course we agree that bankers’ bonuses are a problem which badly needs addressing. But politicians, not bankers, created the febrile and ultimately ruinous deal-making atmosphere of 2004-2006. They skewed the economic landscape by continually releasing funny money from the central banks, and opposing the tendency to mild recession which was the judgement of the market; that means our judgement.
Politicians created a world where the only bankers who could keep their jobs were credit addicts. The villages around London are full of redundant and cautious 60 year old bankers who lost their jobs when their natural risk-aversion allowed credit-fuelled junior banks to win all the business, take them over, and clean out the old guard. Easy, state-sponsored credit found its home under the control of inexperienced and overenthusiastic bankers. They thrived only because politicians had skewed the economic landscape in their favour.
Yes, we can blame ‘the free market’ because those who acquired credit got it freely in trade with a supplier of credit. But to take this line is to wilfully misunderstand what the market is. The market is your freedom to choose. The marketplace is what you get when one billion purchasing decisions are made every day by 400 million individuals who are exercising free choice. The problems occur when people exercise those choices unwisely, which they will certainly do if they are being pushed and shoved into purchasing decisions which suit politicians seeking re-election.
Ever since 2007 the market – that is everyone who has made a choice about it – has been waking up to the deep contradictions within the Euro. Gordon Brown (let’s give him some rare credit) was one of the first. He had understood that no-one was asking the key question of how the Euro could hold together when the weaker nations were bound into union with the extra-ordinary productivity of Germany.
In Europe nothing so simple as an awkward question is allowed to get in the way of government progress. They marched forward regardless, and now the pesky market is expressing the opinion of a billion votes a day that the Euro is going to fail. Why? What went wrong?
This did. The false market in borrowed money which the politicians created back in 2002 made money accessible mostly to people who were a good risk to lenders – which means mostly older, richer people. To begin with they bought houses, which dragged the price up to impossible levels for first time buyers. The money continued to be pumped in by the central banks. Next to bubble was investment assets, and once again it suited those who were already wealthy. Poorer people got to keep their jobs, but investment assets, the bedrock of a retirement income, were becoming ever more expensive, making nice capital profits for richer people but yielding less and less in income. So it was again profiting those who already had money, and condemning hard-working people to a lifetime of slog, crowned with a tiny pension.
Yet whenever the government looked at the numbers there always seemed a risk that if they took their foot of the monetary accelerator the economy would stall; and it would have. So still the money was pumped in, and now bond yields descended to 1.5% as their values bubbled (a bubble which remains un-pricked) and hundreds of billions started accumulating at the banks.
Houses and a comfortable retirement were by now out of reach of hard-working, deserving and particularly younger people. But the enemy was not the free market, still the only practical embodiment of their freedom; the problem was the corruption of the market by monetary politics.
It was the irresponsible and self-serving policy of elected representatives – seeking re-election all over the western world – which is without any doubt the root cause of the explosion of credit which we now have to pay for. Politicians have hoodwinked you if you believe ‘the market’ or ‘the bankers’ are at fault, and you should not be taken in. The market is not a thing you can meaningfully blame. It is simply an expression of a billion private votes cast every day in what appears to both buyer and seller to be sensible and private trade, under the prevailing conditions set by the politicians. The problem was the prevailing conditions set by the politicians, not the mechanism of the market which was, as it always is, simply an expression of the judgement of free people.
But still easy money aggregates to richer people, not poorer ones, and we had ended up with an enormous pile of their savings. It had already bought houses, and investments, and still more kept on coming. Eventually vast quantities accumulated at banks, and for want of remaining opportunities it was lent to underfunded governments. As it turned out this was extremely unwise, because those governments are now threatened by default. That always looked possible, because none of them could keep up with German economic growth.
Bad lending happens from time to time. Usually it means the creditors lose their money, and gain some wisdom. Only this time some of the creditors – particularly Germany and France – don’t want to lose their money. Rather than see their banks suffer they want to force two or three generations of Greeks, Irish, Portuguese, Italians, Spanish and Belgians to pay, pay, pay. Germany and France lent stupidly to your father, yet you become the indentured slave.
That should never be how bad money-lending is resolved. The lender should take the hit when the borrower cannot repay; it helps to focus his mind before he lends. In Britain we got rid of inter-generational debt servitude 200 years ago, and it is not progress to return to it.
But default now would be particularly bad for German and French banks, so our European friends are deluding themselves that what is at fault here is ‘the market’, which is why they are trying to devise ways to tame it. What they want to do is to stop it from making its judgement against the Euro, so that they can follow on with their agenda, controlling first one market, then the other, and always with the officers of Brussels making the decisions which are ordinarily made by people exercising their free market choices. The current European plan is to disenfranchise your judgement upon them by making the financial marketplace somewhere which is too expensive for you to cast a vote, because it will be taxed by them.
Right now they have the financial services market in their sights. If – they reason – they can stop those votes being cast in the marketplace then they can carry on doing what they do (which obviously must be right) and no-one and nothing will hold them to account.
To be fair that is not their conscious intention. They are simply trying to repair a difficult situation of massive debt. But they are failing to make the intellectual connection between free choice and markets. That is a common weakness in governments, and this is what caused David Cameron to be hauled before his Franco-German counterparts and be instructed to accept a tax on financial services.
As it happens in Britain we made the same policy errors as Europe, we created the same mountain of money, we have a similarly bust government, and so we have in one country a microcosm of the entire European mess. But we are going to resolve it in a very different way. We are not going to turn into slaves the subordinates and the children of people who borrowed our money. Nor are we going to take the money explicitly from those who lent it (though perhaps we should). That won’t happen because that would mean our government would go into default, which it will not do while it controls the issue of money. So, instead, we will use a third way.
Our government is going to live with a profound devaluation of Sterling, which will eliminate the government’s own debt without explicit default. In this way it will share the pain of default across all creditors. All savers – even those whose debtors are perfectly solvent – are going to share in setting this thing back on a sustainable course.
At different stages through this process of adjustment we will experience interest rate hikes, currency crises, and sharp inflation, which will continue until twenty five years of savings, and twenty five years of a credit-fuelled house price bubble, have been removed from the system by devaluation. By the time it ends the creditors – taken collectively – will have paid. By then houses will be again affordable by anyone with a half decent job, the bond market bubble will have burst, long standing pension savings will be near worthless, equities will again yield sensible dividends, student loans will have inflated to irrelevance, our freedom to choose our private actions in our marketplace will have been preserved, and Britain will again be a great deal fairer than it currently is. It’s going to be a very unpleasant journey and it looks like we are making it alone.
In Europe many will doubtless laugh quietly as all this happens to us. But they will have no reason to hate us for our problems, which will be wholly independent of theirs. Besides, they will probably be too busy hating each other. The creation of the Euro has caused 1,000 years of carefully constructed and often hard fought mutual independence to be sacrificed on the altar of monetary union. We think that Europe’s political class is making a monumental error in holding on to it because it carries all their political credibility. Their resulting policy is to enslave half of Europe, and to kill the messenger – the financial market. This happens to be the section of the European economy which we in the UK have specialised in, while we have been buying German cars, and French aeroplanes. So let’s be clear, David Cameron did not have much of a choice.
In summary then, the proposed Franco-German policy is built on the lie that it is the market which is the cause of the problem. We think their policy is dangerously brutal to European debtors, that it is unfair to Britain, and that it transgresses the existing treaties whose laws were designed to stop governments doing exactly what the leaders of France and Germany now want – which is to suppress the rest of Europe into servitude. We think it will end in deep loathing of Franco-German power, and destroy the one part of Europe which we wanted to join, and which can be saved if we stick to the existing treaties. That is the single market. To us it is a single market of free choices which guarantees the freedom and the prosperity of our continent, yet that is what is being destroyed in an effort to cling on to the Euro.
Contrary to popular belief most of the British love Europe and the Europeans. But we also love our free market and the way it exposes the vanities of overreaching politicians. Last week Germany and France forced David Cameron to choose between the two, and he chose well.
“In my several decades as a financial and economics commentator – covering banking crises dating back to the early 1970s and the Latin American debt catastrophes of the early 1980s – I have never heard a sitting [Bank of England] governor talk in such apocalyptic terms about the parlous state of the global financial system.”
- Alex Brummer, The Daily Mail.
So what precisely did our inflation-fighter-in-chief actually say?
Well, that euro zone instability had created
an exceptionally threatening environment
as falling government debt prices, softening confidence and distressed asset sales threaten to
spiral
into a systemic financial crisis. Also, the UK financial system was encouraged to continue building up capital to bolster against an
extraordinarily serious
situation not of its own making and which it could not resolve. Also,
The crisis in the euro area is one of solvency not liquidity. And the interconnectedness of major banks means the banking systems and economies around the world are all affected. Only the governments directly involved can find a way out of this crisis.
And
If debt is not to [continue] exploding to ever more unsustainable levels, transfers will be required together with the plan to restore the competitiveness within the euro area. There comes a point where the creditors need to realise that the scale of the debt owed to them is so large that they may have to be part of the solution.
Strong stuff from a fellow who looks like the hamster in “Danger Mouse”. It is all a waste of time, of course, more than a day late and more than a trillion short in whichever currency you care to proffer.
Perhaps things are not quite as bad as they seem. Last week in London we had the pleasure of hearing Gordon Corrigan speaking at Owen James’s always stimulating “Meeting of Minds” investment seminar. The intention of his speech was to put to rest a few myths about Britain’s role in the Great War. There was undeniable tragedy during those dreadful four years, but could there be a chance, asked the ex-Gurkha Major, that the Brits have tended to mythologise the whole World War One experience, magnify the national role, and accentuate the negative – a process that hardens with every passing year?
The late Alan Clark once quoted a conversation between a German general and one of his men that has not just entered the national psyche but become firmly embedded there. These British fight like lions, observed the soldier. Yes they do, replied the general: lions led by donkeys. But apparently Alan Clark made it up. No such conversation ever took place.
And there are evidently plenty of other established “facts” about the Great War that turn out to be somewhat detached from the actualité.
The popular British view of the Great War is of a useless slaughter of hundreds of thousands of patriotic volunteers, flung against barbed wire and machine guns by stupid generals who never went anywhere near the front line. When these young men could do no more, they were hauled before kangaroo courts, given no opportunity to defend themselves, and then taken out and shot at dawn. The facts are that over 200 British generals were killed, wounded or captured in the war, and that of the five million men who passed through the British Army 2,300 were sentenced to death by military courts, of whom ninety per cent were pardoned
The popular conception is that nearly every family in Britain had somebody killed in it. But according to the official census reports, there were approximately 9,800,000 households in Britain in 1914. The British lost 704,208 dead in the Great War. So statistically, only one family in 14 lost a member. Although there were undoubtedly certain parts of the country where fatalities were concentrated due to the way in which British infantry were recruited back then, there were large swathes of the country from where no one was killed. Corrigan has spoken of his own family, and his own black-clad Great Aunt, who never married – perhaps because all of her boyfriends and potential boyfriends met their end at the front ? “Nonsense,” suggests an uncle – his Great Aunt never married because she was “simply too damned ugly”.
By Gordon Corrigan’s account, British soldiers actually spent more time playing football than facing the enemy. By regularly rotating the soldiery and never keeping men in maximum danger for more than relatively short periods of time, the British army was alone among the major forces on the Western Front in never suffering a collapse of morale leading to mutiny.
One in 65 of the British population was killed in the war; for the French, the figure was one in 28. One in every 12 men mobilised in Britain was killed; for the French, one in six. For the Germans, one in 31 of the population was killed, one in every seven mobilised, as shown in the table below:
Country
Population in 1914
Men mobilised
Men killed
Percentage of soldiers killed
Percentage of population killed
France
39,000,000
8,500,000
1,391,000
16.4
3.7
United Kingdom
45,750,000
8,375,000
702,410
8.4
1.5
Germany
60,300,000
13,250,000
1,950,000
14.7
3.2
Source: Mud, Blood and Poppycock: Britain and the Great War
France, with a population six and a half million less than that of the UK, mobilised more men and suffered nearly twice as many deaths. Unlike in the UK, the demographic effect on France was enormous.
The perception of soldiering in the Great War has the young patriot enlisting in 1914 to do his bit and then being shipped off to France.
Arriving at one of the Channel Ports he marches all the way up the front, singing ‘Tipperary’ and smoking his pipe, forage cap on the back of his head. Reaching the firing line, he is put into a filthy hole in the ground and stays there until 1918. If he survives, he is fed a tasteless and meagre diet of bully beef and biscuits. Most days, if he is not being shelled or bombed, he goes “over the top” and attacks a German in a similar position a few yards away across no man’s land. He never sees a general and rarely changes his lice-infested clothes, while rats gnaw the dead bodies of his comrades.
Just on the topic of transportation, many soldiers were moved by train until a few miles from the front, and as the war went on, motor lorries and even London buses were used as troop carriers. And as Corrigan has already pointed out, the rotation of troops alone ensured that conditions were altogether more bearable than the popular conception would have it.
But back to the present. The war then may have been ultimately much less bleak for the British, for example, than the media and propaganda have portrayed. That does not mean that the peace now is any less bad for any of us than Mervyn King suggests. As investors we remain trapped in a surreal nightmare in which clueless politicians and desperate central bankers can see nothing other than money printing as a way out of the gloom. In the euro zone the problem is worse to the extent that the currency crisis is not merely severe but existential. Tragically, former voices of sanity such as The Telegraph’s Ambrose Evans-Pritchard seem to have now taken leave of their senses and joined with the inflationists, as this recent mad piece indicates.
This crisis can be stopped very easily by monetary policy.. to expand the quantity of money..
Oh, really? I am indebted to Tony Deden for the following quotation, from Alasdair Macleod in excerpts from a speech given to the Committee for Monetary Research and Education, given in New York on 20 October 2011:
I support sound money for two very good reasons. Firstly, it is a basic human right to choose to save, without our savings being debased by the tax of monetary inflation. Those who are worst affected by this inflation tax are not the rich, they benefit; but the poor and the barely well-off, which is why monetary inflation undermines society and why the right to sound money should be respected. If government gives itself a monopoly over money, it has a duty to protect the property rights vested in it.
Secondly, it is a basic right for us to own our own money rather than have it owned by the banks. For them to take our money and expand credit on the back of it debases it. It is an abuse of an individual‟s property rights and a banking licence is a government licence to do so. If anyone else was to do this, they would be guilty of fraud. Banks should be custodians of our money, and it should not appear in their balance sheets as their property..
Sound money guarantees a stable yet progressive economy where people are truly equal. It allows people to save properly for their retirement so that they will not become a burden on the state. It leads to democracy voting for small governments. It encourages peaceful trade and discourages war. It is the only path, after this mess, that leads us to long-lasting and peaceful prosperity. We really need everyone to understand this for the sake of our future.
Are you listening in the chancellories of Europe? Here in Britain we may not have had lions led by donkeys, but we now have liars throughout finance being led by junkies addicted to the printing of money. As democracies throughout the continent now topple to be replaced by technocrat stooges, and as the monetary and social chaos accelerates, we must hope that we at least manage to avoid the devastating political mistakes our forebears throughout Europe committed almost a century ago.
Everyone seems to be searching for a roadmap for the Euro-crisis. A precedent to guide policymaking and financial decisions would give some assurance that feasible outcomes are available. I have argued elsewhere (here, here and here) that there are examples for individual countries to follow. But what of the eurozone as a whole?
With luck, precedent for the precarious situation the 17 members of the euro-club face is available. Across the pond, the United States of America once faced a similar challenge.
After the revolutionary War, the US was faced with a band of individual member states (emphasis placed on the “States” aspect of the USA). The Articles of Confederation allowed each state the exclusive right to tax its population. The Continental Congress was given the right to issue paper money – “Continentals”, as they were known.
Individual states refused to give the Continental Congress the ability to tax, nor did they consent to sharing their tax revenue with it. With no ability to raise funds through taxation, the Continental Congress turned to the only fund-raising means available – issuing new Continentals. The phrase “Not worth a Continental” predictably resulted, as hyperinflation set in.
This course of events prompted Alexander Hamilton and his Federalists to argue for a stronger central government, with the ability to both tax and issue debt. The ratification of the U.S. Constitution in 1789 was the culmination of this drive.
This is the situation roughly analogous to what the eurozone faces today.
Each of the 17 member states has the ability to tax but not to issue currency. The European Central Bank has the ability to issue currency, but not to tax. Some countries can no longer remain solvent through increasing taxes alone. Two solutions result:
Allow individual states the right to issue money.
Allow for a centralized fiscal agency to collect taxes for redistribution within the eurozone.
Option 1 amounts to a breakup of the currency union. Option 2 is currently the more popular option. By having a fiscal union with one tax-collecting agency, transfer payments can solve country specific insolvencies. (Of course, longer-term issues remain, but that is for another article.)
Is such a solution as efficient, or equitable, as we are led to believe?
The longevity of the United States suggests that fiscal union is not such a bad idea for a currency union. But important differences exist between the eurozone’s future and the US.
First, with no central fiscal agent for the eurozone there is no central spending required, unlike with the Continental Congress. Each eurozone member state funds its own activities. For example, there is no joint military that requires funding, as is the case with the United States. Hence, there is no threat that the ECB would hyperinflate the euro to fund its fiscal activities (as it has none). This was decidedly not the case with the Continental Congress.
Second, has the centralization of fiscal power been beneficial to the US? The longevity argument is not as strong as one might think. America has, after all, defaulted explicitly on its debt four times in its history. It has evaded insolvency numerous times by inflating its liabilities away. But such an action is default by another means. It has taken from the citizens in the form of an inflation tax to pay for its excesses.
Third, with a central fiscal agency, the US Congress has continually seen a strengthening of its role and scope. New agencies to displace the rights of the individual states have become the norm. The bill to fund the increase in federal activities has risen commensurately. The cost of a centralized fiscal agency in the US has been paid with increasing taxes – whether explicitly through the income tax, or implicitly through the inflation tax.
If the eurozone finds itself amidst a crisis set off by too much government spending (an insolvency crisis) does anyone seriously think the solution is a centralized fiscal agency with the incentive to increase its own indebtedness?
As the United States’ own history demonstrates, calls for a centralized fiscal agency to complete a currency union are misplaced at best and damaging at worst. If history is any guide, fiscal consolidation will result in increased indebtedness on a supranational level. This indebtedness is solved in one of two ways: increased taxes on the member states, or increased inflation. Neither of these seems like a welcome option.
