The following is a proposal for the Eurosystem (ES) to change the way it operates in order to become able to fulfill its objectives. The proposal relies on the principle that international transactions should not have an impact on a country’s money supply. In the eurozone, this can be accomplished with the National Central Banks (NCB’s) coordinating to increase or decrease the domestic money supply using a combination of central banking instruments when intra-eurozone international claims arise. The result of their combined operations should not have an impact on the aggregate money supply of the eurozone.
An illustration will help explain how this system could work. It involves a deficit country and a surplus country, with the deficit/surplus referring to the monetary balance of payments. Under the current system the money supply of the deficit country decreases after an international payment occurs towards the surplus country. This can be corrected with a few accounting entries:
In the illustration, a client of a deficit country bank orders a payment of 100 euros to a surplus country bank ( to ). Once the payment is executed, the surplus country finds itself with excess liquidity, which can be reduced if the surplus country NCB raises its minimum bank reserve requirements. This will reduce the credit provided to the residents of the country ( to ). The surplus country NCB raises this way the necessary funding to finance the deficit country NCB, with the intermediation of the ECB, as is done already via TARGET2 ( to ). Then the deficit country NCB purchases shares in a specially setup “Growth Fund” which in turn makes a deposit at a deficit country bank ( to ). After this cycle is complete, the money supply (highlighted with blue color in the illustration) will have remained constant, on aggregate and separately in each country.
The Growth Fund will use its resources to fund private investment in the deficit country with the following dual goal:
- To increase the country’s long-term potential GDP
- To strengthen social cohesion and reduce income inequality
The Fund will operate like an open-end mutual fund, and will be managed and initially capitalized by the country’s private banks; the country’s government will also be able to participate, albeit with a non-controlling stake. The shares of the NCB will be redeemable at par and will pay interest equal to the ECB’s refinancing rate. The country’s banks and the State will jointly guarantee full redemption of the shares to the NCB.
Once and if the deficit country runs a balance of payments surplus, its NCB will be able to redeem the Growth Fund shares, settle the claim towards the Eurosystem, and the surplus country NCB will be able to decrease its minimum reserve requirements. For operational reasons, the NCB’s could opt to intervene on a lower than daily frequency and fund temporary imbalances with central bank liquidity as is done currently.
The reorganization of the Eurosystem’s operations is directly dictated by its mandate to maintain price stability in the eurozone. Over the last few years, the large and abrupt fluctuations in the money supply of the eurozone countries through the balance of payments have given rise to strong inflationary and deflationary forces in product and asset prices. By allowing this to happen, the Eurosystem itself has caused price instability, has destabilized the European banking system and has undermined the social and political relations among and within the member states. The failure of the current system is evident; and so is its need to reform.