In a previous post I described my proposal for dealing with the eurozone crisis. Although the proposal is fairly simple, I could elaborate on some of its parts and explain the rationale behind it.
Price stability is the Eurosystem’s primary objective. The ECB has vehemently proclaimed that its actions have served and continue to serve this goal. But they clearly do not. It is simple to understand that inflation and deflation are phenomena driven by movements of the ratio of the money supply over the potential GDP of a country. This relation has moved erratically for some of the eurozone countries over the last years.
The eurozone at this moment suffers from geographical biflation. In the countries of the periphery, the reduction of the money supply inevitably leads to deflation and/or recession. If the ECB achieves its goal of maintaining price stability in these countries too, then necessarily these countries will fall into a prolonged recession and a reduction of their GDP and their potential GDP. But in the long term, these countries will have to rely on deflation to put their economies in motion once again, as it is unlikely that they will manage to improve their competitiveness in any other way given the funding constraints they face.
On the other hand, a very small number of countries are receiving large amounts of euros which cannot be used productively in good investments. The increase of the money supply in these countries will most certainly be inflationary. There is enough evidence of that in the negative yields of sovereign bonds and in housing bubbles that have not yet burst. The ECB cannot control inflation in these countries with its current tools since any tightening of the euro monetary policy deepens the sovereign debt problems of the peripheral countries, to which it has a direct exposure.
In this environment of price divergence, the ECB is “managing” inflation only on average over the entire eurozone. This is not however how the Eurosystem should work. With the ECB acting alone, the Eurosystem is now trying to operate like a thermostat which controls the average temperature of a pool by letting the surface overheat and the bottom freeze. Instead, the ECB could and should be cooperating with the NCBs adding 17 more thermostats to control price stability in each country of the eurozone. Note that under this proposal, the monetary policy of the eurozone would continue to be centralized. The countries will keep sharing the same currency; the ECB will keep influencing interest rates and aggregate eurozone money supply centrally; and Europe will be able to harness the benefits of a common currency in terms of achieving economies of scale through an enlarged common market.
The Growth Fund
The Growth Fund is designed to be the main vehicle for money creation and growth in the deficit countries. It could be thought as an option for the deficit country NCB to purchase newly issued government debt and allow the State to use the money that the NCB would create. But this would lead to moral hazard and is anyway prohibited by the Statute of the ESCB. Governments should not run deficits relying on their central banks to fund them. However, if this simple proposal were adopted and a government guaranteed Fund was setup, the State would continue to have access to the country’s money supply and be able to raise tax revenue. Budget discipline would be enforced by the simple fact that the State would have to compete with the domestic private sector for funding. If the State borrows more, then it will crowd out private investment. Thus, the electorate of the country will exert pressure to the State to reduce its budget deficit and give way to private investment. This is not different to how any country in the world operates anyway.
The Fund then will have two very clear investment objectives: the first is to support growth. Consumer loans, residential mortgages, loans to business sectors that operate below full capacity do not increase the country’s long term potential GDP; they just reshuffle money among the country’s residents and lead to inflation (that’s the general flaw of private commercial banking, more about it in a future post). The second goal of addressing social cohesion will help resolve the problems the current system has so far created. The crisis has lead to widening income imbalances which are deeply unfair. By committing to this goal, the Fund will not only be able to correct the unfairness but also to support the first goal, since social cohesion is a prerequisite of any sustainable economic model.
What is also very important to note about the Fund is that the NCB’s shares will indeed be a contingent liability, an off-balance sheet of the banking sector of the deficit country and of the State. This should not be viewed however as a source of concern. Fiscal stabilizers (e.g. unemployment benefits) are also contingent liabilities of the State, while many governments around the world provide guarantees to numerous (quasi-)public institutions (the Landesbanken in Germany are a good example). Between the two types of contingent liabilities however there is a significant difference: the latter will be assumed by the respective State if the economic condition of the country worsens, whereas the government of a deficit eurozone country will assume the liabilities of the Fund (redeeming part of the NCB shares) only if the economic condition of the country improves (if there is a balance of payments surplus).
Implementation of the policy
The control of monetary policy by the centre gives little room for maneuver to the NCBs. The NCBs cannot engage in open market operations to increase or decrease the money supply of the country without having a direct impact on interest rates. Adjusting the minimum reserve requirements is a measure which can guarantee that the surplus country NCB can borrow from the country’s banks at the interest rate the ECB board sets and contain excess liquidity in the country. Since the minimum reserve requirements have naturally a lower bound, the deficit country NCB cannot decrease its minimum reserve requirement below a certain level. It can therefore monetize the TARGET2 claims only by purchasing securities in a “closed” market, that of Growth Fund shares.
The mechanism faces some rigidity though because frequent adjustment of bank reserves and redemption of Growth Fund shares causes operational strain on the banks and the NCBs. But the mechanism does not have to address the daily TARGET2 imbalances necessarily. The daily noise of international payments on the country’s money supply should not be destabilizing. Therefore the NCB’s can engage in their operations on a less than daily frequency, perhaps monthly. It would work in two stages as shown below:
Why it would work
The TARGET2 claims are the clearest depiction of why the peripheral countries have found themselves in trouble. It is also an exact estimation of the measures that need to be taken to restore their economies back to normal conditions. Take another look into the TARGET2 liabilities of the three countries that were “bailed-out”:
Remember that the TARGET2 liabilities arise from cash outflows to other eurozone countries. A net TARGET2 liability implies a cash shortage for each country. This shortage could never have occurred if the countries had their own currency. It is therefore the central banks’ responsibility to cover it.
Imagine now what would happen if the ECB’s president would announce a complete overhaul of the Eurosystem operations in line with this proposal’s principles. This would mean that within a few weeks, the NCBs of the deficit countries would monetize the TARGET2 liabilities of each country (and demonetize the TARGET2 assets in the other countries) increasing their domestic money supply by the respective amount. Just the announcement itself would be enough to allow all three governments to borrow in the capital markets any amount necessary to repay all EFSF and other Eurozone loans at a reasonable rate immediately. Why? Well, the fresh cash from the monetization of the TARGET2 claims would permanently stay in each country, presenting enormous opportunities for foreign and domestic investors to make money in the periphery, especially given the measures that the countries have already taken and the growth potential that the Growth Fund would unlock. Consider also that the money that each country would borrow, presumably from abroad, to repay the bailout loans would not have any impact on the TARGET2 claims. Even after refinancing the “bailout” loans, these countries would still need to receive the extra cash. The amount they would receive is comparable to the entire M1 money supply of each country! It should be enough to give an enormous boost to these economies and allow their governments to balance their budget within a month. Which sane bond investor would stick onto his holdings of zero-yield German and Dutch government bonds after that?
On the side of the surplus/creditor countries, such a policy shift would also be beneficial, since it would contain inflation, it would avoid an export-led recession and it would secure the value of the foreign investments. If the leaders of the surplus countries are really supporters of fiscal discipline and condemners of inflation they should be fully supporting this plan. The sad reality though is that they are not. Inflation has always been the best friend of governments, and the “core” euro governments are no exception. It is much easier for them to resort to inflation to be able to constrain their budget deficits now and pass on the mess to the next government and the next generation. If only the people of these countries were not blinded by their national media they would be in full support of this proposal too. They would be able to keep their jobs, keep their social benefits, be fully repaid on their “bail-out” loans and not be crashed by inflation. In complete lack of awareness, they are driven to the worst class warfare of the century, unarmed. Pity for them, pity for all of us.
Relation with the “Modest proposal”
My proposal is influenced by the main idea of the “Modest proposal” that the solution to the eurozone crisis has to be given by the existing institutions and within the existing Treaties of the Union. But the one proposal is not an alternative to the other. Creating a euro area risk free asset with the issuance of bonds by the ECB per the “Modest proposal” is a great idea. Then it is highly probable that some European banks will need recapitalization even after the reform. And perhaps some closer control of the capital employment in the eurozone by the EIB could be beneficial. This proposal though has a few advantages (and based on those I made my assessment of the “Modest proposal” in a previous post):
-It does not require any financial innovation by the ECB. It only requires the Eurosystem to do what it is supposed to do. It cannot give any impression of fiscal consolidation among the eurozone countries.
– It will help make clear which banks are really in trouble, which ones can be recapitalized with their own sources of funding and make potential recapitalization needs easier to estimate.
– It calls the Eurosystem to act on its own, perhaps without any approval by the member states. The EIB is for the moment not involved.
– Most importantly, it is based on the Eurosystem’s primary objective of price stability. This proposal bases its strength on the obligation of the Eurosystem by European law to maintain price stability. The EIB is not mandated to act to address the eurozone problems, but the ECB is.
About the ES
The Eurosystem cannot fulfill its objectives in the way it operates now. It has evidently failed and is now as insolvent as a central bank can be.
By revamping its operations, it would manage to save the common currency from collapsing, it would restore macroeconomic normality in the euro area and it would maintain its integrity and solvency. But what is perhaps more important, is that it would protect itself against possible future litigation. The Eurosystem has violated up to now each and every part of its mandate and sooner or later it should be held accountable for that.
So far, the ECB and the NCBs have caused an enormous disruption in the European economy and have caused billions of losses to the banking sector, the very part of the economy that they are supposed to regulate and protect. Time and again, the central bankers of the eurozone have suggested that governments of the member states exercised fiscal discipline to “safeguard” the euro’s stability. When that didn’t happen, it was the turn of the people to make sacrifices to salvage the euro. And as if this was not enough, the Eurosystem has now even managed to subordinate all private holders of government bonds who are now called to voluntarily accept heavy losses on their investments in Greek governments bonds, only to make sure that the Eurosystem itself does not go bust. In their most masochistic display of subservience, the European States, banks, corporations and most importantly the citizens of the eurozone have accepted this as the norm in a currency union.
This all is outrageous: The Eurosystem at the moment is acting like a driver of a vehicle with oval shaped tires that asks the European countries to hop in and get used to a bumpy ride. It is clearly time to come back to our senses and rethink of who is supposed to do what in this Union. The Eurosystem has a very plainly defined mandate, to maintain price stability in the euro area, a mandate given by the European States. The countries of the eurozone do not have a mandate to abide to. The Eurosystem is obliged to provide a service to the countries and not the opposite. And it is given enough freedom in the pursuit of this goal in being able to use a variety of instruments and act independently. There is absolutely no reason that the Eurosystem would not alter its monetary operations. In fact, it is on its best interests to do so, since its current business model leads it to insolvency and the abandonment of the euro project as a whole. The only obstacle to change is that change requires the admission of the mistakes of the past and of full responsibility for them. Such an admission is difficult indeed, but necessary and inevitable nonetheless.
Upon closing this post, I will emphasize for one more time that a monetary system is fair when it ensures relative money supply stability within the economy. Since the eurozone States and their banking systems are to a high degree segregated, the central banks of the euro area will have to ensure monetary stability also on a local/national level. There is nothing unfair from protecting each country from abrupt and persistent fluctuations of their money supply, fluctuations that ultimately lead to inflation or deflation. What is unfair is to leave the countries unprotected; unfair is to provide a flawed economic model which hinders growth and amplifies social imbalances; unfair is for the weak to bear the weight of solving the problems that they never caused.
The money supply of an economy should not be viewed only as a statistic or a bank’s liability. The money supply is a public good that allows an economy to operate, like oil allows an engine to work. This good is created by banks and borrowers by mutual agreements to facilitate their mutual economic aspirations. If in this process the residents of a country take on debt, then they should also maintain the right to the money to repay it. It is their debt and it is their money. And people should protect this right with the same vigor as they would protect their very sovereignty, or otherwise risk losing both.