The Unusual Case of Euroland

The Non-Sovereign Nature of the Euro and the Problems Raised by the Global Financial Crisis

By L. Randall Wray

In the next series of blog posts, we will look in more detail at fiscal and monetary operations of a nation with a sovereign currency. Before we do that, let us briefly examine the case of the Euro. Let me say that we will not address the unfolding crisis across Euroland in detail. The reason is that events are moving too quickly and we do not know where they will lead. This primer in some sense needs to be “timeless”—anything specific that we discuss will quickly become outdated. The fundamental point to be made here is that the Euro arrangement was flawed from the beginning. Crisis was inevitable—as I have been writing since the mid 1990s. There is no way the system as designed could possibly survive a significant financial crisis. And a crisis began in 2007. Due to flaws in the set-up, it was obvious (at least to those who adopted MMT) that the original arrangement was not sustainable. We could not say for sure how the resolution would turn-out, but a fundamental change would be required.

At one end of the spectrum of outcomes, the European Monetary Union would simply be dissolved and each nation would return to a sovereign currency. At the other end, a “more perfect union” would be created. We always argued that separating fiscal and monetary policy was the basic problem. Almost no one would listen to us. A notable exception was the economist Charles Goodhart. Now, in fall 2011, it has become common to blame the separation of monetary and fiscal policy for the crisis of the EMU. It is finally recognized that an arrangement in which monetary policy is unified under the international ECB, but fiscal policy is left to individual nations, was the primary flaw. Most economists still do not recognize, however, that it comes down to currency sovereignty. It is not just that you need unification of fiscal policy; you need a sovereign currency issuer that will take responsibility for fiscal policy. Extremely slow recognition of that problem has now dragged out the crisis for four years; and as of Fall 2011 it still is not clear that resolution is politically possible.

However, before we get the discussion underway, let me just refer to a “current event”. US Treasury Secretary Geithner has flown over to Europe to provide what turned out to be quite unwelcomed advice on how to deal with their crisis. The European finance ministers not only rejected his prescriptions to stimulate their economies, but they also lectured him on US economic policy:

“I found it peculiar that even though the Americans have significantly worse fundamental data than the euro zone that they tell us what we should do and when we make a suggestion … that they say no straight away,” Maria Fekter told reporters afterwards…

“We can always discuss with our American colleagues. I’d like to hear how the United States will reduce its deficits … and its debts,” Belgian Finance Minister Didier Reynders said somewhat tartly.

Now, I do find it rather shocking that Geithner would presume that he should be lecturing the Europeans, because I think he made a mess of the US response to the crisis, by focusing almost all his attention on Wall Street rather than Main Street—and as a result, the US is poised for another crash. But what is interesting about the European response is that they are still clueless. While they have begun to talk about the need for linking fiscal and monetary policy at the level of the union, they do not understand currency sovereignty. As we have discussed in previous sections, a sovereign currency nation like the US can always afford to spend more and faces no solvency constraints; the size of its budget deficits or outstanding debt do not impinge on that. Deficits can be too big—inflationary—but the problem today in the US is that deficits are too small given demand gaps and Treasury debt outstanding is too small relative to domestic and global demands to save in US Dollars. So, to argue that the US is in the more precarious situation is just plain wrong.

The Euro: the Set-up of a nonsovereign currency

For the nations that have adopted the Euro, their currency is not sovereign in the sense adopted throughout this primer. To some extent, it is as if they had adopted a foreign currency—something like “dollarization” of a country that chooses to operate with a currency board based on the US Dollar. It is not quite that extreme because the formation of the European Union has ensured some willingness of member states to come to the rescue of states in financial trouble (something that has been witnessed since the Global Financial Crisis first touched Euroland in 2007). Further, the existence of the European Central Bank (ECB) that has the ability to act as “lender of last resort” provides some flexibility for individual nations. When a country—say, Argentina—adopts a currency board based on a foreign currency, it has no assurance (and perhaps no expectation) that the issuer of that currency (say, the US) will come to its rescue. And while the Maastricht criteria had appeared to erect strong barriers to financial rescues of troubled states, there probably always was some expectation that “bail-outs” would be provided in an emergency.

So let us see why the users of the Euro should not be considered as sovereign issuers of their currency. While the followers of Modern Monetary Theory had long predicted that the structure of Euroland would not permit it to deal with a financial crisis, the problems did not become apparent until Greece faced a collapse in the aftermath of the Global Financial Crisis. Only scrambling by other member nations and the ECB forestalled a collapse of the market for Greek government debt. As of Fall 2011, the crisis continues to roll across Euroland because no permanent solution has been found to the problems raised by use of a nonsovereign currency.

It is important to recognize the difference between a sovereign currency (defined as a floating, nonconvertible currency) and a nonsovereign currency. A government that operates with a nonsovereign currency, issuing debts either in foreign currency or in domestic currency pegged to foreign currency (or to precious metal) faces solvency risk. However, the issuer of a sovereign currency, that is, a government that spends using its own floating and nonconvertible currency cannot be forced into debt. This is something that is recognized—at least partially—by markets and even by credit raters. This is why a country like Japan can run government debt to GDP ratios that are more than twice as high as the “high debt” Euro nations (the “PIIGS”: Portugal, Ireland, Italy, Greece, and Span) while still enjoying extremely low interest rates on sovereign debt. By contrast, US states, or nations like Argentina that operate currency boards (in the late 1990s), and Euro nations face downgrades and rising interest rates with deficit ratios much below those of Japan or the US . This is because a nation operating with its own currency can always spend by crediting bank accounts, and that includes spending on interest. Thus there is no default risk. However, a nation that pegs or operates a currency board can be forced to default—much as the US government abrogated its commitment to gold in 1933.

The problem with the Eurozone is that the nations gave up their sovereign currencies in favor of the Euro. For individual nations, the Euro is a foreign currency. It is true that the individual national governments still spend by crediting bank accounts of sellers and this results in a credit of bank reserves at the national central bank. The problem is that national central banks have to get Euro reserves at the ECB for clearing purposes. The ECB in turn is prohibited from buying public debt of governments. The national central banks can get reserves only to the extent the ECB will lend them against national government debt (or other debt submitted as collateral).

What this means is that although national central banks can facilitate “monetization” to enable governments to spend, the clearing imposes fiscal constraints. This is similar to the situation of individual states in the US, which really do need to tax or borrow in order to spend. Similarly, because a nation like Greece is integrated into the Eurozone, if its government runs deficits then the central bank of Greece is likely to face a continual drain of reserves from its ECB account. This is replenished through sale of Greek government bonds in the rest of the Eurozone, reversing the flow of reserves in favor of the Greek central bank. The mechanics of this are somewhat different for US states (which, of course, do not operate with their own central banks) but the implications are similar: euro nations and U.S. states really do need to borrow.

By contrast, a sovereign nation like the US, Japan, or UK does not borrow its own currency. It spends by crediting bank accounts. When a country operates on sovereign currency, it doesn’t need to issue bonds to “finance” its spending. Issuing bonds is a voluntary operation that gives the public the opportunity to substitute their non-interest earning government liabilities, currency and reserves at the central bank, into interest-earning government liabilities, treasury bills and bonds, which are credit balances in securities accounts at the same central bank.  If one understands that bond issues are a voluntary operation by a sovereign government, and that bonds are nothing more than alternative accounts at the same central bank operated by the same government it becomes irrelevant for matters of solvency and interest rates whether there are takers for government bonds and whether the bonds are owned by domestic citizens or foreigners. 

(Of course, as we discussed before, government can impose rules on its own behaviour, for example, rules that require it sell treasuries and obtain deposits in its account at the central bankbefore it cuts a check. Once it has adopted such a rule, you could say it has “no choice”. This is much like the Jack Nicholson character in the movie “As Good as it Gets” who had self-imposed a series of actions he had to take before he could open a door. These are matters better addressed by behavioural psychologists than by economists.)

Solvency questions and Ponzi finance in a nonsovereign currency

There is a further consideration. When a private entity goes into debt, its liabilities are another entity’s asset. Netting the two, there is no net financial asset creation. When a sovereign government issues debt, it creates an asset for the private sector without an offsetting private sector liability. Hence government issuance of debt results in net financial asset creation for the private sector. Private debt is debt but government debt is financial wealth for the private sector.

A buildup in private debt should raise concerns because the private sector cannot run persistent deficits. But the sovereign government as the monopoly issuer of its own currency can always make payments on its debt by crediting bank accounts—and those interest payments are nongovernment income, while the debt is nongovernment assets. Said another way, Ponzi finance is when one must borrow to make future payments. (This is the term popularized by Economist Hyman Minsky, named after Charles Ponzi, a fraudster who ran a “pyramid scheme.” A more recent pyramid scheme was run by Bernie Madoff. In Minsky’s terminology, Ponzi means that a debtor must borrow just to pay interest, which means debt grows—typically in an unsustainable manner.) For government with a sovereign currency, there is no imperative to borrow; hence it is never in a Ponzi position.

Sovereign governments do not face financial constraints in their own currency as they are the monopoly issuers of that currency. They make any payments that come due, including interest payments on their debt and payments of principal by crediting bank accounts meaning that operationally they are not constrained in terms of how much they can spend. As bond issues are voluntary, a sovereign government doesn’t have to let the markets determine the interest rate it pays on its bonds either.

On the other hand, nonsovereign issuers like Greece that give up their monetary sovereignty, do face financial constraints and are forced to borrow from capital markets at market rates to finance their deficits. As the Greek debt crisis shows, this monetary arrangement allows the markets and rating agencies (or other countries in case of Greece) to dictate domestic policy to a politically sovereign country. Nonsovereign governments can become Ponzi—unable to service existing debt out of tax revenue, they must go to markets to borrow to pay interest.

Clearly such debt dynamics severely constrain the nonsovereign government. As it borrows more, markets demand higher interest rates to compensate for rising risk of insolvency. The government can easily get into a vicious spiral as it must borrow ever more to pay ever higher interest rates. Markets will cut-off credit, probably even before a true Ponzi position is reached. Orange County, California (one of the richest pieces of real estate in the US) got caught in a situation in which markets refused to lend. While Euro nations like Greece have not quite got to that point, they have required intervention by the ECB (as well as other entities that have helped provide a series of quasi-bail-outs).

While we won’t go into details, most of the so-called PIIGS got into serious trouble only because of the global financial crisis—both because tax revenue fell while fiscal demands increased but also because many of them tried to rescue their financial institutions. All of that led to rapidly growing government debts; interest rate differentials (between troubled PIIGS and stronger economies such as German, Dutch and French) exploded. The vicious interest rate dynamics set in.

Had the European governments attempted to follow the restrictions of SGP–an attempt that would most certainly fail because of the endogenous nature of budget deficits–they would not have been able to support their economies in the global crisis, possibly leading to a global or at least a continental depression. Swings of the government budget balance need to be as large as swings of investment (or, more broadly, swings of the private sector balance) so that fiscal policy can be used to counteract the business cycle.

Instead of using the government budget as a tool to create a system that is relatively stable and supports high employment, the Europeans have made low deficits the policy goal without any regard for the consequences that will have for the economy. Yet even without the SGP government spending is constrained by market perceptions of risk—precisely because these nations do not have a sovereign currency system like that of the US, the UK or Japan.

In other words, the arrangements of the EMU were not up to the task of dealing with the GFC. Now, the US did not deal well with the GFC either—but that was almost entirely due to bad policy. In Euroland, even with the best possible policy the nations individually could not deal with the problems they faced. They needed something equivalent to a central treasury (a US-style national treasury) with the ability to spend on the necessary scale. Instead, they have bumbled through, relying on a combination of half-steps by the ECB plus austerity. And that is why Euroland is in much worse shape than the US, in spite of the proclamations made by their finance ministers.