The Euro system contains a serious design flaw

By Stephanie Kelton

I recently sat down with Dara McHugh, Co-ordinator of Dublin-based Smart Taxes, to discuss Ireland’s debt problems and the economic prospects for the Irish economy. The interview appears in the June-August issue of Ireland’s Village Magazine.

Dara McHugh (DM): Can you discuss the fundamental features – and the fundamental flaws – of the design of the Euro system?

Stephanie Kelton (SK): The Euro is premised on a philosophy that is best characterized by the slogan, “One Market, One Money.” At the core of the Euro system is the European Central Bank, an institution that was given a limited but ostensibly critical role: keep a tight lid on inflation by strictly controlling the supply of euros. Because they could not conceive of an event that would trigger a breakdown in the payments system itself, the authors of the Maastricht Treaty did not give the ECB the statutory mandate to act as a ‘Lender of Last Resort’ in times of crisis. And, because a group largely composed of bankers (the Delors Committee) had written the blueprint for the Euro, it contained no systematic framework for regulating and supervising Europe’s financial institutions. Instead, the ECB was given a sole mandate: maintain price stability. These are significant departures from the customary modus operandi for a central bank.

Because they assumed that a sharp decline in output and employment would be rectified through emigration or a depreciation of the euro, the authors of the Maastricht Treaty saw no reason to create a fiscal analogue to the ECB, an institution that would bear responsibility for promoting growth and employment in the Eurozone. Instead, the political intention of the Treaty was to subordinate the role of fiscal policy, leaving it to the individual member nations to cope with a downturn by permitting only a modest increase in their deficits.

The problem, as everyone now observes, is that an individual member nation can find it impossible to engineer a recovery on its own.

During a recession, the private sector retrenches, preferring to save or pay down existing debts rather than parting with cash or borrowing to finance new purchases. Without an offsetting increase in demand – from the public or foreign sector – unemployment will rise and GDP will decline. The Maastricht Treaty assumed that a small increase in the deficit, together with some emigration, would be sufficient to bring about a recovery. That was wrong.

The bottom line is this: the Euro system contains a serious design flaw. It failed to recognize that it was designing a system that would cause its members to become more like Alaska, California or Utah than Australia, Canada or the US. That is, it was stripping them of their capacity to use their budgets to stabilise their own economies.

DM: What are the key differences between the Euro and another currency, such as the US Dollar?

SK: The primary difference is that the Euro can only be created by the ECB – it is the ISSUER of the currency. The governments of Ireland, Greece, Spain, Germany, etc. are the USERS of the currency. The implications of this distinction cannot be overstated.

Members of the Eurozone are like individual states in the US. Like California, Ireland must go out and ‘get’ the currency – either by taxing or borrowing – before it can spend. It must pay whatever financial markets demand, and it can be priced out of the market. It can become insolvent, and it can be forced to default on its debt.

In contrast, the Federal Reserve is the government’s bank. The government does not need to ‘get’ dollars before it can spend because it is the ISSUER of the currency. It simply spends by crediting bank accounts. It does not need to sell bonds in order to run a deficit, and it does not have to pay market rates. It can never become insolvent, and it can never be forced to default on its obligations.

DM: How do these differences affect the response to the Euro-zone debt crisis?

SK: The US has a monetary system that remains “wedded” to its fiscal system. The Euro system created a “divorce” between the fiscal and monetary institutions within each member nation. Because of this, members of the Eurozone cannot sustain the kind of deficits that can be run in the US. When rising interest rates and declining tax revenues force countries like Ireland and Greece into a substantial deficit position, they respond the same way Illinois and Georgia do – with massive spending cuts and tax increases to try to reduce the deficit.

DM: What is your opinion about the current response adopted by the peripheral economies and supported by the ECB?

SK: It is difficult to blame the peripheral economies for their response to the crisis (save Ireland’s bone-headed decision to add to its debt problems by bailing out foreign creditors). They are doing what they believe they must in order to avoid default and live up to the promises they made when they adopted the Euro.

As it stands, Greece, Ireland and Portugal have no choice but to try to meet the terms of the EU/IMF bailouts by driving through massive austerity programs. It is a policy response that could only have been engineered by a group of economists who lack even a basic understanding of first principles, and it is already yielding disastrous and perverse effects across the periphery.

Indeed, the European Commission has just reported that Greece’s deficit has failed to come down as expected. Any decent economist understands why. Pay cuts, layoffs, tax increases and the like will only reduce private sector incomes, dragging sales and tax revenues down along the way. Unfortunately, the EC has insisted that the government must push through even deeper cuts in order to satisfy the EU-IMF inspection team. This is the definition of economic malpractice.

DM: Do you see any better solutions to the debt crisis?

SK: First, let us be clear. What is currently in place is not a “solution.” The EU/IMF extortion program will not resolve the debt crisis – it will only prolong the ultimate demise of the Euro project.

In order to preserve the “Union,” the ECB must recognize that the member governments are neither responsible for the debt crisis nor capable of resolving it. The ECB must recognize the design flaw in the Euro system and, like Toyota, inform its users that it will take corrective measures to fix it. My good friend Warren Mosler – an expert in financial markets – has pointed out that it took 10 years for most analysts to discover the flaw in the Euro system but that it would take the ECB only 10 minutes to correct it.

The fundamental problem is that member nations have no safe funding mechanism under the existing system. To fix the problem, the ECB should create the euros that its member governments, as USERS of the currency, cannot. It would do this simply by crediting bank accounts, just like the Federal Reserve does when it transfers money to cash-strapped states in the wake of a national disaster. The funds could go directly into the member governments’ accounts, or they could be routed through the European Parliament, which could distribute them on a per-capita basis to all seventeen members of the Eurozone. Because these are transfer payments – not loans – the ECB would not seek repayment. A back-of-the-envelope calculation suggests that an annual distribution of about 10 percent of Euroland GDP would be sufficient to eliminate the funding risk, reduce borrowing costs, permit the repayment of debt and help to restore growth.

If the ECB refuses to create a safe funding mechanism for its member nations, then there may be no alternative but to abandon the euro and return to the more conventional “One Nation, One Money” arrangement.

DM: Why is currency sovereignty so important?

SK: Because without it you are merely the USER of the currency, no different from an individual state in the US. You have no independent monetary policy and very little control over your budget. You are at the mercy of financial markets, and your only hope is that some other source of demand will emerge and drag you out of the trenches.

This article first appeared at New Economic Perspectives .

  1. Richard Rosso on Facebook says

    This is just excellent..Thank you

    1. Edward Harrison on Facebook says

      I liked it too. Stephanie Bell-Kelton is a very good writer and makes the concepts easy to understand without getting bogged down on ideological claptrap. While the euro area is not an optimal currency zone, I understand the political reasons for having it. They make sense. What the Europeans need to do is either create greater fiscal federalism or ditch the euro project altogether. The system as designed now is prone to crisis.

  2. Mark says

    Wouldn’t this solution only inflate away the debt; causing inflation and higher prices throughout the Euroland?

    1. Edward Harrison says


      Stephanie Kelton, who wrote this post wrote me with her answer as follows:

      “There is no reason to suppose that the per-capita distribution would be inflationary. The distribution, itself, doesn’t add to spending. Member governments would still have to comply with deficit rules in order to receive their distribution.”

      1. Fabian says

        This doesn’t make sense to me. The problem with the Euro crisis is that goverments do NOT comply with the deficit rules, which causes their inablility to borrow more money on the financial markets. If they complied withe the deficit rules, they could still borrow and hence wouldn’t need any distribution from the ECB. Therefore, the system proposed by Stephanie must be for cases where countries run too high deficits, and therefore I agree with the comments below that say that this system would be very inflationary.

        1. Edward Harrison says

          Fabian, that is not the problem with the Euro crisis at all. Remember that Ireland and Spain had budget surpluses before the Lehman panic and subsequent downturn. See here:

          Their inability to borrow money is a liquidity crisis because of doubts about their long-term solvency. The right way to deal with a liquidity crisis is to make it easier for market participants to discern which debtors are actually insolvent and which face liquidity problems. The EU has failed to solve the crisis because they have failed to do this.

    2. Edward Harrison says


      My own view is that this solution would result in Euro weakness and would in effect be a currency devaluation. But that is a one-time change in the price level as opposed to embedded and persistent inflation.

      1. MLS says

        Nice reply Ed, I was interpreting it the same way. Another way to explain what the problem: EZ countries have sacrificed independent monetary policy, and while it’s true they can only tweak fiscal policy, it’s the lack of ability to implement their monetary policy that is really killing them. The peripheral states badly need to devalue their currency but they cannot do so. This is also part of the reason why austerity hasn’t worked (which Stephanie does not mention), it’s not just because incomes and tax revenues etc. are lower.

        I am of the belief that the Euro will eventually be dissolved as we currently know it. Germany has no interest in a weaker currency since their economy is so export-dependent. They benefit from the original euro structure because the DM historically traded strong relative to other European currencies, so having a common Euro opened up export markets to other member states. IMO, the periphery will ultimately drive the deconstruction of the Euro, since they were afforded an artificially strong currency (the Euro trades like the DM) such that they could borrow at lower rates than they should have gotten. Now the challenge for them is to delever, which becomes a lot easier with a weaker currency.

      2. Mark says

        That sounds reasonable. Thanks Ed.

  3. blankfiend says

    The idea of the ECB changing its charter in “10 minutes” to allow it to become a safe, reliable source of governmental borrowing sounds so deceptively easy. In fact, I believe this concept is currently strictly prohibited as a matter of Treaty. In practice, it would require that member states fund capital losses or shortfalls as transfer payments. Is Europe ready for this degree of unity?

  4. pka says

    I think stephanie fails to mention several points here. 1) Not having the flexibility to issue currency is not necessarily a bad thing. Most kingdoms/countries in the past used gold and silver without any problem. 2) A monetary system based on fiat is inherently unstable and never lasted more than 100 years, whereas hard currencies have been around for more than 5000 years. A roman gold coin still has value but not the reischmark. 3) Flexibility to issue currency is only a temporary fix. Once there is unbacked emission of credit, the loss of faith in currency is usually permanent and WILL end in tears. A good example is the Indian rupee, in the early 70’s India resorted to unbacked emission. The result is that gold has appreciated by 1000 times when measured in Indian rupees and even today inflation hovers around 10% and is rising. This is despite great economic growth and improvement in fiscal condition.

  5. Mario says

    All this is not a flaw of the euro, is the benefit and the advantage of the Euro over other fiat currencies. If countries consumed “from the future” now is the time for their citizens to live below their means, and pay for what they used in the past.

Comments are closed.

This website uses cookies to improve your experience. We'll assume you're ok with this, but you can opt-out if you wish. Accept Read More