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 .