Sunday, February 23, 2014

A simple plan to fix the euro (Part I)

The problems with the euro have been widely documented.  For a great overview, I will point you to the inaugural lecture of  prof. Paul De Grauwe, the head of the European Institute at LSE.  Also, for a more technical analysis, you can refer to two excellent papers published in the Journal of Economic Perspectives (Cross of Euros and Political Credit Cycles: the Case of the Eurozone).  First and foremost, the euro lacks a mechanism for sovereign default.  Credit markets correctly predicted that in the absence of such mechanism sovereigns will be bailed out.  Accordingly, huge credit flows were directed to the periphery which enabled the very imbalances the euro was intended to prevent.  Second, the ECB does not have tools to deal with asymmetric shocks to individual member-countries.  In other words, the ECB is constrained to one-fits-all monetary policy which acts to amplify booms and deepen recessions.  Next, the monetary union deprived national governments of the discretion to deploy fiscal stabilizers but failed to put in place union-wide mechanisms that could serve the same purpose during times of crisis.  Last but not least, the ECB, just like any other central bank, is constrained by the lower-zero bound prompting fears of stagnation and extended period of low growth and high unemployment.

Over the last 5 years, the flaws in the euro have caused depression-like conditions in the periphery, which if allowed to persist, could threaten the existence and viability of the union itself.  By design, the euro relies on internal devaluation and structural reforms to resolve imbalances.  The historical record is clear - during the boom years, the euro relieved any pressures for structural reform in the periphery, and during the recession the prescribed remedies initiated further downward pressures and proved counter-productive.

I will attempt to describe a simple solution based on VAT and Investment Credits to be administered and funded by the ECB.  I lay out the philosophical argument for such hybrid approach to government intervention here.  The use of such credits will enable the ECB to fine-tune policy to the needs of each member-country.  Such tax credit authority can also serve as a substitute for a fiscal union and act as a stabilizer in times of crisis.  More importantly, the ECB can fund the credits with Euro-zone debt, and in the process, inject reserves in the financial system which are not linked to the credit of member-states.  By severing the link between the euro and the credit of member-states, the ECB will begin to lay the ground for orderly sovereign default.  Finally, VAT and Investment Credits are powerful tools that can do away with the lower zero bound.

In Part I of this post I will focus on the fundamental design flaw of the euro, namely the lack of a mechanism for either sovereign default or sovereign debt monetization.  In Part II, I will lay out the the proposed solution in more detail and discuss how it addresses each of the problems identified above.  

First, let's understand the true meaning of money.  All modern money represents debt.  Banks create money by substituting their liabilities for those of their borrowers be it consumers, businesses or governments.  Not all debt can be used as money.  Debt moneyness (or capacity to be used as money) is determined by two criteria - zero credit risk and zero duration (meaning that the nominal value of the debt does not change with interest rates).  The first requirement is the hard one.  There is no such thing as zero credit risk - every type of debt carries risk of default with one notable exception.  Domestic currency reserves are deposits held at the central bank.  Since central banks have authority to print domestic currency, they have unlimited capacity to meet their deposit liabilities.  Central banks can create reserves either by buying assets (debt monetization) or by lending to banks against good collateral.  There is an important distinction between the two methods.  When central banks buy assets, they take on the associated credit risk in effect monetizing the assets and the corresponding bank liabilities. If, on the other hand, a commercial bank were to borrow reserves from the central bank, the credit risk associated with the assets pledged as collateral remains with the commercial bank.

Should bank solvency come under question, bank deposits quickly lose their moneyness and can no longer be used as a medium of exchange.  This leads to rapid destruction of money, which is a scary prospect in our highly-specialized modern economy.  Without a mechanism for transferring credit risk off of bank balance sheets, the entire monetary system could implode as a house of cards.  Debt monetization by central banks is precisely that mechanism.  It creates the illusion of risk-free debt, which is simply another name for money.  Without such illusion there will be no money, and the modern economy will cease to operate.  The transfer of credit risk through debt monetization does not mean that the underlying losses are never recognized.  Rather, it is the form of recognition that changes.  When central banks monetize debt, the associated losses are recognized through higher inflation, which shifts the loss burden from private creditors to the general public.

Clearly, this type of loss transfer is the ultimate moral hazard because it privatizes gains and socializes losses.  That's why there are strict limits on what kinds of debt central banks can purchase.  In the United States, the Federal Reserve can only buy debt which is issued or guaranteed by the Federal Government.  Since the US public is already responsible for obligations of the Federal government, such debt monetization does not result in a loss transfer (as long as federal fiscal expenditures are equally spread among the 50 states).  The Federal government through the FDIC can also monetize private debts in the form of bank deposits up to $250K; however, banks have to pay deposit insurance premium, which mitigates the risk of loss transfer at least to the extent the insurance premium is properly priced.  After Lehman Brothers collapsed in 2008, the Federal Reserve broadly expanded the range of private debts it was prepared to monetize by guaranteeing liabilities of money market funds and putting a backstop to commercial paper markets (Bernanke 2012).  This clearly shows that in times of severe financial distress, when the integrity of the entire monetary system is at stake, the moral hazard argument will lose out to the financial stability argument.  In other words, central banks are prepared to take any available measures to preserve the illusion of risk-free debt and the existence of money.

It is notable that the Federal Reserve does not purchase state bonds.  Under the Federal Reserve Act, it is illegal for the Federal Reserve to engage in such purchases unless the underlying debt matures in less than 6 months.  If such authority existed, it would truly represent a loss transfer from the insolvent state onto the rest of the country.  That, of course, is not necessary. US member-states can default without posing a threat to the monetary system because dollar reserves are tied to obligations of the Federal government not the individual states. Accordingly, when lenders extend credit to one of the 50 states, they have to consider the risk of default.  When they extend dollar-denominated credit to the Federal government, they have to consider the risk of inflation.

The euro is structured differently.  The ECB can engage in lending operations which do not transfer credit risk onto its balance sheet.  By design the ECB is prohibited from purchasing debts of member-states.  Simply, European integration has not advanced to the point where member-states are prepared to accept such loss transfers.  This leaves the ECB without access to a debt monetization mechanism.  Instead, monetization of bank liabilities falls on the respective member-states, which rely on national deposit insurance schemes as well as outright bank bail-outs.  However, without a monetization backstop for sovereign debt, banks and national governments are locked in what professor De Grauwe in the lecture referenced above calls a "deadly embrace".  If sovereigns were to default, national banks would be left without a monetization backstop, which exposes the economy to the risk of money implosion as bank liabilities lose moneyness.

The disappearance of money can bring a  modern economy to an abrupt halt.  This is the worst-case scenario that central banks and national governments will always try to prevent at all cost even if it means backstops to private debt markets, bank bail-outs and even EU member-state rescues through the ESM.  The ECB has even put forth the possibility of unlimited sovereign debt monetization through the OMT program.  However, the legality of OMT was challenged in the German supreme court and currently, remains uncertain.  As a result, the euro has created the perfect credit arbitrage.  European governments will not be allowed to default because that would threaten the existence of the euro, and the ECB is not allowed to monetize sovereign debt, which removes the risk of inflation.  The euro shields private creditors from both credit risk and inflation.

Until this design flaw persists, the euro will continue to enable imbalances between member states.  The original solution was a cap on annual fiscal deficits of no more than 3% of GDP.  The thought was that by keeping government debt at low levels, the risk of sovereign default would be negligible thus mitigating the lack of debt monetization tools.  The absence of enforcement mechanism and shady accounting by some member-states such as Greece doomed this plan from the start.  Furthermore, economic downturns can cause large fiscal deficits.  Without the flexibility to absorb such deficits, the 3% cap initiates a vicious cycle of austerity and ever-growing debt burdens.  Finally, in countries such as Spain and Ireland, it was the private sector that increased debt levels to unsustainable levels which threatened to bring down the financial system.  

The fundamental flaw of the euro monetary system is that it does not allow for discharge of bad sovereign debts either through default or inflation.  It is like a "Cross of Gold" hanging on Europe that imposes huge burdens on borrowers but relieves creditors of default and inflation risk.  In part II of this post, I will discuss a simple solution based on the hybrid approach to government intervention.  The idea is to equip the ECB with fiscal policy tools in the form of VAT and Investment Credits.  There is so much national mistrust that if there is any hope for EU fiscal union, it's got to be through the technocratic mandate of the ECB.  The fact of the matter is that you cannot have credit-based money without the backing of a fiscal authority that can issue risk-free debt.  The idea of giving such authority to the ECB is the first step toward unlocking the deadly embrace between the sovereign member-states and the euro.

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