Coronavirus recession: the test of fire of the Euro?

 

Introduction

In the run up to the Maastricht treaty and before the introduction of the Euro a collection of articles on the shortcomings of the monetary union as proposed were published by some independent economists who believe that the relationships between the fiscal authority (treasury) and the central bank is an important part of the present monetary system. Apart from the fact that they were British, the other common feature they seem to share is a practical experience of economics developed by either working in government or central bank. This practical experience seems to be a common feature with other former governments officials in other countries, namely Medina Carreira in Portugal, who have expressed similar views on the money side of the economy. More recently, Randal Wray, a proponent of Modern Money Theory, has anticipated the problems arising from the flawed setup of the monetary union . Three of those articles are: One government, one money by Charles Goodhart, Maastricht and All That by Wynne Godley and European Monetary Union: Is There a Halfway House? by Tim Congdon. This have now mostly been forgotten; however, if anything, these are more relevant today than they were a few decades ago as the difficulties foreseen have materialised and for some of the countries those have the potential to wreak havoc. This article relies for the most part on these works.

There is an inability of economists to incorporate money into economic theory and one can say that the old economic joke still holds: economists are still working out how something that works in practice can work in theory. Mervyn King alluded to the dangers of relegating money to the behind the scenes role and that this would cause problems in the future. A primary example is the discussion of the Eurozone economic problems without trying to ascertain the role of the euro in those problems. In particular, the importance of the relationship between the monetary and fiscal authorities in the pursuit of traditional economic goals: price stability, economic growth, and the reduction of unemployment.

The incomplete institutional arrangement of the European Monetary Union with a supranational monetary authority (central bank) but no corresponding fiscal authority (Treasury) is a clear departure from the (almost) universal rule: one government, one currency, one central bank which was the norm in most developed countries before the Euro. Now in the Eurozone, there is one currency, one central bank but several governments (Treasuries). This arrangement has not only contributed to decades of low growth in the Euro area but more importantly it has curtailed the various governments capacity to take independent action on major issues, in particular, during economic recessions. Therefore, the eurozone countries are no longer sovereign nations-states, at least not as traditionally understood, as monetary sovereignty is perhaps the central symbol of the sovereignty of a country.

There are two main views about the centrality of the relationship between the fiscal and monetary authorities and according to Charles Goodhart these arise from two different viewpoints on the origins and evolution of money: Metalist/Monetarist and Cartalist.

The Mettalist/Monetarist view believes that money originated to facilitate trade. It’s a private answer to reduce costs of transaction and therefore think of the Euro in terms of the theory of the optimum currency area. It can be summarized in the Commission of the European Communities report slogan’s “One market, one money” In addition, as explained by Charles Goodhart, there has been an overlap between these theorists and those who believe that government intervention in the economy in unnecessary. This view that governments intervention in the economy should be limited has been the mainstream view in Europe in the last few decades.

On the other hand, the Cartalists defend that money is a creature of the state and therefore governments not only create money but drive their acceptance by demanding that taxes and debts are paid in its currency of choice. The central idea, summarized in Mr Goodhart corollary “One government, one money”, is the relationship between the monetary authority (money creation) and the fiscal authority. Within this view, government intervention in the economy “is as inevitable concomitant of the operation and organisation of the political system”, to put another way is just the way the system works.

The mainstream view undoubtedly shaped the design of the monetary union with a supranational authority (ECB) but without a corresponding fiscal authority (treasury). Only within this extreme view can we conceive of a separate central bank and treasury. One thing is to have an independent central bank and completely other to have a separated central bank. Moreover, to the Cartalist or alternative view, this never made any sense because the relationship between treasury and the central bank is fundamental to their understanding of money.

The standard monetary arrangement of the modern age with a country having a legal tender issued by one central bank with this functioning as the government’s bank and the bankers bank did not developed accidentally as Tim Condon has argued. The development of modern central banking since the advent of the first Central Bank has been on par with the evolution of money from the17^th century to our days. Its functions evolved slowly and at times in reaction to specific monetary crisis. The emergence of the territorial currencies and the evolution of central bank functions is inextricably intertwined with the development of the nation-state. The emergence of the modern fiat money system, after the abandonment of the gold standard, depends completely on the backing of the government as it is this that gives paper money it’s legal tender status within the borders of any jurisdiction.

Hence, a modern monetarily sovereign state can be defined as a state that issues its own currency through a (independent) central bank that is both the Government’s bank and the bankers bank. This is the pattern for most of the developed countries: US, UK, Japan, Sweden and Denmark and was the same for the Euro area countries before the Euro. On the other hand, a monetarily non-sovereign state does not issue it’s own currency. An example of the later are small states like Monaco, San Marino and all US States like New York or Illinois.

The difference between monetarily sovereign states and monetarily non-sovereign states would be evident if the treasury had a printing press and printed money as necessary to buy goods and services. If this was ever the case, the existence of (1) central banks and (2) government debt securities have blurred the picture. In fact, the picture is not complete unless commercial banks reserves with the central bank are included in the “money”. Today, coins and paper money (both as bank vault cash and as currency circulating in the public) represent a small amount of the monetary base. The bankers balance at the central bank is a highly liquid government created money also called high powered money (HPM).

"The Federal Reserve influences the economy through the market for balances that depository institutions maintain in their accounts at Federal Reserve banks. Banks keep reserves at Federal Reserve banks to meet reserve requirements and to clear financial transactions." ( New York Fed)

 

Thus, a more accurate version of the "printing money" is one that incorporates not only new issuance of paper currency but mainly the crediting of reserve accounts at the central bank. As Ben Bernanke observed in a speech in 2002:

“the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.”

This institutional arrangement, with the central bank acting as both the banker's bank and the government's bank, opens a range of options of coordination between the Treasury and the Central Bank that would not be available if the Treasury had a bank account at any private bank. It not only allows that one part of the government (Central Bank) to "finance" other part of the government (Treasury) but also that both can coordinate when setting interest rates. In other words, the central bank can help the government with the implementation of its fiscal policy and government can assist with monetary policy.

"Transactions in the federal funds market allow depository institutions with reserve balances in excess of reserve requirements to sell reserves to institutions with reserve deficiencies at an interest rate known as the fed funds rate. The FOMC sets the target for the fed funds rate at a level it believes will foster financial and monetary conditions consistent with achieving its monetary policy objectives and adjusts that target in line with evolving economic developments." (New York Fed)

The operations between treasury and Central Bank can take the form of overdrafts and cash advancements on the Treasury account at the Central Bank -"printing money"- and or the purchase of government debt securities in the primary market or secondary market-debt monetization.

Direct financing of government deficit through money creation for monetarily sovereign countries: printing money

Overdrafts and cash advancements are primarily a short-term way to finance government expenditure without having to issue debt. Its main purpose is to offset any shortfall due to seasonal fluctuations of revenues. While in the past decades many countries have passed legislation with a view to restricting this operations between the Treasury and the Central Bank, as a paper by the IMF on central bank regulation around the world highlights, these restrictions in a monetarily sovereign nation are self- imposed and can be easily surpassed by the Treasury and central bank when needed. That is evident by the recent announcement of the Bank of England it would expand the government overdraft facility, called Ways and Means:

HM Treasury and Bank of England announce temporary extension to Ways and Means facility:

The notes on the press release are self-explanatory:

Regulations have had the effect of reinforcing the belief that Treasury must tax or borrow before it spends as in effect, due to this self-imposed restrictions, the Treasury must maintain a positive balance in its account at the central bank, which it can do only by receiving tax balances or by issuing debt securities in the open market. However, as it’s clear from the above, even if due to current legislative restrictions the Treasury is forced to keep a positive balance on its account at the central bank in normal times, this can be override when necessary. Therefore, a monetarily sovereign government does not have to tax or borrow before it spends. It can “print money” and finance the budget deficit directly and although this is used mostly for short term operations but there´s nothing to say that this cannot be used for longer terms if necessary. In any case, this facility is very convenient for times of distress when the government might face unexpected expenses.

Monetary financing of the government deficit though debt securities for monetarily sovereign countries

While governments can always print money when necessary, sovereign governments nowadays usually issue debt securities to finance their short and long-term needs. However, for a sovereign government issuance of debt securities is not in a true sense a financing operation like the securities issued by non-sovereign governments or local entities. Bonds issued by a sovereign government in the domestic currency carry no credit or liquidity risk. (the same does not apply for any issuance in a foreign currency)

There’s no credit risk because a monetarily sovereign governments cannot default on debt issued on its domestic currency as explained by the Federal Reserve Bank of ST. Louis:

"As the sole manufacturer of dollars, whose debt is denominated in dollars, the U.S. government can never become insolvent, i.e., unable to pay its bills. In this sense, the government is not dependent on credit markets to remain operational. Moreover, there will always be a market for U.S. government debt at home because the U.S. government has the only means of creating risk-free dollar-denominated assets (by virtue of never facing insolvency and paying interest rates over the inflation rate, e.g., TIPS—Treasury Inflation-Protected Securities)."

Because the sovereign bonds are the safest asset in any sovereign currency, there is never a shortage of demand for it at home- no liquidity risk. In particular, large deposit holders in the domestic currency face the choice between the most liquid, most safe (no default risk), interest bearing asset in domestic currency over less liquid, less safe that with little or no interest bank balances (bank accounts carry default risk)1. Additionally, liquidity of the sovereigns arises in part from the fact that government debt securities don’t serve only the purpose of "financing" a sovereign government but are also the preferred instrument to implement monetary policy:

"The Fed uses three tools to implement monetary policy, the most important being open market operations. These “domestic operations” are conducted for the System only by the New York Fed under direction of the FOMC. Through open market operations, the Fed buys or sells U.S. Treasury securities in the secondary market to produce a desired level of bank reserves. These securities are held in the System’s portfolio, which is known as the System Open Market Account or “SOMA.”"( New York Fed)

This Open Market Operations consist mostly on the sell and purchase of government debt securities by the Central Bank. When the Central Bank wants to decrease reserve balances, it sells government debt securities to the banks until demand and supply match at the target rate. On the contrary, when the central bank wants to supply liquidity, it buys the government securities from counterparties until they have their desired holdings of reserves at the target rate. As the holdings of government securities for the Open Market Operations by the Central Bank are limited, this opens the door for further cooperation with the Treasury, so the later can provide enough debt securities to allow effective rate targeting. In any case, if there was shortage of demand for any issuance the central bank could always buy the securities that were not subscribed.

Therefore, by the fact that the sovereign government produces the safest and most liquid of all the securities in that sovereign currency there’s never a shortage of demand (quite the opposite) for its debt securities. In fact, demand increases in times of economic or financial distress as investors fly to safety. During the 2008 financial crisis the “flight to safety” explained why the demand for US government securities outstripped the increase supply of the same.

Rates on sovereign debt securities are not subject to market forces but ate mainly the result of monetary policy. Contrary to conventional wisdom, yields on sovereign debt do not necessarily increase with deficits and debt stock. In the era of low inflation, in recessions and financial crisis yields tend to decrease as interest rates set by monetary authority are cut. As rates hit the zero bound central banks are increasingly using unconventional monetary policies: quantitative easing, forward guidance and negative interest rates-designed to decrease rates across the board and in particular the yields on government debt securities. In addition, in economic recession and financial crisis rates tend to decrease also because of the “fly to safety” effect as investors take refuge on sovereign debt, prices increase and yields decrease. These are some of the factors that explain why Japan government bond yields have continued to decrease while its debt stock kept on rising and it’s now the highest in the world.

Thus, not only there is always demand for government debt of a sovereign government issued in its domestic currency but also the interest rate(yields) on these securities are mainly influenced by monetary policy rather than bond vigilantes. Evidence of this is that on the 20/05/2020 the UK issued a government bond with negative yields and still the demand was over twice the amount on offer, confirming not only that there is never shortage of demand -no liquidity risk- but also that yields will tend to go down during recessions even when the government borrowing increases. This was noticed in an early issue in May when the writer noted perplexed: “Britain has massively stepped up its borrowing plans to fund government efforts to lessen the impact of the coronavirus, but its cost of borrowing has fallen, not risen.”

Ultimately, the Central Bank can always purchase, through new money creation, the government debt in the primary or secondary market and roll it over – debt monetisation. Interest received by the central bank is then paid to the government together with the other profits of the Central Bank; effectively, a sovereign government can finance itself at zero cost in the debt held by central bank.

There might be good reasons for not “printing money” or monetise the debt but historically the fear of inflation has been the main deterrent for doing it. However, there has been a secular decline in inflation in the last decades in most of the advanced economies and deflation is now the great threat This has released the central bank, and the government, whose primary mandate is stable prices, to increase support of the economy in recessions. This is obvious in the case of Japan, where the bank of Japan recently announced that it would buy government bonds “without upper limit”. Recession are now fought by printing large amounts of money (i.e. quantitative easing) together with fiscal stimulus. Therefore, a monetarily sovereign government can never default on its debt. Alan Greenspan asserted this fact fallowing a S&P downgrade of the US sovereign debt:

"The United States can pay any debt it has because we can always print money to do that. So there is zero probability of default"

Monetary Non-Sovereign governments: deficit financing, interest rate and demand for debt securities

A non-Sovereign government, however, does not have unlimited power to create its currency as such rather than an issuer of the currency it is a user of the currency. Contrary to a sovereign government, a non-sovereign government must obtain "money" before spending it, which it can only do by taxing or borrowing. By drawing cheques on a private bank account, not at the Central Bank, a non-sovereign nation must ensure it has money on the account all the time otherwise the cheque might bounce. When it spends, its accounts at the private bank are debited and when it receives taxes its accounts are credited. Any shortfall of taxes in relation to spending must be borrowed from a bank or by issuing debt securities. Whichever the case, it will receive a deposit to spend. At the end of the term, it must have collected enough money to repay the principal and interest or be able to roll over the loan.  The issuance of debt by a non-sovereign government is truly a financing operation in the terms we are used to think of it. First implication is that interest rates for a non-sovereign are ultimately determined by market forces.

If markets perceive the credit worthiness of a government is deteriorating it can increase rates and ultimately turn off the tap. This can be especially worrying during recessions when tax revenues fall and borrowing increases. In such a situation, market sentiment can change very quickly and the government might find it difficult to borrow, whether for new spending or to roll over debt, and be forced to cut spending or even default if costs of borrowing became too high. Therefore, the ability of a non-sovereign government to pay its bills is not unlimited once it depends not only on its powers to tax but as well on "perceived" default risk.

 The euro and the road to serfdom

The sovereign Euro nations decided to become non-sovereign when they joined the Euro. This was the case of Portugal. Prior to joining the Euro, it had a domestic currency – the Escudo – issued by the Central Bank of Portugal and it was legal tender in its territory. The “financing” of the government by the central bank was allowed as it is made clear by a law that seek to regulate this type of financing, the Decreto-Lei n.º 337/90:

“(…) it is important to highlight a solution, enshrined in the present diploma, to prohibit the central bank from financing the government, in any form, with the exception of the free current checking account with a limit defined as percentage of current revenues and the underwriting of bonds issued by the government under negotiated conditions.”

In section IV that regulates the relation of the government and the bank it is stated that:

“Art. 26.º - 1 - The State may use a free account opened at the Bank with a debit balance which cannot exceed 10% of the respective revenues collected in the last year.”

In fact, even its autonomous island regions, Azores and Madeira, could avail of similar accounts as stated in line 2 of the same article. In any case the underwriting of treasury bills was also allowed:

“Art. 27 - 1 - In addition to the cases provided for in articles 35 and 26, and without prejudice to the operations permitted in paragraph b) of paragraph 1 of article 35, the Bank is prohibited from granting credit to the State and other legal persons governed by public law, except underwriting of Treasury bills, under conditions agreed between the Ministry of Finance and the Bank and subject to legal limits.”

One of the implications of the above is that these restrictions were self-imposed and obviously could be removed if the case arose. (Not making a judgement on whether these restrictions were not good or necessary but only that they were voluntary and as such can also be done away with if a situation arose in which that course of action was deemed necessary.)

At that time Portugal together with the other euro area countries initiated the surrender of its monetary sovereignty when following the presentation of the Delores report it was decided to start the first stage (out of three) of the monetary union that would culminate in 2002 with the physical introduction of Euro currency. A major step was taken in 1992 with the signature of the Maastricht Treaty (Treaty on European Union) that formally introduced the prohibition of the central banks "financing” the government as is made clear by article 104:

"1.Overdraft facilities or any other type of credit facility with the ECB or with the central banks of the Member States (hereinafter referred to as “national central banks”) in favour of Community institutions or bodies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments."

 (Council Regulation (EC) No 3603/93 of 13 December 1993 that came into force at the same time as the Article 104 to clarify some definition above)

Monetary sovereignty was further severed with the establishment of the European and Monetary Institute in 1994-stage two-forerunner of the European Central Bank (ECB), and the process of surrender would culminate with the introduction of the single currency- the Euro- and the conduit of a single monetary policy by the ECB. With the introduction of the Euro, the countries that adhered to it, surrendered completely their monetary sovereignty  by transferring the power of issuance of currency to a supranational authority, the ECB, but contrary to other monetary unions where a single currency was adopted, Us or Swiss, no Central (or Federal) Government was created, as such the Eurozone is a particular case of monetary union "one money, (too) many governments".

For the countries themselves it is as if they became users of a foreign currency, akin to a dollarization, but contrary to this, they gave up their own currency for good. This raises two types of problems: first, by surrendering their monetary sovereignty or the power to create money, they have become effectively non-sovereign states, similar to a local authority; second, by separating their fiscal and monetary authorities, they have given up their power to pursue policies to achieve full employment. The European nations effectively become non-sovereign nations. similar to US states, but with no Federal government to take on those responsibilities.

Indisputably, the Euro countries knew they would lose their independent monetary and exchange rate policies and that their fiscal policy would be somewhat limited by the Maastricht rules (already major surrenders of sovereignty). What they fail to understand is that they would also lose the capacity to act as the “spender of last resort” because they can neither “print money” nor can they borrow unlimitedly, as they no longer create the risk-free asset on their currency -no credit risk, no liquidity risk – the sovereigns bonds.

In addition, as Randall Wray notes in his 2001 paper titled Is Euroland the Next Argentina?, interest rates on government bonds for non-sovereign governments depend on two factors:

"Since it is borrowing dollars/euros, the rate it pays is determined by two factors. First there is the base rate on dollars/euros set by the monetary policy of the US government (the issuer of the dollar) or the ECB (issuer of the euro). On top of that is the market’s assessment of the nonsovereign government’s credit worthiness. A large number of factors may go into determining this assessment. The important point, however, is that the nonsovereign government, as user (not issuer) of a currency cannot exogenously set the interest rate. Rather, market forces determine the interest rate at which it borrows."

Markets did not perceive the status change initially, as the yields on government bonds for the Eurozone countries converged from the introduction of the Euro up to the eurozone debt crisis. Randall Wray defended that rates were converging because markets were not pricing default correctly following the introduction of the Euro:

"Markets, likewise, have not yet fully recognized the regime shift that has eliminated currency sovereignty for the nation states. While interest rates have not fully converged (and will not), they are typically more similar than they had been before union. This is because while currency risk has been eliminated, markets have not yet begun to fully price- in default risk. Rating agencies are still treating the individual nations as if they were sovereign, with eyes focused on the Maastricht criteria (most importantly, the 3% deficit ratio limits)."

Although rates never fully converged, as predicted, they came quite close to it. However, this came to an end in 2007 with the onset of the recession when markets started to realize that not all sovereign bonds were equal. Given the severity of the recession, deficits ballooned, in particular those of Greece and Ireland, and the markets started pricing the default risk, demanding a premium to hold debt from countries they believed were less creditworthy, making their situation even worst. These countries would later lose access to the markets, which led to the intervention of the troika, and this would be known as the Eurozone crisis (timeline). All of a sudden market views started to matter more than the Maastricht criteria. This is an important change from the past because these countries are now subjected to the more subjective appreciation of the market than to the more objective Maastricht criteria. Moreover, markets are prone to have mood swings and although these can happen at any time, they are more likely to happen when financing is more urgently needed. Rates would peak in 2012 and only came down decisively after Mario Draghi “whatever it takes to preserve the euro” speech.

Although rates went downhill since the announcement of the ECB, they have not been in step with the ECB rates again. The markets are now pricing the default risk of each country and this is reflected not only in the spread between the eurozone bond rates but also in the rate swings. Market perceived default risk is prone to swings in contrast to the pre-2008 financial crisis period marked by stability.

The Mario Draghi speech and the subsequent sovereign bond purchase program have been successfully in taming interest rates because it seeks, in a certain way, to re-establish the link between the central bank and the treasury(s), which article 104 (quoted above) severed by expressly prohibiting the purchase of government debt by the national central banks:

“shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments”

Monetary policy, namely the public sector purchase programme (PSPP) is in part now again driving the interest rates and that is why rates have decreased. Not only that, but the Euro area governments are now effectively financing themselves at nil cost on the part of their debt which is owned by their National Central Banks (purchases are done by the Eurosystem) as the interest received by these is then returned to the government together with the other profits. Since the introduction of the PSPP the holdings of government debt by the national central banks has increased markedly and it now around 20% for most countries according to the Bruegel dataset. The ECB programmes have resulted in higher profits for ECB which have been distributed to the Euro governments. All these together have contributed to improve the budgetary position of the distressed countries markedly.

Sovereign vs non-sovereign Euro countries

This finale was in no way envisioned when Portugal joined the euro. The journey actually started rather promising as government bond yields started to fall in line with ECB rates and converged with the rates of other euro countries who had had historically lower rates. (This again reinforces the idea that rates of sovereign bonds are controlled by monetary policy rather than set by the markets). However, this all changed with the onset of the great recession when both rates began to move in opposite directions. Portuguese debt increased steadily, albeit from a low level since the introduction of the euro up to the 2008 financial crises when it accelerated as the government increased spending to counter the recession. Rates increased above pre-euro levels despite Portugal rushing through austerity measures and agreeing a rescue package with the European Union and the IMF on May 2011.2

If during periods of economic expansions, the differences between sovereign and non-sovereign governments are not always evident, during periods of recession this are made clear. While the sovereign government can spend without regard of revenue, the non- sovereign government ability to spend is dependent on tax revenues and its ability to borrow, both of which tend to fall during recessions and increase during expansions as such leading non-sovereign governments to act pro-cyclically. i.e increasing spending during expansions and cutting during recessions

That difference, between a sovereign government and non-sovereign government, can be seen in Italy’s government deficit spending capacity in the early 90’s recession, when it was a monetarily sovereign country, and the Great Recession, when it had already become a non-sovereign country. Italy has kept a high and stable debt stock since the 90´s, well above the 60% in the Maastricht treaty, which make comparisons between the pre-euro and euro stages possible. Italy's debt burden rose from 92% in 1988 to reach a peak of 126% in 1994, as a result of running deficits of 10% GDP and above until 1992. Yields were in the double digits all throughout the period starting at 13% in 1991 (start of series) and remaining above 10% until 1995. By contrast in the Great Recession while the debt stock rose from 99% in 2007 to 123% in 2012 the deficit rose only slightly from a low 2.5% in 2007 to a high of 5% in 2009 but subsequently went down starting in 2010 and in 2012 was already below 3% again. Yields, rose from 4% to 7%.

While in the pre-euro period Italy could run deficits above 10% of GDP for more than 5 consecutive years with yields of 10% or more, under the euro Italy’s capacity to increase deficits seems to have been reduced. In 2009, after running a deficit of 5% only, it suddenly had to reverse course by imposing austerity measures even while its rates remained low by historic standards. The situation would deteriorate further with the eurozone crisis when its yields increased to 7% and markets considered it now unsustainable and only the ECB intervention avoided a more serious crisis. Back in the 90’s there was no talk of default. The sovereign bonds in Lira, the domestic currency at the time, was the safest asset in the domestic market – no default risk- and so there was no shortage of demand for it. 3

It’s precisely the ability to run large and sustained budget deficits that marks the difference between a sovereign government and a local authority. In a recession, when unemployment is increasing and monetary policy has lost traction, only deficit-spending fiscal policy can effectively lead the economy out of recession as Keynes enlightened a long time ago. In this situation, the difference between the Euro economies (non-sovereign) and other major economies (sovereign) becomes all the more evident. In the Great Recession, while initially both groups let their budget deficits increase, it is clear that in the sovereign countries the increase was greater and longer. In the Euro economies the increases were not only smaller but by 2010 these countries were already reducing their budget deficits while unemployment was still rising.

In France and Italy this is quite obvious, the more their unemployment increased the more they cut. Keynes must be turning over in his grave. No surprise then that unemployment kept on rising in the Eurozone while it started to fall in the other sovereign countries. When comparing the deficits of the sovereign and non-sovereign countries for the year 2009, when these were at their highest, we can easily see that the US, UK and Japan were able to run deficits of 10%, whereas France and Italy just 7% and 5%, respectively. Certainly, this difference translated into a couple of p.p. difference in the unemployment rate. By 2011, when the unemployment rate was going down or at least levelling off in most sovereign countries, in the Euro area it just gathered pace and at the end of 2013 it rose above 12%. Like the early 90's recession these countries started to cut the deficit before unemployment started to decrease(explained here).

The implications from this for the non-sovereign states is that their ability to spent is now pro-cyclically biased. This is because during expansions not only taxes revenues tend to increase but market will also lend at more favourable terms, as their assessment of creditworthiness will certainly be more positive. The problem is that during recessions the opposite is true. Not only will tax receipts fall, but market assessment of creditworthiness will necessarily be more negative and as a result, governments will find it increasingly difficult to finance their borrowings or will do so at more unfavourable terms, making a bad situation worse.

The procyclical behaviour of non-sovereign states of Portugal, Ireland, Spain and Greece has had a lasting effect on unemployment in these countries. Having increased their budget deficits sharply following the onset of recession, in some cases to rescue their banks, soon the markets started to doubt the sustainability of their debts, resulting in higher yields, which in turn made their debt even more unsustainable. They rushed austerity budgets in a last effort to please the markets but they would eventually lose market access and had to be bailed out by the Troika. The loans came with very strict goals in terms of budget deficit reduction, therefore, these countries had to implement measures to reduce their deficits, either by increasing taxation, reducing spending or both. The price was high and lasting unemployment and emigration.

The debt stock of a non-sovereign country must truly be paid to the last cent. When one says that every Portuguese in 2018 owes €24,255 ( 2001: €7.495) it really means that’s the amount on average every Portuguese would have to be taxed if Portugal was to pay its debt in full. As a non-sovereign government can only pay its debts by increasing taxation or reducing expenses. With falling populations and increasing debt Portugal, Greece, Italy and Spain face bleak perspectives all this in the face of rising pension and health costs. In any case, many of the countries affected in the Eurozone Crisis are starting the current recession in a worst position if anything as their debt stock is much higher now than they were in 2008.

The ECB bond purchase program has been successful in taming the rates allowing countries in part to continue to finance themselves even if their debt stock is for the most part higher today than it was in the Eurozone crisis. However, one cannot escape from the fact that this is just stocking problems for the future as lower rates have postponed a speedier reduction in the debt stock. While good for growth and unemployment not so for credit risk.

 

 The coronavirus recession

The anticipated depression as result of the coronavirus containment measures has in the space of months dismissed what has constituted conventional wisdom in Europe for at least three decades. Now that Keynesian type response-government stimulus to pull the economy out of recession is on the table again, the difference between monetary sovereign countries and non-monetary sovereign countries will once again become evident as in the eurozone debt crisis. In any case, this is already becoming apparent in the size of the stimulus packages and their approval. On one hand, we have the US, Japan and Sweden, who had approved sizeable packages in comparison to the Euro sovereign nations.

Japan, which has the highest debt stock in the world at 230% of GDP in 2019, has taken fiscal measures that amount to 21.1% of GDP but yields have remained at zero with the promise of the Governor of the Bank of Japan. “Since no investor bets against the BOJ, Mr. Kuroda didn’t need to fill his purchase quota before and probably won’t need to buy more now.” If Italy or Greece, the most indebted non-sovereigns, were to try something similar markets would not permit or the ECB would have to buy the debt directly.   

Although some of the fiscal incentives advanced were quite generous at first glance, when these are broken down the picture looks quite different. As per a Bruegel publication, while the US and to some extent the UK have advanced the money primarily as immediate fiscal impulse the non-sovereign countries of Europe have done these mostly through deferrals and guarantees. The immediate fiscal impulse, in the words of the authors, lead to an immediate deterioration of the budget balance without any direct compensation later whereas the other might have a compensatory effect later on or only affect future budgets as mostly are contingent liabilities.

Italy, one of the most affected countries with the pandemic, has one of the highest packages but, understandably, very little to say nothing of immediate fiscal impulse. A sensible option given its high debt stock. On the other hand, it is probably the country that is most in need of an immediate impulse. Germany who has also used deferrals and guarantees for the most part, has nonetheless the highest immediate fiscal impulse of the group. It can do so because not only it has a low debt stock(60%) but also because markets perceive it as having no default risk as investors are accepting negative yield to hold German Bonds. These have become the benchmark safe asset in Europe on the absence of a Euro area bond issued by an EU government.

The coronavirus effects have been unequal and the economic consequences will also be uneven among the eurozone economies. It has affected more some of the most indebted countries in the Euro: Italy, Spain, France and Belgium. Facing falling revenues and increasing expenses as well as the need to support their economies some of the most indebted countries have started to demand European wide solutions. Whatever form this takes it always involves transfers of money from some countries to others. It’s no surprise then that the infighting has already begun: the fiscally frugal vs the over indebted. In the US the non-sovereign states of Mississippi, Arizona and New York did not have to negotiate any corona bonds to access emergency funds. This is the responsibility of the federal government who has the means to provide them. In the Euro while the responsibility in the response to pandemics, natural disasters and economic crisis has remained with the national governments, their capacity to do so has been curtailed.

 

Monetary policy and the coronavirus response

Contrary to the Eurozone crisis the ECB can and is now buying the Euro area countries debt and that has capped bond yields. In addition to the PSPP program, the ECB has started a new scheme: Pandemic emergency purchase programme (PEPP). The allocation rate among jurisdiction is “guided” by capital keys but designed in a flexible way to allow fluctuations among the different countries. If not, it might run into difficulties early as it needs to purchase more debt from the stressed countries in order to keep their rates lower which is has successful achieved so far. As debt will increase as result of the coronavirus recession, to keep yields low the ECB will have to buy an increasing amount of the “sovereign” bonds from the most indebted countries. It will then have to relax the capital keys requirement or purchase debt of the non-indebted countries in order to keep the allocation rates in that way draining the envelop quicker. Further increases are thus expected if the capital keys are nor relaxed and the Eurosystem will probably hold a majority of the euro bloc debt before the crisis is over.

The venture of the ECB into the Euro area countries government debt although deemed necessary to save the Euro is not absent of challenges. The Euro nations are not sovereign issuers of their currency and so can default on their debt, contrary to sovereign countries. Interest rates on non-sovereign debt reflect in part the risk of default. By intervening in the market, the ECB is affecting the correct pricing of the default risk and the signs it transmits. The situation arises because the EBC considers the Euro area bonds equivalent to those issued by monetary sovereign countries, like the Gilts or Treasuries, but they are in a way more similar to the debt issued by US States. In the US the Fed has for the most part stayed out of the state debt market because there is a better understanding of what this entails. By keeping interest rates low it has allowed overindebted countries to take on more debt. In the US some states are already cutting their spending. The ECB intervention has resulted in a distortion of the market and it will be very difficult to reverse this because the ECB now holds a substantial part of the Euro area debt.

The ECB has set monetary and time limits to the programs, however, the programs must be unlimited; otherwise, rates will increase when those limits are reached if debt reduction has not been achieved by then. If there is one thing one can be sure at this stage is that the debt will be significantly higher not only in absolute value but especially in proportion of GDP. The ECB will have to support the over indebted countries until their debt stocks are reduced to more manageable sizes, which will take a couple of decades at least. By then the ECB might own the majority of the debt of these countries. That might be politically toxic. The alternative, to inflate away the debt, would be politically and economically complex given the diversity of governments and economies in the Euro area.

Although the ECB intervention has been successful in taming interest rates, it risks creating political and legal challenges. By holding and increasing amount of Euro Area debt - 20% in 2019 – it is placing itself at the centre of the legal and political debate, increasingly forfeiting its independence. The German court challenge to the ECB’s bond buying programme is primary example. A federal bank buying federal debt is very different from a supra-national bank buying national debt. It might be understood that the ECB is endorsing the policies of one government in detriment of others. Even the wind down of the bond buying programs might be now problematic if, for instance, interest rise for the indebted countries. Monetary policy is not neutral. This is an example of the many challenges and problems of having a supra national central bank and (too) many government

Conclusion

It's here that the flaws of the European arrangement became evident. While the ability of the Europeans nations to implement counter-cyclical measures to smooth the business cycle has been curtailed in the same way of US states, no supra-national or Federal government has been created to take on the responsibility to pursue growth and full employment policies as is the case in the US. The fundamental problem with the Euro Economic and Monetary union is that nobody has the responsibility and the means to maintain full employment; i.e. the one who has the means has no responsibility and the one who has the responsibility has no means. In practice, given that there's no de facto government, just the ECB has the means but by no means has it the responsibility or even the legitimacy to maintain full employment. On the other hand, the national governments of the Euro states have the responsibility but limited means.

Before the Eurozone crisis many governments behaved like they still had the means. The Irish and Greek bank bailout are the foremost example as this were the catalyst to the Eurozone crisis and their cost still lingers in their accounts. The affected countries have since began to realize that they are not sovereign, even if they don't fully comprehend the implications. However, with the coronavirus crisis, some government are feeling emboldened again, announcing a wide range of measures that will expand greatly their debt stock. France is predicting a deficit of about 11.4% and a debt stock rising above 115% and Italy a deficit of 10.5% with debt increasing above 155.7%. This is looking increasingly worrying as some of these countries have not only large debt to GDP ratios but have had no growth in the past decades. Italy GDP is now lower than when it joined the Euro.

More worryingly still, is that the electorate still sees the national governments as sovereign, even if they nowadays resemble more local authorities, as a result, they believe that governments have the same responsibilities and means they had before joining the Euro. By holding them accountable for their incapacity to improve the economic situation, in particular unemployment, they are wreaking havoc to the traditional party system in Europe with unforeseen consequences.

Therefore, if these countries are ever going to get out of the present economic malaise, there must be a marriage or remarriage of responsibilities with the means to maintain full-employment. This can be achieved either by creating a Central government and other supranational institutions for the Euro area or the Euro nations must reclaim their powers to issue their national currencies. The fact that this has not happen - as the incomplete banking union is an example- or is not even discussed just shows how little is understood about the causes of the Eurozone crisis. Otherwise, by keeping the current status quo, the countries in difficulty in the Eurozone will suffer from never-ending austerity. Eventually they will arrive to the conclusion that the problem with the Eurozone is the Euro and break free from the its straitjacket.

Wynne Godley in 1992 in the article Maastricht and All That highlighted the same untenable position of those evolved in the discussion:

"I sympathise with the position of those (like Margaret Thatcher) who, faced with the loss of sovereignty, wish to get off the EMU train altogether. I also sympathise with those who seek integration under the jurisdiction of some kind of federal constitution with a federal budget very much larger than that of the Community budget. What I find totally baffling is the position of those who are aiming for economic and monetary union without the creation of new political institutions (apart from a new central bank), and who raise their hands in horror at the words ‘federal’ or ‘federalism’. This is the position currently adopted by the Government and by most of those who take part in the public discussion."

Each economic crisis is a test to the Euro and the Coronavirus might be its test of fire and the (almost) universal law of money: one government, one money – will exercise its gravitational force once again and at the end an European federation with a supra national treasury will emerge or nations will come a step close to regain their monetary sovereignty.  

 

 Notes

1.There’s never shortage of demand for US dollars. Contrary to Japan, where only 6% of outstanding bonds are held by non-residents, in the US non-residents hold more than 30% of outstanding Treasury securities, being China and Japan the biggest foreign holders, although only Chinese holdings are singled out as being a national threat. As China has been running trade surpluses with the US (US trade deficits) for years the accumulation of dollars or dollar denominated assets is just a natural consequence of that trade pattern.  As the Chinese exporters must be paid in renminbi (yuan), US importers must exchange their dollars for renminbis at the People's Bank of China (PBC), (simplification) the issuer of renminbis. The transaction increases People's Bank of China (PBC) dollar reserves, that must be held in a bank account in a US bank (ignoring the Eurodollar market), unless it prefers to hold the dollar bills in its vaults, which for sure is not the case. At the end of the day, the PBC has only a couple of options: 1. exchanges it for another currency (a bank balance in another country); 2. Keep the balance in dollars at a US bank, or 3. Buy dollar denominated assets (US Debt). Assuming it prefers to keep its balance in dollars, the choice is between the most liquid, most safe (no default risk), interest bearing asset in dollars-i.e. Treasuries- over less liquid, less safe (bank account carry default risk) that bear little or no interest- bank balance. There's little doubt which one is preferable. That is the choice faced not only by foreign deposit holders but also the decision that many other large surplus deposit holders face every day, from Social Security to insurance companies, mutual funds, pension funds and the like. Not surprising all of them are large holders of Treasury Securities. Return to text

2. The 2011 IMF/EU bail-out was very different from the previous 1977 and 1983 IMF interventions. Their origins were different as the later originated in the foreign exchange market while the 2011 had origin in the government bond market. In 1977/1983 interventions Portugal reserves of foreign currency were running low due to recurrent deficits in its trade balance and because of increasing difficulties in servicing external debt in 1983 (debt in a currency other than its sovereign currency). Portugal was short of foreign currency (dollar, DES), but not of the escudo, its domestic currency. As it was the only issuer of that currency it can never run out of it as such the IMF loan was in the international currency. On the other hand, in 2011 the Portuguese government run short of Euros the currency it uses as its domestic currency nowadays. As Charles Goodhart predicated, the crisis in the foreign exchange market have passed into the bond market. Return to text

3. Debt ownership in Italy has changed greatly since the introduction of the euro. The shift has been felt more abruptly among the domestic retail investors which were traditionally the major owners of Italian debt at the time of lira. In 1997 they held 37% of it but this has dropped sharply and its now at 3.1%. As the Italian government securities are no longer issued in the sovereign currency these are no longer the most safe and liquid asset in the domestic currency (the Euro), therefore, this sector has no interest in holding Italian debt. If safety is the issue, they are better off holding German bonds for instance. This were mostly taken up by foreign owners up to 2009 but they have reduced their exposure. It’s clear that from 2015 this the Central bank increased their holdings following the setup of the bond buying program. Return to text