The Euro, the surrender of monetary sovereignty and the two lost decades (Part 1 of 3)

On the 2nd of May 2010 the "troika" agreed to a 110 billion bailout package for Greece, in what the European leaders hoped would draw a line in the sand in the sovereign debt crisis that would soon became known as the Eurozone crisis.  But contrary to their hopes, this was just the beginning of a wave that would also engulf Ireland and Portugal, threaten Spain and Italy; and with it the very existence of the Euro. The main causes of the market turmoil, according to the great majority of experts, were the "unsustainable" debt burdens and deficits. Yet, when one compares the debt burdens for the affected countries at the beginning of the Eurozone crisis to those this countries had back in 1995/96, one can easily see that 2008’s debt burdens were not significantly out of line with those in 1995/1996, and in some cases this were even lower, such is the case of Italy, but back then there was no talk of default; nor did these countries have any problems financing themselves.

Italy's debt burden, measured by debt-to-GDP, rose from 90% to reach a peak of 121% in 1995, following the recession of the early 90's, but it went down steadily since and at the beginning of the Great Recession, in 2008, it stood at 106% "only". With the onset of the recession the trend was inverted and the debt burden started to rise again, but in 2011, at 120%, this was still below the 1996 value.  On the other hand, the deficits, measured as deficit-to-GDP, have remained below the 5% mark which is a stark contrast with the 10% or more during the early 90's recession. 

In addition, while Italy's ten-year bond yields rose to their highest euro-area level after 2011, they remain well below the yields of 10% or more paid in the early 90's recession.  In 1995, with a debt burden of 121%, a deficit of 7% and paying yields of 12%, Italy had no problems financing itself, but in 2011 with a debt of 121%, a deficit of 3% and yields of 5%, Italy's debts costs were now considered unsustainable and markets started to see it as default risk, which led governments to impose austerity measures.

It’s reasonable to conclude that for these countries something fundamental has changed in relation to their recent past; somehow they are now subject to market forces they had never experienced before. Forces that can ultimately push theme to default, as in the case of Greece, or to adopt austerity measures in the middle of a recession with high levels of unemployment. All of a sudden the bond vigilantes became more important than the voters.

So the question is what changed?  Why are these countries subject to market discipline like they have never experienced before? Why are they having difficulties financing their debts when this was not a problem before?  Why are their debts and deficits now considered unsustainable while in the 90's, similar or worst levels, where not considered a serious problem? Why are these countries adopting austerity measures in the middle of a recession?  In addition, one has to wonder if the Maastricht limits on debt and deficits are so important, why were Italy and Greece ever allowed to join the Euro with debts well over the 60%?  Put simply, what changed was the Euro and the Maastricht limits never really mattered. To understand why, however, we must understand what changed with the introduction of the Euro.

Although the term Eurosceptic has been used to cobble together a diverse group of people and points of views, mostly non-economics related, there are at least two discernable groups of economists that were sceptical about the Euro experience on economic grounds. The mainstream view, that thought of the euro in terms of the theory of the “optimum currency area” , theory which was itself the basis of the monetary union, concluded within the framework that the costs could outweighed the benefits and as such were against the euro from the beginning; On  the other hand, despite arriving at the same conclusion, a fringe group of economists , the neo-Chartalists, takes a competitive approach to money as a starting point. While the implicit theory behind the Optimum Currency Area is the Metallits approach to Money that defends that Money was invented to facilitate trade, to the neo-Chartalists money is a creature of the state, and this mean not only that the state determines what is money but also that it drives its acceptance by demanding that taxes are paid in the currency of its choice. (For a presentation of the competitive approach and a critic to the optimum currency areas theory see Charles Goodhart ).

Even though, many others neo-chartalists and MMT's have long warned to the consequences of the faulty construction of the Euro, I want here to highlight in particular an article by the late Wynne Godley published in 1992 under the tittle Maastricht and All That, and a paper by Randall Wray with the title of Is Euroland the Next Argentina from 2001, both scholars of the Levy Institute, where several scholars issued warnings well in advance of the Euro area sovereign debt crisis. While Wynne’s article explains not only the flawed views that governed the constitution of the monetary union but also the consequences of not having a Central (Federal) government, the paper by Randall Wray, taking as a starting point the Argentina experiment with the dollarization and establishing some parallels with the Euro experiment, makes not only some insightful predictions to what would later became the Eurozone crisis but also possible solutions if the crisis came to materialize.

Monetary sovereign nations vs non sovereign states

Some aspects of the theory might be controversial and at times seem counterintuitive but the main idea can be resumed in Charles Goodhart corollary: "One government, one money" or one currency, one nation" to which we all can relate easily, once this is the model for most countries, or at least it was until the  introduction of the Euro, with the exception of some small states like Monaco, San Marino and the like. What derives naturally from the on-to-one correspondence between countries and currencies is the definition of monetary sovereignty, which can be understood as the" exclusive" and "unlimited" power of the government to issue its own money.

A Monetarily Sovereign government has the exclusively unlimited power to create its sovereign currency. This exclusive power, nowadays delegated in the central bank, means that it has a monopoly of currency issuance, as such no other government or entity can issue the sovereign currency. The unlimited part refers to the fact that it can create as much of it as it desires. This does not mean that it should, as it might have undesired effects, most important of all inflation, but only that there are no financial limits to its issuing power. There might be some legal restrictions, as the debt ceiling in the US or the budgetary process is most of the countries, but this are self-imposed rather than built-in restrictions. Government creates money by paying its bills and retires it by taxing.  Therefore, a monetary sovereign state does not have to tax or borrow money prior to spending it.

On the other hand, non-monetary sovereign states don't possess this exclusive and unlimited power to create the currency they use and so they have the status of a local authorities. These are users of the currency rather than issuers and as such they must borrow or tax before they can spend it. Us states and Swiss Cantons are a good example of non-monetary sovereign states.

The degree of monetary sovereignty depends as well on the exchange-rate regime.  When a country pegs it currency to a foreign currency or to a commodity like gold, it limits its power to create money as it must manage its holding of reserves of the foreign currency or commodity, if the promise is to be credible, otherwise, it might have to break its promise to convert at a fixed rate, as eventually always happens. As a result, a second important element of the monetary sovereignty is a flexible exchange-rate.  A flexible exchange rate is not only important to guarantee currency independency but also a condition to have fiscal independence.

Money financed deficit

"While we commonly think of a government needing to first receive tax revenue, and then spending that revenue, this sequence is quite obviously not necessary for any sovereign government." (Randall Wray)

Monetary sovereign countries can spend before they tax, this is actually necessary if one takes the view the state has a monopoly of money creation, as it must spend (lend) the money into creation before it can tax (borrow) it, which contradicts the current dogma that the government always needs to tax or borrow first before it can spent. A sovereign government it's not revenue constrained. This is easy to see if one thinks that the Government (Treasury) has a printing press and prints money as it needs to buy goods or services. However, if this was the case in the past, the introduction of the (1) Central Bank and (2) governments debt securities has blurred the picture. Picture that was already distorted by the fact that paper money and coins represent a small amount of the monetary base, which in addition to coins and paper money (both as bank vault cash and as currency circulating in the public), includes commercial banks' reserves with the central bank. This highly liquid government created money is also called high powered money (HPM). 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 explained by Randall Wray:

"The sovereign government spends (buys goods, services, or assets, or makes transfer payments) by issuing a Treasury check, or, increasingly, by simply crediting a private bank deposit. In either case, however, credit balances (HPM) are created when the Fed credits the reserve account of the receiving bank. Exactly analogously, when the government receives tax payments, it reduces the reserve balance of a member bank (and, hence the quantity of HPM). Simultaneously, the taxpayer’s bank deposit is debited, and her bank’s reserves at the Fed are reduced. While we commonly think of a government needing to first receive tax revenue, and then spending that revenue, this sequence is quite obviously not necessary for any sovereign government. If a government spends by crediting a bank account (issuing its own IOU--HPM) and taxes by debiting a bank account (and eliminating its IOU-- HPM), then it is not as a matter of logic “spending” tax revenue. In other words, with a floating exchange rate and a domestic currency, the sovereign government’s ability to make payments is not revenue-constrained."

This institutional arrangement, with the central bank acting as both the banker's bank and the government's bank, opens a range of options for 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:

"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)

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 the purchase of government debt securities in the primary market or secondary market. Whether the government "prints money" or the government issues securities that are latter purchased by the central bank has the same end result as demonstrated by Stephanie Kelton:

"There is virtually no macroeconomically significant difference between the Fed providing the Treasury with an overdraft versus the Fed owning the short-term debt of the Treasury—the Fed will return any interest it receives on the T-bill or the overdraft to the Treasury along with the rest of its profits."

While in the past two decades  many countries have been passing legislation with a view to restricting this operations between the Treasury and the Central Bank, as a recent paper by the IMF on central bank regulation around the world highlights, MMT argues that this are self- imposed constrains and can be easily surpassed by the Treasury and central bank when needed, as quantitative easing has shown. However, this regulation has 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. Even if due to current legislative restrictions the Treasury is forced to keep a positive balance on its account at the central bank that should not distract from the fact that it all starts with the government spending first, as Frank N. Newman, former Deputy Secretary of the U.S. Treasury (1994-1995), explained ( by Stephanie Kelton):

"I recall from my time at the Treasury Department that the assumption was always that there was money in the fed account to start with. Nobody seemed to know where it came from originally or when; perhaps it was established in biblical times. But as a matter of practice, if the treasury wanted to disburse $20bn a given day, it started with at least that much in its fed account. Then later would issue new treasuries and rebuild its account at the fed.  (I do not recall ever using an overdraft.)

In my view, this is still consistent with the MMT perspective that you mentioned, and in my own book the explanation starts the cycle with government spending, thus adding to the money supply, and then issuing treasuries for roughly equivalent amount, thus restoring the money supply and the Treasury’s Fed account to the levels they were prior to that round of spending. Every cycle is: spend first, then issue treasuries to replenish the fed account. The fact that Treasury started the period with some legacy funds in its Fed account is not really relevant to understanding the current flow of funds in any year."

In practise, however, this is a bit more complicated but the essence is maintained:

"In practice, Treasury varies its issuance not only to match outlays, but also to deal with seasonal factors, and to avoid wide swings in new-issue sizes; so at one point of a year, treasury might actually issue some extra securities because the next month was expected to have low tax revenues, or might not fully replenish recent spending because the next month was expected to have high tax revenues. That seasonal process doesn't really affect the overall flow of funds over a year.  The substance of the cycle is still: spend then replenish. Debating that would seem highly philosophical, and would miss the practical aspects of the flows."

If the government spending always comes first why does the government need to issue government debt securities? This brings us to one of the central point of the MMT which is the fact that government debt securities don't serve the purpose of "financing" a sovereign government but are instead an instrument to implement 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)

While Treasury spending leads to monetary creation (bank reserve balances at the central bank), taxation has the opposite effect as it involves monetary destruction. Therefore, if the treasury spends more then what it takes in taxes (i.e. runs a deficit), it creates net excess reserves in the interbank market -in excess of what banks want or are required to hold- as such putting downward pressure in the interbank rate (rate at which  banks lend reserves to each other), all the way to zero. Unless that's the target rate of the Central Bank, which in normal times rarely is, it must drain the excess reserves to achieve the desired rate. Treasury surpluses have just the opposite effect, they drain reserves and in this situation the Central Bank must supply reserves otherwise rates will rise above the target rate. The Central Bank supplies and drains reserves through its open market operations:

"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 drain the excess reserve created by deficits, it sells government debt securities to the banks until demand and supply match at the target rate. On the contrary, when it wants to supply liquidity, it buys the government securities from the banks 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. This idea was resumed in Randall Wray:

"Note that the sale of its own treasuries by a sovereign government is not best thought of as a borrowing operation, even though it is frequently described as such. Rather, the purpose of such sales (even if policy- makers do not realize this) is to drain any excess reserves created by deficit spending. If the bond sales were not undertaken to drain excess reserves, the overnight rate would fall. Operationally, the Treasury and the Central Bank work together to ensure that the overnight interest rate target (set by monetary policy) is hit. They do this through security sales or purchases to drain or add reserves as necessary to allow the monetary authorities to hit rate targets."

Interest rate on government debt securities 

But what drives banks preference to hold governments securities instead of reserve balances at the Central Bank? The main reason it's interest payment: reserve balances at the Central Bank do not pay interest, at least they did not until the recent financial crises, while government debt securities do pay. So, for banks the choice it’s always between non-interest paying reserve balances at the Central Bank or interest bearing government securities. Profit seeking banks, with excess reserves, will want to hold any combination that maximizes their profit. Which simple means that besides any reserves they are required or want to hold they will want all the government securities they can get their hands on. This has important implications, namely that interest rate paid on government securities of a sovereign government are not subjected to market forces as explained by Randall Wary:

"The final point to be made regarding such operations by a sovereign government is that the interest rate paid on treasury securities is not subject to normal “market forces”. The sovereign government only sells securities in order to drain excess reserves to hit its interest rate target. It could always choose to simply leave excess reserves in the banking system, in which case the overnight rate would fall toward zero. When the overnight rate is zero, the Treasury can always offer to sell securities that pay a few basis points above zero and will find willing buyers because such securities offer a better return than the alternative (zero). This drives home the point that a sovereign government with a floating currency can issue securities at any rate it desires—normally a few basis points above the overnight interest rate target it has set. There may well be economic or political reasons for keeping the overnight rate above zero (which means the interest rate paid on securities will also be above zero) But it is simply false reasoning that leads to the belief that the size of a sovereign government deficit affects the interest rate paid on securities."

Japan is a case in point: since the 90's its budget deficit and debt increased steadily until 2005 but, contrary to conventional wisdom, this was accompanied by a fall in Government bond yields. In actual fact, government bond yields actually increased slightly when a reduction of the deficit was initiated in 2005. However, since the onset of the great recession, the budget deficit has reversed course and started to increase again and now stands above 10% of GDP, with little sign it will abate anytime soon. Once again, contrary to the mainstream view, bond yields have fallen further. The situation was made even worse with the earthquake in 2011, which prompt many to predict that the day of reckoning was around the corner:

Japan already has the largest debt burden of any industrialized country, at about 200% of GDP, and even though Japan is not yet showing signs of following Ireland, Greece and the rest of the euro zone periphery into a full-blown debt crisis, pressure has been mounting for Tokyo to finally put in place a credible plan to reduce its yawning budget deficits and contain its debt levels.

We are now in 2015 and that day has not yet arrived. On the contrary, Japan debt burden has increased and the IMF estimates that at the end  2014 it will be 242% GDP, yet there's no sign of the day of reckoning is closer than in 2011 as bond yields are  getting ever close to Zero despite the proposed record budget for 2014.

Demand for government debt securities

Another important point to be made from the graph above is that against all predictions there is no shortage of demand for Japan's debt securities as its outstanding debt just keeps on increasing. In fact, as Frank N. Newman, former Deputy Secretary of the U.S. Treasury (1994-1995), explains in the same post by Stephanie Kelton, there's never shortage of demand for sovereign government debt securities:

"In any case, the treasury can always raise money by issuing securities. The bond vigilantes really have it backwards. There is always more demand for treasuries than can be allocated from a limited supply of new issues in each auction; the winners in the auctions get to place their funds in the safest most liquid form of instrument there is for US dollars; the losers are stuck keeping some of their funds in banks, with bank risk. (I even try to avoid using the expression “borrow” when the treasury issues securities; the treasury is providing an opportunity for investors to move funds from risky banks to safe and liquid treasuries.)"

The reason why there's always demand for debt securities of a sovereign government that issues its debt in its own currency is that it produces the most safe and liquid of all the securities in that sovereign 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)."

This can easily be illustrated with an example that so many times has caused confusion because this is not understood. 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), 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's 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 and other government funds to insurance companies, mutual funds, pension funds and the like. Not surprising all of them are big holders of Treasury Securities.

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 at all times 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 as Randall notes:

"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."

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.