"This may not be obvious, but, creating money in a currency union is no simple task. In any single country, central banks usually restrict themselves to buying government bonds, and making loans to regulated commercial banks. Net purchases of these securities by central banks creates what is called “high-powered money” [currency and deposits of commercial banks with the central bank]; this feeds into the financial system and results in the creation of what we all use to make payments and store value, i.e., money, plain and simple.
However in the European Monetary Union there are now 17 nations and a plethora of banks. So, to put it crudely, there is sure to be a fight to decide who gets the newly printed funds. The ECB [European Central Bank] resolved this by what seemed like a fair rule: All commercial banks can borrow from the ECB if they provide collateral, in the form of highly rated government and other securities, to the ECB. So, for example, a Greek bank can gain liquidity by depositing Greek government bonds with the ECB – as long as those bonds are “investment grade”, i.e., highly rated.
This simple and seemingly reasonable rule created great dangers for the eurozone, which have come back to haunt Mr. [Jean-Claude]Trichet[, president of the ECB]. The commercial banks in the zone are able to buy government bonds, which “paid” 3-6% long term interest rates (for all the sovereign bonds of members) over the last decade, and then deposit them at the ECB. They could then borrow from the ECB at the ECB financing rate, which today is 1%, against this collateral so pocketing a profit — and then buy more sovereign bonds with the funds. Mr. Trichet recognized this system had inherent dangers of turning into a new Ponzi game: if nations spent too much, and built up too much debt, eventually the system would collapse. So at the foundation of the eurozone, Mr. Trichet led a contingent within the EU that demanded all nations live by a “Growth and Stability Pact”, whereby each nation could only run deficits of 3% of GDP, and they had to keep their debt/GDP ratio below 60% of GDP.
Of course, politics trumped Mr. Trichet – as it always must – and the Greeks, along with the Portuguese, used their new found cheap lending system to run large deficits and build up debt. The cheap access to money also helped feed the real estate booms in Ireland and Spain."
Peter Boone and Simon Johnson, "Greece And The Fatal Flaw In An IMF Rescue", The Baseline Scenario (6 April 2010).
http://baselinescenario.com/2010/04/06/greece-and-the-fatal-flaw-in-an-imf-rescue/
Peter Boone, a Canadian, is chairman of the charity Effective Intervention and a research associate at the Center for Economic Performance at the London School of Economics. Simon Johnson is the Ronald A. Kurtz (1954) Professor of Entrepreneurship at MIT's Sloan School of Management, a position he has held since 2004. He is also a senior fellow at the Peterson Institute for International Economics in Washington, D.C. From March 2007 through the end of August 2008, Professor Johnson was the International Monetary Fund's Economic Counsellor (chief economist) and Director of its Research Department.
One of the most difficult questions at the intersection of monetary theory and practical politics is who should receive the benefit of seigniorage, that is, who should gain the purchasing power derived from issuing currency or expanding the stock of money. In a world of government-issued fait currencies, where the cost of "printing money" -- that is, expanding the money supply -- is almost nothing, governments can and do usurp and spend newly created money to command real goods and services from private markets with no matching provision of anything in return for the resources they obtain. In doing so, governments receive valuable real resources in exchange for issuing mere sheets of newly printed paper called government bonds, which they "sell" to their central bank and receive in return new currency and electronic blips representing additional deposits of money in some government bank account. Rather than simply giving it to the government, some of this valuable seigniorage can be "transferred" to the economy as a whole by the central bank through the influence of monetary policy on the operation of the banking system.
One of the purposes of the modern, independent central bank is to ensure that the value of the currency is not debased by an overexpansion of the money supply, that is, by the purchase of such a large volume of government bonds that the increase the stock of money is more rapid than the rise in domestic production and the corresponding demand for money. If the money supply expands faster than the transactions demand for money, inflation will result, and the wealth of people who hold cash or bank deposits will decrease as the wealth of the ultimate issuer of the currency, i.e., the government through its central bank, increases. This theft of purchasing power by the government is often called "the inflation tax".
Needless to say, the temptation to issue currency in excess of the economy's immediate need for additional money is great. Governments are always under pressure to spend more and tax less and it is easy to rationalize the need for an "easy money" policy to support objectives such as the promotion of economic growth or a reduction in unemployment. For this reason, once governments gained control of the money supply under modern fait-money systems, the price level has at times risen rapidly and then fallen rapidly whereas inflation and deflation were generally low or nonexistent in the United Kingdom and the United States for centuries under the gold standard. Since the creation of the Federal Reserve in 1913, the U.S. dollar has fallen to a twentieth of its former value, with annual increases and decreases in the price level sometimes approaching 10 per cent. Experience has shown that controlling increases and decreases in the stock of money under a fait-money system is difficult for both technical and political reasons.
In addition to the question of how much to expand the money supply is the question of exactly who should benefit from the seigniorage associated with any increase in the money supply. If the Treasury or finance ministry directly sold a newly issued bond to the central bank and received in return newly printed money, the government would then gain the full benefit when it spent the proceeds from the sale of the bond. Alternatively, in the fractional reserve banking systems of the United States and Europe, some (much?) of the benefit from seigniorage is captured by the banking system (not any one bank, but the system as a whole through bond purchase rules and the operation of the money multiplier). Basically, the new money issued by the central bank when it purchases an old government bond eventually takes the form of new loans made by banks on the basis of their expanding deposits. To their benefit, banks can borrow low and lend higher and as they do the economy benefits through greater liquidity and lower credit costs than would otherwise prevail. Everyone also benefits from a more buoyant economy and faster economic growth brought about by the creation of bank credit.
Needless to say, there is a debate about whether governments should appropriate the entire benefit from seigniorage or allow its benefits to be spread to the economy through the banking system. Right now, in the case of the U.S., this decision is made by the Open Market Committee of the Federal Reserve in light of its assessment the state of the economy and its objectives for monetary policy. This of course could change, and some members of Congress urge reforms that would in effect center seigniorage on the Treasury.
As noted by Boone and Johnson, for the European Union the question of seigniorage is much more complex than in the U.S. The Federal Reserve buys and sells only U.S. Treasuries and the seigniorage from its open market activities either benefit the U.S. Treasury directly by providing it with cash or indirectly with higher tax revenues from a more buoyant economy. The European Central Bank must deal in the sovereign bonds of the 17 member-states of the European Monetary Union. When it buys a newly issued bond from one member-state, the ECB provides purchasing power to that country's government not available to the others. Similarly, when it augments bank reserves in one country, their availability to banks in other member-states is of a lesser degree. These problems are in addition to those associated with the over-issuance of sovereign debt by these countries mentioned by Boone and Johnson.
The euro has brought many benefits to the European Union and its member-states. It has eliminated the costs associated with currency conversions among its members and fixed the internal exchange rate among their major trading partners. It has also allowed them to harmonize their domestic policies in ways not possible before and provided a stable exchange rate to the rest of the world. In these ways, and more, the euro has been helpful to European prosperity and peace.
But the longer-term viability of any monetary union depends on a degree of discipline among its members. Greece and some other members of the EMU simply have not been able to bring their national budgets under control, and given this reality the monetary union generates more instability than stability. Until the countries of the EMU work out acceptable rules for determining national budgets, Greece will be only the first in a long line of problem countries.
In a larger sense, the problem goes beyond budget discipline. Simply because there are so many independent fiscal policies and only one common monetary policy, it is difficult to see how the EMU can work. The question of seigniorage and who gets it will always be in the background, and it is the key issue because it reflects both money creation and sovereign bond finance. The Greeks can argue that if they had access to the euro's seigniorage, i.e., if the ECB would just buy their bonds, the burden on them would be far lighter, and they would be right. Other countries can argue that because they have been disciplined with regard to their finances, their bonds are of the highest quality and therefore they are more deserving of its benefits. For all countries, the question of an appropriate expansion in their money supply is critical to their economic future; however, an expansion rate appropriate to a fast growing economy is not for a slow growing one.
Until the problem of money creation and seigniorage and its distribution among the countries of the EMU is satisfactorily worked out, it is difficult to see how the euro can survive.
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