There appears to be little or nothing in the monetarists' handbook to
enable them to assess the risk of a loss of confidence in the purchasing
power of a paper currency. Furthermore, since today's macroeconomists have
chosen to deny Say's Law1, otherwise known as the laws of the
markets, they have little hope of grasping the more subtle aspects of the
role of money in price formation. It would appear that this potentially
important issue is being ignored at a time when the Eurozone faces growing
systemic risks that could ultimately challenge the euro's validity as money.
The euro is primarily vulnerable because it has not existed for very long
and its origin as money was simply decreed. It did not evolve out of marks,
francs, lira or anything else; it just replaced the existing currencies of
member states overnight by diktat. This contrasts with the dollar or
sterling, whose origins were as gold substitutes and which evolved in steps
over the last century to become standalone unbacked fiat. The reason this difference
is important is summed up in the regression theorem.
The theorem posits that money must have an origin in its value for a
non-monetary purpose. That is why gold, which was originally ornamental and
is still used as jewellery endures, while all government currencies
throughout history have ultimately failed. It therefore follows that in the
absence of this use-value, trust in money is fundamental to modern
currencies.
The theorem explains why we can automatically assume, for the purposes of
transactions, that prices reflect the subjective values of the goods and
services that we buy. This is in contrast with money that is not consumed but
merely changes hands, and both parties in a transaction ascribe to money an
objective value. And this is why the symptoms of monetary inflation are
commonly referred to as rising prices instead of a fall in the purchasing
power of money.
The European Central Bank (ECB) is plainly assuming the euro is money on a
par with any other major currency with a longer history. Despite caution
occasionally expressed by sound-money advocates in Germany's Bundesbank, the
ECB is aggressively pursuing monetary policies designed to weaken its
currency. For example, it has reduced its deposit rate for Eurozone banks to
minus 0.2%. This is wholly unnatural in a world where possession of money is
always more valuable than an IOU. Furthermore banks are encouraged to limit
their customers' cash withdrawals, often under the guise of fighting tax
evasion or money laundering. But in Greece restrictions on cash withdrawals
are clearly designed to protect the banks.
So far, there is nothing identified in this article that actually points
to a destabilisation of the euro, other than it's generally a bad idea to
fool around with peoples' rights to it. But lets assume for a moment that
Greece defaults. In that case the Greek banking system would certainly
collapse (assuming the ECB suspends its emergency liquidity assistance (ELA)
because bad debts already on their balance sheets exceed tangible equity by a
substantial margin. If that assistance is withdrawn, some €80bn of ELA will
be lost. Furthermore, TARGET2 2 settlement imbalances at the other
Eurozone central banks, which have arisen through capital flight from Greece
and which are guaranteed by the ECB, total a further €42bn. This leaves the
ECB in the hole for €122bn. Unfortunately, the ECB's equity capital plus
reserves total only €96bn, so a Greek default would expose the euro's issuing
bank to be woefully under-capitalised.
Therefore, if Greece defaults we would at least expect the validity of
this relatively new euro to be challenged in the foreign exchange markets.
Even if the ECB decided to rescue what it could from a Greek default by
rearranging the order of bank creditors in its favour through a bail-in, it
would still have to make substantial provisions from its own inadequate
capital base. For this reason, rather than risk exposing the ECB as
undercapitalised, it seems likely that Greece will be permitted to win its
game of chicken against the Eurozone, forcing the other Eurozone states to
come up with enough money to pay off maturing debt and cover public sector
wages. So will that save the euro?
Perhaps it will, but if so maybe not for long. If the Eurozone's finance
ministers give in to Greece, it will be harder for other profligate nations
to impose continuing austerity. Anti-austerity parties, such as Podemas in
Spain, are increasingly likely to form tomorrow's governments, and Spain
faces a general election later this year. Prime Minister Renzi and President
Hollande in Italy and France respectively are keen to do away with austerity
and increase government spending as their route to economic salvation.
Unfortunately for both the undercapitalised ECB and its young currency, they
are increasingly likely to be caught in the crossfire between the Northern
creditors and the profligate borrowers in the South.
Even if Greece is to be saved from default, the ECB will need to
strengthen the Greek banks. This is likely to be done in two ways: firstly by
forcing them to recapitalise with or without bail-ins, and secondly to
restrict money outflows through capital controls and harsh limits on
depositor withdrawals if need be. Essentially it is back to the Cyprus
solution.
Whichever way Greece is played, Eurozone residents will see themselves
having a currency that is becoming increasingly questionable. The bail-in
debacle that was Cyprus is still etched in depositors' minds. Cyprus
certainly has not been forgotten in Greece, where ordinary people are now
resorting to buying mobile capital goods that can be easily sold, such as
German automobiles, with the bank balances that cannot be withdrawn in cash
and are otherwise at risk from a Cyprus-style bail-in. Greek depositors have
realised that euro balances held in the banks are not reliably money. Folding
cash is still money, but that is all, and furthermore the folding stuff is
rationed.
The next blow for the euro could come from the exchange rate. If the euro
continues to lose purchasing power on the foreign exchanges, it is likely to
undermine confidence on the ground. And when that happens it will be
increasingly difficult for the ECB to retrieve the situation and maintain the
euro's credibility as money. It just doesn't seem sensible to take such enormous
risks with a currency that has existed for only thirteen years.
1 'Say's Law Of Markets' An economic rule that says that
production is the source of demand. According to Say's Law, when an
individual produces a product or service, he or she gets paid for that work,
and is then able to use that pay to demand other goods and services.
2 TARGET2 is an interbank payment system for the real-time
processing of cross-border transfers throughout the European Union. TARGET2
replaced TARGET (Trans-European Automated Real-time Gross Settlement Express
Transfer System) in November 2007.
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