The Euro and International Financial Stability

We are witnessing a fundamental dualism in the eurozone, many “real euros” in place of a single currency (

the

euro) that would maintain financial stability and promote growth. This manifests in countries like Greece and Italy (and also Portugal and Spain to some extent) experiencing problems with their public debt forcing them to adopt austerity measures to manage their public deficits and spending.

The first fact has to do with the “creative accounting” of EU bureaucracy. The creation of the euro zone was largely a political decision in the altar of which they sacrificed actual deficits, actual rates of inflation and public debt as a percentage of GDP. These aggregate indicators are easy to monitor but they are not always transparent to the public. More importantly, as aggregate indicators are only rough measures of the fiscal burden or economic efficiency.

What will happen with Greece’s public debt? In fact, the EFSF is nothing but a set of consistent policies aiming at full repayment of the debt using bailouts. In fact, the scheme is apparently a bailout for European banks and the European financial sector as a whole.

What should have been done instead of the EMU? Or, what would have been a reasonable basis upon which to base a sound monetary union? We do not intend to pose this as a historical question but rather as a way to understand the best way to form stable currency unions in the future.

Several people pose the question: Why would the EU not accept the conversion of all government bonds to the so called Eurobonds? That would be a reasonable idea, if the Bureaucracy of the EU did not have its own objectives which are quite different from national objectives, a fact that would never occur in the US or the different regions of the UK.

The author has been an alternate member of the EPC (Economic Policy Committee) representing Greece (along with the governor of the Bank of Greece and the chairman of the Council of Economic Advisors of the Ministry of Finance) during 1997–2000. Although, in this capacity, one cannot possibly know everything that happened in the “inner circles” of the European bureaucracy, one thing was clear.

The short answer is not necessarily. First of all, the markets dictate competition of currencies in order to result into endogenously formed currency unions. When money was introduced, it had to compete with all sorts of alternative exchange media like furs, corn or clay vases and jewels. It prevailed not because someone ordered it. In fact, someone ordered gold and silver coins with his face upon it (kings, emperors etc.) precisely because that sort of money was already in use, in one form or another, in the vast majority of exchanges.

Historical experience with monetary unions suggests that they were dissolved when it was found advantageous to inflate the currency by changing the silver content of the papal coinage. The Latin Monetary Union of 1865 undermined its own foundation before it adopted the gold standard in 1878 and was sustained, formally at least, until 1927. It is no accident that it the gold standard was found to be the only way to preclude individual members from engaging in inflationary policies. The union was dismantled as the result of the First World War and its financing. That was hardly an efficient way to dissolve the monetary union and suggests that returning back to national currencies is not a way to ensure international financial stability.

The question whether to allow complete fiscal freedom for national governments in the immediate period following the dissolution of the euro is not so much related to stability of the international financial system: Most Europeans governments

will not

do so. Electoral and other motives might, of course, make

some

of them resort of inflationary finance. The economic history of Greece in the 1980s shows us that inflationary finance has a limit and, after that, governments rely on borrowing. In the transition period or after, that will not be possible since it is already anticipated by the international markets.

To understand the essence of a crisis or depression, as a basically monetary phenomenon, is necessary. If the crisis has been the result of a credit expansion then proposing credit expansion as a cure, would be an absurd idea. Indeed, the 2008 crisis resulted from an unprecedented expansion in the housing market in the US but it was transmitted to Europe only because credit was already loose, given tight monetary policies. Indeed, European and US investment and inventories were huge just before 2008 (and for the whole period 2000–2008), the same was also the case in Greece, and Greece in particular experienced and unprecedented expansion of credit on all fronts (household, business, etc.).

As we remarked, there are bailouts at several levels. To bailout the public sector wages and salaries or pensions in Greece, Greece needs a plan according to the Poincare lines. A public debt authority and a pensions authority that will consolidate obligations and revenues, backed on real resources. This is a matter of short run importance and immediate consideration must be given to it.

The destabilizing effects arising from bailout programs can be found in the massive re-allocation of resources that they induce and divert from other uses that, normally, would have a priority. The underlying motivation for a bailout lies in preventing large banks to fail and thus prevent a collapse of the entire banking system. The amount and extent of the bailout depends on: (a) the amount artificial credit created by the entire banking system, induced by the ease of credit and low interest rates imposed by the Central Bank, and (b) the extent of malinvestment induced by the artificial credit expansion.

It may appear at first sight that the EMU has done everything possible to maintain stable monetary and credit conditions. National currencies were substituted for a common currency whose stability rests upon restrictions on fiscal deficits and inflation.

In the Austrian school’s tradition, the commercial banks should be free to issue currency, exactly as the government does since the objective is to limit the monopoly of the government or an European central bank on money. Currency competition is the way to eliminate most of these currencies in favor of a few, or even a single one, in the long, provided this currency is stable enough to accommodate the plans of private agents.

The theory is precisely the same when it comes to governments that borrow from the international markets. The acquired funds could have been transferred to the private sector or the public sector for investment and consumption, or they could have been plainly wasted in one way or another. Borrowing in the form of issuing bonds is no different to plain

fiat

money creation before the time of maturing. After that time the government has to pay back a multiple of the initial amount determined by the rate of interest on its bonds.

Following its announcement of lower interest rates, the ECB decided to lend 489 million euros to selected European banks at the low rate of 1 % (December 21, 2011). This amounts to an increase in money supply by a significant amount and a further lowering of interest rates, at least for certain European banks and the projects that will be financed. What will be the likely effects of this policy action? According to the analysis of the Austrian school, the effect depends on how the monetary expansion will be distributed among consumption and production and also among the various branches of production and the various branches of consumption.

To look closely at the “Greek problem” means examining some aspects that are often taken for granted. One of them is the low productivity of the Greek economy, the absence of competitiveness, the highly regulated markets

etc

.

The ECB during 2012 set a new mode of monetary and credit policy, amounting to new credit given at low interest rates of 1 % to be propagated into the system by selected commercial banks. We have shown that, despite its prospects, this policy is futile and will, in fact, result into a new recession. If we consider this as the first in a series of last attempts to save the essential unity of the Eurozone, the question begs itself: What will happen in the future?

One of the reasons for the growth and prosperity of the United States has been the fact that we have enjoyed one money throughout the large area of the country. We have had a gold or at least a single dollar standard with the entire country, and did not have to suffer the chaos of each city and county issuing its own money which would then fluctuate with respect to the moneys of all the other cities and counties. The nineteenth century saw the benefits of one money throughout the civilized world.

A monetary Union is not good by itself unless it rests on real economic foundations.

A good monetary Union, in turn, is a Union that protects the stability of the value of money

. Without going into unnecessary investigations regarding the “value of money”, suffices to say that the—often overlooked-flight from the euro and the sky—rocketing gold prices are not unrelated to the policies of the ECB that reduced considerably the value of the euro through its monetary and credit policies. Of course lower productivity in the EU compared to the US is often blamed but this cannot be the whole story. In fact, the lower European productivity can be

explained

by the

mal

investents following the credit policies of the ECB.

We maintain that it cannot but be the case that there is low inflation in the EMU; actual inflation is hidden below the statistics and the sizeable movements in relative prices which as a result of the credit and monetary expansions, set in motion sizeable reallocations of investment as well as new investment which is, in fact,

mal

investent. The flight from euro is documented in the recent increases of gold’s prices, so we hardly need any evidence in addition to that. But the flight from euro can result only as the result of depreciation relative to the US dollar

and

the associated inflation in the eurozone.

The euro’s most significant advantage, from the Austrian point of view, is the enforcement of stability in exchange rates and the discipline that it imposes on governments that have the motives to be fiscally and monetary irresponsible. The point has been emphasized by de Soto (2012, “An Austrian defense of the Euro”, Ludwig von Mises Institute)

To the extent that there is a European bureaucracy the question is whether there is a need to move further to coherent governance or stay within the present, fragmented system. Coherent governance requires a notion of common political and economic interests whose objective foundation already exists but has not found yet a concrete, material form. Conditions for financial stability exceed the national boundaries and cannot be treated properly within them. Even small steps

cannot

be taken towards more stable financial sector by the member-states themselves and solely at the national level. For example, national banks that impose willingly upon themselves a 100 % reserve requirement will have to face the competition from their foreign counterparts.

With competitive banking and/or freely moving interest rates in Europe, what would happen if elsewhere in the world, there was monetary or credit expansion and competition from foreign banks and financial institutions? If foreign governments (say the United States) continue to expand their deficits and/or the money base, a classical recession will take place to correct the misallocations of investment with its subsequent effects in factor and product markets. The recession would certainly affect European exports to the United States but it would promote them in countries that used to import from the United States. With no pressures upon the Euro coming from fragile financial markets, the appreciation of the dollar would only make the recession worse in the United States.

Von Mises has insisted that money is not a creation of the Law or a simple medium of exchange but rather a commodity itself whose value has to be determined, along with the prices of all other commodities, in the general equilibrium of an unhampered, competitive economy.

We have argued that fiscal consolidation is the necessary first step towards what is really required for sound economic systems; namely, a general reduction in the size of taxes and expenditures. This, again, is easier to do at the global rather than the national level. Fiscal reduction, as part of coherent governance, should be accompanied by (1) limiting fractional banking, (2) liberalizing the financial markets with special attention to freely determined interest rates, and (3) removing the hurdles and obstacles to mobility of resources in the Eurozone. This fiscal reduction can, of course, be designed as a gradual process whose details, however, have to be delineated so that the private sector can adjust as best as possible to predictable changes.

We have chosen construction as an example, deliberately, because this sector is usually the first to be hit by the recession and also because of the price bubble that has created an immense stock of unsold houses and apartments in the United States and Europe. We see, all over Europe and particularly in its South, an impressive fact: Although prices adjust, they do so sluggishly and, of course, construction, has not recovered. Despite the large income shocks prices of certain consumption goods have not decreased considerably, and unemployment has increased. In Greece, price adjustments took considerably more time relative to the rest of Europe and, at the same time, they have not adjusted as much.

We have argued that a reduction in government expenditure will result in re-distributional effects arising from the re-shifting of resources from the public to the private sector. Since new funds are now available for savings the effect is likely to be felt, first of all, in the profitability of the banking sector and its overall stability. This is important because it is a common misconception that financial stability is endangered during a recessionary period

if

the government does not act in an expansionary manner. In fact, quite the opposite is true. First of all, the commercial banks are not forced to buy government debt and create an artificial credit expansion whose final effects will be quite the opposite from what the government intended. Second, financial stability is maintained in the short-run by the transformation of expenditure cuts to savings. Third,

if

we have a reduction of public debt it is hard to see how overall financial stability is hampered by the austerity measures. The question is whether we will have, indeed, a reduction of public debt. Accommodation of interest payments would seem impossible in the short-run unless the measures are accompanied by a re-structuring of the tax system which yields higher tax revenues.

International financial stability depends on flows of funds that exploit arbitrage opportunities in international markets, in the form of various financial products, some of which are considered “toxic” or harmful to the economy.

A significant aspect of the bail-out programs was that banks were forced to buy government bonds of European countries in distress (particularly Spain and Portugal) so that interest rates on debt could be contained and the governments would find it easier to repay. This expansion of debt or accommodation, of course, acted as a catalyst and, in effect, it was equivalent to a “European bond” backed by the European Central Bank—an idea that was resisted forcefully, in this form, by Germany. But the effect was the same, on the main. The accommodation of debt and the artificial reduction of interest rates were not in line with the changes that were taking place in the European economies for years, following the significant credit expansion. If it were not for the significant increase of institutional uncertainty generated by the policies that were shaping up in the European Union—given that nothing of this magnitude has been allowed by the Treaty of Maastricht or Basel I—the signals that were given to the private sector, amounted to the fact that “speculation” with the public debt was more profitable compared to fostering transactions in stock markets or real investment.

The selling of bonds from countries in distress, like Greece, put a strain on Greek resources to accommodate these transactions. The lower demand for Greek debt should

decrease

rates

and

the number of outstanding bonds. Since net supply decreased, there should be a net increase in rates and a further reduction in outstanding bonds. What happened then was further selling of bonds by the European Central Bank which

would

lower the bond rates if it were not for the fact that their demand was increased by the commercial banks: Eventually this restored, approximately, the previous equilibrium at almost the same bond rates! Clearly this policy did not help the payment of short-term obligations, which is why the European Central Bank resorted to the policy of “hair-cut” inspired by the Latin American debt crisis of the 1980s.

According to certain assessments the European Union and the common currency do not reflect the Christian-Democratic vision of their founding fathers and the Treaty of Rome, but rather a socialist vision for the creation of a mega-state.

Without the European Central Bank’s ability to divert massive resources to banking and produce a tremendous distortion, in addition to the one that led to it through maintaining artificially low interest rates, there would be little reason to worry about stability in the banking and financial intermediation sectors.

“It is not possible to theorize a priori about the future evolution of money. Our theoretical analysis must be limited to the observation that money is an institution which emerges spontaneously, like law, language, and other legal and economic institutions which involve an enormous volume of information and appear in an evolutionary manner throughout a very prolonged period of time in which many generations of human beings participate.

Voices are mounting in the South of Europe that servicing the public debt is unsustainable and to avoid the “counter-productive” austerity measures it is necessary to have another generous haircut accompanied with rescheduling of interest payments. The concern of the ECB and the IMF is that extensions of this sort implied by rescheduling will be used exclusively to avoid cutting expenditures and sustaining various inefficiencies in the public sector and, primarily, in rationalizing the tax revenue collection system. The concern of Southern governments and Greece in particular, is that the austerity measures reinforce the deep recession (of the order of negative 7–5 % growth rates according to various forecasts).

Common sense suggests that transactions and contracts are denominated in terms of currencies that tend to be stable and under conditions of relative stability, such contracts tend to account rationally for the inherent uncertainty in exchange rates. The discussion about “exogenous shocks” was found to be largely irrelevant to our discussion and uncertainty, for the most part, is not due and does not come from “exogenous” factors to the economy as a whole but rather from policy uncertainty. Confidence to a currency means confidence to the event that a stable configuration of fiscal and monetary policies will persist in the future without drastic changes beyond any expectation. If such changes occur there will be price and quantity effects in all markets along with a revision of plans for future investment and the re-allocation of financial portfolios. The opponents of the Euro tend to focus too much on appearances instead of analyzing the issues in depth. They argue that because the European South ran large public deficits at a specific time period the whole experiment of the common currency is at stake and then they argue about optimal currency areas, “asymmetric shocks” and various other matters that are only peripheral if not totally misguided and unfounded.

Although the rate of interest, as we have emphasized repeatedly plays a fundamental role in the allocation of investment, particularly as the result of cheap credit, in most instances the crucial role is played by the rate of profit. The interest rate, at least in the beginning of business fluctuations resulting from an artificial expansion of credit, facilitates the expansion and in that way it leads to distortions between the distribution of investment plans and the distribution of consumption. Yet the further induced re-allocations of resources are governed by the rate of profit. This shows, in particular, that the rate of interest does not play the significant role that economists trained in thinking about “aggregates” suppose that it plays. With a given rate of profit per annum, which can be obtained proportionately at any subdivision of time such as a month or a quarter, the “Ricardo effect” takes place. As Hayek notes:

The international structure of industry is no less affected by changes in the rates of profit not only among the sectors of a given economy but internationally. The less capitalistic sectors can move internationally more freely compared to the more roundabout processes but the formation of a national industrial structure is not independent or isolated from the international shifts of funds that take place as the result of changes in all relative prices. On a world scale, economic growth and the dominance of more roundabout processes depends primarily on the prices relative to the consumer goods sectors—or the sectors closer to them in term of durability—and the international relative prices for the same type of equipment. In a frictionless world funds would tend to move to production where prices and profit rates are higher taking into account the variable costs but this movement is limited although it materializes through international trade. A rise in the demand of consumer goods in one country will tend to be supported by raw materials or capital of low durability either from the domestic market or through imports if that proves to be advantageous. During a short-run period which is determined by the time requirements of placing new orders and delivering the local industry can expand to accommodate the increase demand but eventually imports will prevail if the foreign markets can supply at significantly lower prices (after taxes, tariffs, transportation costs, etc.).

Another important aspect of the problem is that the re-structuring of industry on the European level has important implications for financial stability. Artificially low interest rates created a “bubble” in the durables sector which, when exploded, brought the American and European economies through the most deep recession since 1929. The very idea that interest rates are policy variables that can be changed at will, due to the belief that there is a negative relationship with “aggregate investment” and “aggregate demand”, should be abandoned in the interest of international financial stability. The markets operate on a global level not only through real variables but also through various contracts and agreements in the financial markets. Trading of these contracts is extremely easy and anticipates the low turnover of various resources and factors of production, including capital. The underlying forces that led to the sub-prime crisis were in effect long before and the crisis came as a natural outcome of processes that were operating under the influence of movements in relative prices and rates of interest along with rates of profit.

In this part we test the validity of the Austrian theory of the Business Cycle (

ABC

). We use data for major economies over 1980–2006 well before the 2008 financial crisis. We utilize the information available in the most efficient manner through panel unit root panel co-integration analysis. The relationships between variables in the Austrian theory of business cycle are studied with co-integration techniques. We investigate the causality implications of the Austrian theory

at various time horizons

using the method of Dufour et al. (

2006

). All our results tend to favour the Austrian theory in general terms