Economic fundamentals and the eurozone

Mainstream macroeconomics presents monetary and fiscal interventions as independent policy options, and this spills over to institutional structures. In the UK, for example, the Bank of England and the Treasury respectively assume responsibilities for monetary and fiscal policy; and in the eurozone, Chancellor Merkel resists pressure from President Sarkozy to allow the ECB to rescue (potentially) insolvent national treasuries.

Such presentations are wrong. A balance sheet identity (the ‘credit counterparts to money’) shows all macroeconomic policy options (monetary policy, fiscal policy, interest rate policy, credit policy and exchange rate policy) to be interdependent. A related error is the failure to extend monetarist analysis to its limit; that is, to fiscal monetarism.

Monetarism portrays money supply growth beyond a general willingness to hold money as the cause of price inflation. The broader presentation of fiscal monetarism draws no distinction between sovereign debt instruments – that is, between sovereign bonds and money. Sovereign debt grows with fiscal deficit spending; and the sustainability ofthat spending rests upon the willingness of market participants to hold sovereign debt (money and bonds). As the volume of sovereign debt rises (in relation to potential to draw upon tax revenues to repay that debt), the greater the exchange risk premium; or, for a sovereign state within a single currency area, the greater the default risk premium.

If fiscal surpluses are not achieved during periods of prosperity, sovereign debt may rise to unmanageable proportions in any subsequent recession. Monetary stability requires a sovereign state to accept the discipline of an upper limit to the real value of its debt. Interest payments to bond holders must be financed and ultimately redeemed from fiscal surpluses. Sovereign debt reaches an upper limit when the capitalised value of servicing the debt exhausts the capitalised value of expected future fiscal surpluses. Beyond that limit, the volume of debt selling exceeds that of debt buying, which causes yields to rise and the value of debt to fall. As that depreciation fuels domestic price inflation, the real value of sovereign debt is held at the limit.

In finer analytical detail, the pace of inflation may be determined by the composition (bonds or currency) of sovereign debt; that is, the higher the proportion of fiscal deficit spending financed by issuing currencythe faster the pace of inflation. Put differently, sovereign debt is more willingly held the greater the proportion that is interest-bearing.

When a sovereign state enters a single currency area, the ‘safety valve’ of currency depreciation is replaced by the risk of sovereign debt default. For the eurozone, the initial convergence criteria (1992) and the subsequent Stability and Growth Pact (1997) respectively set and reasserted upper limits to fiscal deficit spending and sovereign debt. Had those parameters been strictly applied, the eurozone might have avoided a crisis in its current form. That crisis was entirely foreseeable:

‘Can anyone doubt that the ECB will receive new treaty instructions when – without a sovereign currency and the debasement option to turn to – insolvent members of the EMU find themselves bereft of new credit opportunities?’ (Steele, 2001, p. 48)

More generally, however, as a principle of overblown government, political agendas override sound economics. In his foreword to a recent pamphlet covering the history of ‘the European project’, Peter Jay endorses criticism of the Financial Times for its ‘Euro-mania’; but he praises that newspaper’s most prominent economic commentators Samuel Brittan and Martin Wolf, who he describes, respectively, as having

‘been consistently clear-eyed in dissecting the delusions and dangers of large currency blocs which suppress the all-important shock-absorbers between economies, namely changeable exchange rates’;

and as having

‘repeatedly and devastatingly exposed the basic economic fallacies on which the dream of monetary union among multiple countries of uneven competitiveness was based’(Oborne and Weaver, 2011, xi-xii)

In this particular instance, however, it is the case that political agenda overrode sound economics. According to Jay, the political project of ‘Eurocentralisation’ was directly served by the periodic economic crises that ‘supplied the political context for the next great leap forward’ (ibid.).

History shows many episodes of decline and fall: Greek, Roman, Ottoman, Soviet and British. Whatever short-term palliatives and/or fiscal reforms and/or treaty changes might give life-support to European hegemony, it is unlikely to survive to a ripe age.

Further reading:

Oborne, P. and F. Weaver (2011) Guilty Men, Centre for Policy Studies.

Steele, G. R. (2001) ‘Currency options: Hayek and competing currencies’, Economic Affairs, vol. 21, no. 2, June, pp. 46-8