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How austerity in Europe works

This post describes how austerity works in the European Monetary System where the euro is used as a currency. I will start by framing the difference between currency users and currency creators, then move to how central banks and government spending affect the economy to make it clear what is happening now in Europe.

Understanding government money is crucial here because in any economy using state money like the euro zone, government creates the currency unit of account to operate throughout the system. This currency is a promise to repay a specific amount of the currency unit of account backed by nothing but taxing authority. In state money systems, the government chooses a money of account and then imposes tax liabilities in that unit. It then issues the currency used to pay taxes.

This is a system in which the currency creator can create an infinite supply of IOUs if it so desires. As I like to say, if you march down to the government’s offices with your paper IOU demanding your money, you will just receive different IOUs in the same or different form summing to the same amount.  And while the government is the creator of currency, all other entities within the money system are currency users. They have to ‘get’ money, to ‘earn’ money because they cannot create it. If they cannot ‘get’ money, they are rendered insolvent.

In principal, modern money systems have two ways of controlling the money they create. One is via fiscal policy and the other is via monetary policy.

The principle way central banks conduct monetary policy is through interest rates. They raise or lower rates based on how high inflation is or, in the Fed’s case, also how low unemployment is. In the absence of changing rates, the central bank can also buy and sell financial assets. The central bank is never permitted to add net financial assets to the system. It can only conduct asset swaps, changing private portfolio preferences for the types of liabilities it buys and sells. For example, the central bank can buy Italian bonds and pay for them with reserves. These are asset swaps. There is no net addition to the number of net financial assets in the system, ever.

Unlike with the central bank, a national government can always add or subtract net financial assets in the system if it so chooses. This is the essence of fiscal policy. If you pay taxes, that creates a net loss of private sector financial assets. Deficit spending, on the other hand is a net gain of financial assets in the private sector. Whenever the government taxes you, on net, it is draining net financial assets from the system. Whenever the government spends, it is adding net financial assets to the private sector, instantly creating a zero-day net financial asset.

The problem for the euro zone, however is that the national governments are not currency creators. They are currency users and that means, like all other entities within the euro system, they have to ‘get’ euros because they cannot create them. If they cannot ‘get’ that money, they are rendered insolvent.

In a downturn, currency users are necessarily pro-cyclical. The economy is shrinking, so for currency users in general, revenue is shrinking. And since they have to ‘get’ euros, they cut back their outlays to deal with this or risk insolvency.

Now, this pro-cyclicality is always the case for national governments because a shrinking economy means shrinking tax revenue. Moreover, in the case of governments with automatic stabilisers to pay for, outlays are also increasing. So a worsening of the government’s budget is automatic in a recession. As currency users, the euro zone’s national governments must also be worried about insolvency as we now see. They too must act pro-cyclically then.

Procyclicality is one of the structural flaws of the euro zone; there is no federal agent to add any net financial assets counter cyclically during a recession. Thus, the euro zone business cycle will always have to be more volatile as every economic agent must act pro-cyclically. That makes current account imbalances a lightening rod for intra-European recrimination.

Against this backdrop, national governments are then forced to cut spending, reducing net financial assets in the private sector. Reducing net financial assets means sucking money out of the private sector. And that will reduce consumption demand and harm credit. if private sector debt levels are high and banking systems are leveraged, as they now are in the euro system, this reduction of credit leads to financial distress, bankruptcies, bank failures and potentially systemic failure. That’s what austerity means in an environment of high debt and excessive financial sector leverage.

So I am not at all optimistic about the outcome in the euro zone given the current policy path. There is zero chance the central bank can stop this train of events by easing policy because central banks are not fiscal agents and therefore cannot add net financial assets to the private sector. The only chance the euro zone has to escape the evolving debt deflation without a systemic collapse is by allowing the European Central Bank to take on a quasi-fiscal role in backstopping national government debt and allowing national governments to add net financial assets to the system without fear of insolvency. Short of this, we should definitely expect things in Euroland to get worse, not better.

P.S.- As I first explained in July:

This is a rolling crisis wave through the eurozone infecting more countries, closer and closer to the core. As Marshall wrote recently, this is a structural problem. All of the euro zone countries face liquidity constraints and all of them will eventually succumb to the rolling wave of yield spikes one by one until we get a systemic solution: full monetisation and union or break up.

Just because a policy leads to recession doesn’t mean it should be avoided, by the way. One should proceed with caution, cognizant of the causes and effects of policy and trying to avoid the perils of debt deflation. Remember my argument is to avoid depressions but to not avoid recessions. Some readers seem to forget that when I lay out the options.

The reason the ECB has not acted as yet is clear.

the ECB is buying just enough bonds to send a message to the Spanish and Italians that they need to live up to their austerity quid pro quo or else the ECB will stop buying.

At a minimum, the ECB wants to prevent ‘free riders’, if they are to move into a quasi-fiscal role. That means the quid pro quo is austerity for purchases. Moreover, institutionally, there is no appetite for capital losses at the ECB and that means buying Greek bonds is something the ECB sees as fraught with peril for the ECB itself.

Ireland is seen as the model here. Nicolas Sarkozy is reported to have said: "Ireland is today a country which is out of the crisis, or on the way out of the crisis". A leaked Troika document has admitted this policy has failed in Greece.

-Greece in debtor’s prison

This is why Greece has been cut loose. They create problems for the larger periphery economies of Spain and Italy. German Chancellor Merkel summed it up yesterday: "We would rather achieve a stabilisation of the euro with Greece than without Greece, but this goal of stabilising the euro is more important."

P.P.S. – And given that the European Commission is now saying that A country must leave the European Union if it leaves the Eurozone, it is clear that the ECB will eventually step in.

One final note: as the European Union has a balanced external current account, the large internal current account imbalances should be seen as a form of vendor financing, whereby the creditors, principally Germany forward their customers, the debtors trade finance in order to sell their wares. The Telegraph story about Porsches in Greece shows you an extreme example of how this works. Vendor financing works successfully as long as the customer can pay back the vendor financing, which in this case it cannot.

About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.

37 Comments

  1. hate the pensioners says:

    a worsening of the government’s budget is automatic in a recession

    ok but you can have others factors

    in europe you can have a huge Fdi in europe Ex china russia invest bln in real estate ecc.. (with eu/dl 1,4 probability are low)

    or with commercial balance

    the worst thing is that when ecb buy spanish italian bond buy under the price of emission in effects burning money!!

    i think that the worst thing is the aeging population of europe not like usa or uk and no inflation when you have a lot of welfare is a bad bad thing

  2. Bernd says:

    You are missing a substantial part of the argument. The ECB essentially has the same powers as any of the other central banks(BOE, BOJ, Fed,…). What is currently holding the ECB back is political considerations.
    What we probably disagree on is whether some of the austerity measures are actually sensible and whether this is the right time to implement them(in my opinion: yes, it´s never possible during easy periods).
    I guess what we disagree on on top of this is your basic analysis. The pain will reach France and Germany at some point, at which point the ECB will act just as any of the other central banks have. The current execise seems to be an effort to force Italy to implement at least some reforms.

    • Bernd, I have always understood the political considerations. Stop commenting here that I don’t. I am getting tired of it.

      • anon says:

        Correct.

        The “it will sort itself out” argument misses the nature of debt deflation: it’s caused by trade imbalances and is magnified by creditor-friendly gold standard policies.

        So the required fix is for the cause: trade and capital flow excesses, not for the symptom, exponentially worsening debtor economies.

        ECB inaction is causing irreversible, inexcusable damage while creating the false impression that the debtor economies are to “blame”.

        • David Lazarus says:

          I do agree, and why the current policies will not stop at Greece or even Italy. Italy really should not be even considered. Yes its debt to GDP is high but then so is its savings rate. Like Japan it can fund itself. Longer term it does need to make some changes such as retirement age but that applies to the entire western world where people are living longer and retirement age was set when life expectancy was much lower. There also needs to be pain from Italian politicians who are exceptionally well paid. That might make some savings and show that they are willing to take pain as well.

      • Bernd says:

        Hi Edward,

        I´m sorry for annoying you. I was just trying to argue a couple of points which I believed to be relevant, in the hope of getting some counterarguments from you. I really value your insights, but given that my comments seem to be unhelpful, I will gladly refrain from commenting in the future. Keep up the good work!

        • My apologies as well then, Bernd. Feel free to comment but please avoid leading in “You are missing a substantial part of the argument” on a subject we have covered in the past. I am surprised you keep on this subject when my view is well-documented and I have responded to you on this in the past. I have always understood the political considerations constraining the ECB.

  3. haris07 says:

    The ECB can easily behave as other central banks….just because they are the monetary authority for 17 countries instead of 1 doesn’t prevent them from doing it.

    Second thing is the distinction between fiscal and monetary is and will remain blurred. At some point, ECB will just issue currency to backstop all the governments.

    The real problem is that the government programs are unproductive (in Europe and elsewhere) and as a result create unproductive assets, asset bubbles, speculation rather than productive improvement. If the fiscal government deficit spending could be channeled effectively into productive uses alone, there would be no bubbles, but alas, there isn’t such a way in a corrupt society that is beholden to special intersts that usurp the government spending.

    In order to right this, the unproductive debts need to be wiped out, not in a disorganized manner (that would just cause anarchy!) but in a methodical fashion and with safety net to prevent chaos.

    Won’t happen, so end result is going to be bad.

    • Agree 100% haris. fiscal and monetary are blurred when the CB is helping the fiscal agent to monetise debt. But remember that it CANNOT add net financial assets. It can print all the money it wants. That won’t change the net financial assets in the system.

      The real problem is that the government programs are often unproductive, especially when cronyism is well-entrenched as it is now. Stimulus should be automatic and not discretionary or else you will see cash for clunkers and a host of similar hand outs that distort the economy.

      And I agree, you need the writedowns, plain and simple. Until you get them, we’re going nowhere.

  4. serge says:

    Edward, maybe you can help me on this. I understand how money is created in a monetarily sovereign nation such as the US: the government add net financial assets in the system by running a public deficit. Doing so, it can increase the amount of money in the economy in order to keep pace with the increase in the production of goods and services (assuming economy expands). No threat of inflation here.

    Now for non-monetarily sovereign nations, like in the euro zone, how does money creation take place?

    How is it possible to increase the amount of net financial assets in the EZ assuming that:
    - the ECB, like any Central Bank, cannot add net financial assets to the system
    - the eurozone governments are currency users and have to get their euros trough taxation to pay for their spending. They cannot create new euros trough public deficit. On the contrary, deficits must be financed with pre-existing euros.

    To ensure price stability with an expanding production of goods and services in an economy, you must be able to increase the net financial assets in this economy. Otherwise you have a deflation process.
    So, where does the increase in net financial assets come from in the eurozone?

    Thanks!

    • The national governments are constrained as users but their deficit spending adds net financial assets to the private sector just like sovereign governments.

      • Hugo Heden says:

        Posted a long comment that presumably was eaten by the spam filter?

      • Hugo Heden says:

        Ed,

        I’d like to consider an alternative view.

        MMTers often say that the Eurozone governments function as non-sovereigns (financially/monetarily), much like federal states in the U.S. The Eurozone governments are revenue constrained, much like households, firms, states and municipalities.

        Now, when we speak of those old “net financial assets”, I would argue that what is relevant is the net financial assets among the currency-users. That is the sector that cannot create “net financial assets” itself. Only the currency-issuer can create net financial assets for the currency-users.

        So, unlike you then, I would argue that the European governments should actually be considered to be part of what MMTers often call the “non-government sector”. In the case of the Eurozone, let’s call it the “currency-user sector” instead. The governments are revenue constrained — like households and firms. It is revealing to think of them as currency-users — just like the other revenue constrained entities.

        (Does this make sense so far?)

        (Will try to split up the comment here.)

        • Hugo Heden says:

          (Continued)

          Ok. We know that currency users themselves can never create net financial assets. The Eurozone governments can’t either. (Yes, they can issue bonds, just like corporations etc. But the bonds is a liability for the government and an asset for the bond holder — it nets to zero. A Eurozone government can not create net financial assets any more than a corporation can. A currency user borrowing money does not create net financial assets).

          The only entity that can create net financial assets is the sovereign currency issuer. What comes closest to that in the Eurozone is the ECB.

          But, as you note, the ECB does not create net financial assets either. It only changes the proportion of government bonds versus currency.

          So, given all this: There is no-one in the Eurozone that creates new Euro-denominated net financial assets for the currency users. The Euro-denominated net financial assets held by the currency users remain constant. Forever. Not that good a plan.. huh?

          There may some flaw in this reasoning though. This is just an utterly weird conclusion to arrive at.

          (My first comment here I think.)

          • Andrew P says:

            You are correct. This is why the British referred to the Euro as “a burning building with no exits” when they examined the scheme more than a decade ago.

            I see only one solution. The EZ proceeds to a maximal crisis with bank runs, panic, arson, and blood in the streets. The ECB declares a state of emergency, assumes full fiscal powers itself, and appoints a new Caesar to rule Europe with an iron fist.

          • Hugo Heden says:

            Thanks Andrew P,

            Where can I find other discussions along these lines? Old British debates? Wynne Godley?

            When designing the system they must have just not thought very much in terms of net financial assets.

            That would be like the U.S federal government running a balanced budget every year. Forever and ever. As MMTers would know: That just won’t work (given a growing economy with positive net saving propensities).

            To support a growing economy in such an environment, ever more endogenous debt must be issued. In the U.S (during the Clinton surpluses etc), I guess households have played that role. In Europe it’s the governments. In either case — it’s bound to burst as debt-to-income ratios for debtors reach unmaintainable levels.

            Your solution sounds super.

  5. serge says:

    Thanks for your answer Ed.
    Of course, this doesn’t solve the problem. Their deficits have to be financed trough tax revenues. No matter if it is today or tomorrow, the governments have to get the euros back.
    In other words, eurozone countries are doomed to a catastrophic deflationary scenario, if the amount of euros cannot be expanded indefinitely in the eurozone. That’s terrible.

  6. Anon says:

    Comparisons between Greece and Ireland are hard to make.
    It is likely that Ireland are indeed masters of austerity while the Greeks are bumblers or something else.
    But I prefer to look at the level of fiscal adjustment. Greece’s is above 16% while Ireland’s comes in at 5.3% so far, since both countries entered the “program.”

    • David Lazarus says:

      Ireland had fiscal and currency surpluses before the banking crisis. If Ireland had not guaranteed the banks liabilities, it would probably be recovering right now. So yes they are very different.

  7. Andrew P says:

    The EuroZone is even worse than a gold standard. Under a gold standard, miners create new financial assets. In the EZ, net financial assets are actually negative, and become more so in exponential fashion. If everyone is a currency user, and no net new currency can be created, total interest owed will always be greater than the amount of money that exists, and will compound with time. There really is no exit from this burning building, as William Hague quipped 13 years ago. Given the impossibility for the Europeans to negotiate and unanimously ratify a new Treaty, the only way out is for the existing EU institutions such as the ECB to usurp powers that they are not given, and establish a new EuroZone government on their own. I don’t see normally cautious politicians taking such bold steps until the moment of maximum crisis is reached and they have no other way out.

  8. plain jane says:

    Really, no new Euros are ever created? That does sound perfectly awful, if true.

    • Hugo Heden says:

      The term “Euro” is too vague though for that statement to be correct (although it sort of captures an intuitive understanding of the problem).

      One should really be saying this:

      No new Euro Denominated Net Financial Assets for the Currency User Sector are created.

      (No new “EDNFACUS” are created? Hmm, we need a better word for that.)

      Net financial assets for currency users is the currency (base money, vertical money) and bonds issued by the currency issuer.

      Normally, there is a currency issuer that adds NFA to the currency users as the economy grows and agents in the economy accumulate funds. That does not happen for the Eurozone.

      The amount of “EDNFACUS” remains constant.

      See http://mmtwiki.org/wiki/Money,_Government_and_Banking for a discussion on some of the concepts.

    • Hugo Heden says:

      The term “Euro” is too vague though for that statement to be correct (although it sort of captures an intuitive understanding of the problem).

      One should really be saying this:

      No new Euro Denominated Net Financial Assets for the Currency User Sector are created.

      (No new “EDNFACUS” are created? Hmm, we need a better word for that.)

      Net financial assets for currency users is the currency (base money, vertical money) and bonds issued by the currency issuer.

      Normally, there is a currency issuer that adds NFA to the currency users as the economy grows and agents in the economy accumulate funds. That does not happen for the Eurozone.

      The amount of “EDNFACUS” remains constant.

      [Would have provided a link with more info, but that just gets me spamtrapped.]

  9. plain jane says:

    OK. “EDNFACUS” it is! Rhymes with Eden-ficus, perhaps.

    The difference between vertical and horizontal money is (very slowly) starting to become clearer to me. Definitely a work in progress, though.

    Thank you for the link to the Wiki!

  10. Anonymous says:

    I have a hard time accepting what has been claimed here, i.e. that the ECB cannot add net financial assets to the system. As Hugo pointed out, there are no other currency issuers in the Euro area (governments are currency users as they have painfully discovered in the present crisis). It is my understanding that the ECB is the currency issuer, the Euro notes are part of its liabilities, and it is the only creator of vertical money in the eurozone. I find the statement about the ever decreasing total base money supply even harder to accept. Could you please point us to some evidence?

    • Central banks never add net financial assets to the private sector.

      You have to think about what is happening when the central bank conducts monetary operations. It has done an asset swap. The central bank drains financial assets from the private sector and replaces it with another one in the form of reserves or assets it previously owned with its purchase of any financial assets.

      If its purchases are sterilised, it purchases financial assets with newly created ‘printed’ base money and simultaneously sells an equivalent amount of other financial assets in exchange for base money. Here there is no change in the monetary base.

      If the central bank’s purchases are unsterilised, it simply purchases financial assets with newly created ‘printed’ base money. Here there is a change in the monetary base. But this change is offset exactly by the asset the central bank now holds. There is no change in net financial assets in the private sector. The CB has simply made an asset swap of base money for financial assets held in the private sector.

      • Anonymous says:

        I agree when it comes to the sterilized but not about the unsterilized operations.

        In the Euro area, as has been pointed out already, country governments are currency users, and therefore from a monetary system point of view they are private sector members, just like any corporation or household. Their debt, the bonds they issue, does not amount to new net financial assets (NFA) in the system, as it has to be purchased by other private sector agents (banks, investors etc.) with base money already created before. It’s operationally and functionally identical to a loan from a bank to an individual or a corporation. The loan creates a deposit, horizontal money has been created, no new net financial assets. The ECB is the only currency issuer in the Eurozone, not the individual
        countries (that are the equivalent of US states from a monetary point of
        view), and therefore the only entity that can create NFA.

        So, when the ECB enters the picture and performs an unsterilized operation to purchase these government bonds by other private sector participants with newly created base money, this operation is creation of vertical money (i.e. addition of new NFA to the private sector). The increase of its balance sheet (increase in assets by the amount of govt debt they acquired, increase
        in liabilities by the amount of new base money they created), reflects this new vertical money creation. Seeing it from the system level, part of the total horizontal money has been replaced by vertical money. The private sector as a whole is now less leveraged, and these marginal savings they have achieved are exactly the amount of the new vertical money that ECB injected into the system. Isn’t that new NFA?

        • No, it’s not new net financial assets. You seem to be confusing base money with net financial assets when you write:

          “So, when the ECB enters the picture and performs an unsterilized operation to purchase these government bonds by other private sector participants with newly created base money, this operation is creation of vertical money (i.e. addition of new NFA to the private sector).”

          The addition of base money has just been offset by the reduction of bonds. The CB has performed an asset swap; it has added base money but reduced the number of bonds available in the private sector. The net financial assets are unchanged.

          Only the fiscal agent changes net financial assets by either spending money, instantly creating a zero-day net financial asset that is not offset by an equivalent liability out of the private sector or by taxing, reducing private sector net financial assets without an equivalent offset. The CB cannot do this. It can only create base money in exchange for already existing assets or sell assets on its balance sheet and reduce base money.

          • Anonymous says:

            Except the ECB is the de facto fiscal agent in the Eurozone, and that government whose bond the ECB bought is just another private sector participant, like you and me. The ECB buying Greek or Italian bonds is exactly like the Fed buying state or muni bonds (not Treasuries) from private investors. Wouldn’t that amount to addition of NFA in the private sector?

            What you say in the last paragraph about the fiscal agent is true for governments with monetary sovereignty, such as the US or the UK, but not any of the Eurozone countries. There’s no fiscal agent that has the power to spend money, thus creating new NFA. The de facto fiscal agent is thus the ECB with these unsterilized operations, that increase the supply of those zero-day NFA available to the private sector.

            This could change if a fiscal union forms, complete with a central Treasury with taxation power and the capacity to perform deficit spending (or issue bonds to “fund” its fiscal operations), but at the moment this is not the case, and the Eurozone governments are NOT fiscal agents from a monetary operational point of view.

          • Look, I’m trying to tell you what the facts are. I have explained it succinctly and these facts are true regardless of whether governments are currency users.

            Central banks cannot add net financial assets. They are monetary agents. Think of it in terms of the balance sheet of the CB or the national government. When a central bank injects base money into the financial system, it buys an asset to do so. Its balance sheet shows an increase in liabilities from the reserves and an increase in assets from the assets acquired.

            When a national government deficit spends it credits accounts in the private sector without offsetting those credits with liabilities. From an accounting perspective, spending is like increasing liabilities that are offset by a reduction in capital. The opposite is true with taxes. Liabilities decrease and the offset is not assets but akin to capital.

            You need to understand the mechanics. It’s irrelevant whether the national government is a currency user. Its status as a currency user is only relevant in terms of solvency, just as with the gold standard. If one thinks of the euro as gold and the national currencies as fixed to it, then this becomes clear. Of course the eurozone governments are fiscal agents, just as they were under the gold standard. What else could they be?

          • Anonymous says:

            “When a national government deficit spends it credits accounts in the
            private sector without offsetting those credits with liabilities”.

            I respectfully disagree. When a national government deficit spends, it credits other accounts (at a bank presumably) and debits its own (at the same bank). It cannot create new euros into existence. The government is just another private sector agent and it has to earn its money (or borrow it) before it spends it.

            “It’s irrelevant whether the
            national government is a currency user. Its status as a currency user is
            only relevant in terms of solvency, just as with the gold standard. If
            one thinks of the euro as gold and the national currencies as fixed to
            it, then this becomes clear. Of course the eurozone governments are
            fiscal agents, just as they were under the gold standard. What else
            could they be?”

            When I refer to fiscal agent, I mean from a monetary system point of view, otherwise the currency creator, the only entity in the system with the ability to decifit spend without limit. I don’t want to go to semantics so let’s stick to currency user/creator terms.

            And let’s start from the one common point we have so far: that the national governments are currency users. With that in mind, can you please tell me who is the currency creator in the Eurozone?

          • The government is not a just another private sector agent. It is the public sector. The currency user status does not alter its function in society. There is no fiscal agent from a monetary point of view.

            Think about it for a second; the mechanics of government spending in Italy under the euro are largely the same as they are in the US or the UK, and largely the same as they were under the gold standard. Government’s fiscal role of adding and subtracting net financial assets is not about the currency user status. The fiscal role doesn’t change because of the currency. All that has changed with the euro is the potential for national bankruptcy. Everything else is the same.

          • Anonymous says:

            But this (the potential for bankruptcy) and the fact that they are not currency creators changes the whole game. It’s not a small difference, it’s a fundamental one.
            And how are the mechanics the same? When the US government spends $100, it credits the payee’s account and debits its own account at the Fed (an effective overdraft and at the same time an increase in the base money and the NFA in the system). On the other hand, when the Italian or Greek government spends, it has to actually have the money in hand (from the money that already exists in the system) in order to spend. In Greece in particular this has already reached a point where the government does not have money and therefore it can’t spend. CAN’T. Spending in certain school facilities stopped, some suppliers are not paid etc. This is black and white compared to the US or the UK situation.
            And I repeat my previous question: with governments being currency users, who is the currency creator in the Eurozone?

          • What you’re saying about net financial assets is not correct. I can’t keep going around in circles on it.

            At a minimum we agree that this currency user thing is dramatic and fundamental,turning the euro area countries into something more akin to US states and that this has created a crisis.

          • P.S. the US federal government is legally prohibited from running overdrafts at the Federal Reserve.

  11. Derivatives_Trader says:

    I have a hard time accepting what has been claimed here, i.e. that the ECB cannot add net financial assets to the system. As Hugo pointed out, there are no other currency issuers in the Euro area (governments are currency users as they have painfully discovered in the present crisis). It is my understanding that the ECB is the currency issuer, the Euro notes are part of its liabilities, and it is the only creator of vertical money in the eurozone. I find the statement about the ever decreasing total base money supply even harder to accept. Could you please point us to some evidence?

    • Central banks never add net financial assets to the private sector.

      You have to think about what is happening when the central bank conducts monetary operations. It has done an asset swap. The central bank drains financial assets from the private sector and replaces it with another one in the form of reserves or assets it previously owned with its purchase of any financial assets.

      If its purchases are sterilised, it purchases financial assets with newly created ‘printed’ base money and simultaneously sells an equivalent amount of other financial assets in exchange for base money. Here there is no change in the monetary base.

      If the central bank’s purchases are unsterilised, it simply purchases financial assets with newly created ‘printed’ base money. Here there is a change in the monetary base. But this change is offset exactly by the asset the central bank now holds. There is no change in net financial assets in the private sector. The CB has simply made an asset swap of base money for financial assets held in the private sector.

      • Derivatives_Trader says:

        I agree when it comes to the sterilized but not about the unsterilized operations.

        In the Euro area, as has been pointed out already, country governments are currency users, and therefore from a monetary system point of view they are private sector members, just like any corporation or household. Their debt, the bonds they issue, does not amount to new net financial assets (NFA) in the system, as it has to be purchased by other private sector agents (banks, investors etc.) with base money already created before. It’s operationally and functionally identical to a loan from a bank to an individual or a corporation. The loan creates a deposit, horizontal money has been created, no new net financial assets. The ECB is the only currency issuer in the Eurozone, not the individual
        countries (that are the equivalent of US states from a monetary point of
        view), and therefore the only entity that can create NFA.

        So, when the ECB enters the picture and performs an unsterilized operation to purchase these government bonds by other private sector participants with newly created base money, this operation is creation of vertical money (i.e. addition of new NFA to the private sector). The increase of its balance sheet (increase in assets by the amount of govt debt they acquired, increase
        in liabilities by the amount of new base money they created), reflects this new vertical money creation. Seeing it from the system level, part of the total horizontal money has been replaced by vertical money. The private sector as a whole is now less leveraged, and these marginal savings they have achieved are exactly the amount of the new vertical money that ECB injected into the system. Isn’t that new NFA?

        • No, it’s not new net financial assets. You seem to be confusing base money with net financial assets when you write:

          “So, when the ECB enters the picture and performs an unsterilized operation to purchase these government bonds by other private sector participants with newly created base money, this operation is creation of vertical money (i.e. addition of new NFA to the private sector).”

          The addition of base money has just been offset by the reduction of bonds. The CB has performed an asset swap; it has added base money but reduced the number of bonds available in the private sector. The net financial assets are unchanged.

          Only the fiscal agent changes net financial assets by either spending money, instantly creating a zero-day net financial asset that is not offset by an equivalent liability out of the private sector or by taxing, reducing private sector net financial assets without an equivalent offset. The CB cannot do this. It can only create base money in exchange for already existing assets or sell assets on its balance sheet and reduce base money.

        • No, it’s not new net financial assets. You seem to be confusing base money with net financial assets when you write:

          “So, when the ECB enters the picture and performs an unsterilized operation to purchase these government bonds by other private sector participants with newly created base money, this operation is creation of vertical money (i.e. addition of new NFA to the private sector).”

          The addition of base money has just been offset by the reduction of bonds. The CB has performed an asset swap; it has added base money but reduced the number of bonds available in the private sector. The net financial assets are unchanged.

          Only the fiscal agent changes net financial assets by either spending money, instantly creating a zero-day net financial asset that is not offset by an equivalent liability out of the private sector or by taxing, reducing private sector net financial assets without an equivalent offset. The CB cannot do this. It can only create base money in exchange for already existing assets or sell assets on its balance sheet and reduce base money.

          • Derivatives_Trader says:

            Except the ECB is the de facto fiscal agent in the Eurozone, and that government whose bond the ECB bought is just another private sector participant, like you and me. The ECB buying Greek or Italian bonds is exactly like the Fed buying state or muni bonds (not Treasuries) from private investors. Wouldn’t that amount to addition of NFA in the private sector?

            What you say in the last paragraph about the fiscal agent is true for governments with monetary sovereignty, such as the US or the UK, but not any of the Eurozone countries. There’s no fiscal agent that has the power to spend money, thus creating new NFA. The de facto fiscal agent is thus the ECB with these unsterilized operations, that increase the supply of those zero-day NFA available to the private sector.

            This could change if a fiscal union forms, complete with a central Treasury with taxation power and the capacity to perform deficit spending (or issue bonds to “fund” its fiscal operations), but at the moment this is not the case, and the Eurozone governments are NOT fiscal agents from a monetary operational point of view.

          • Look, I’m trying to tell you what the facts are. I have explained it succinctly and these facts are true regardless of whether governments are currency users.

            Central banks cannot add net financial assets. They are monetary agents. Think of it in terms of the balance sheet of the CB or the national government. When a central bank injects base money into the financial system, it buys an asset to do so. It’s balance sheet shows an increase in liabilities from the reserves and an increase in assets from the assets acquired.

            When a national government deficit spends it credits accounts in the private sector without offsetting those credits with liabilities. From an accounting perspective, spending is like increasing liabilities that are offset by a reduction in capital. The opposite is true with taxes. Liabilities decrease and the offset is not assets but akin to capital.

            You need to understand the mechanics. It’s irrelevant whether the national government is a currency user. It’s status as a currency user is only relevant in terms of solvency, just as with the gold standard. If one thinks of the euro as gold and the national currencies as fixed to it, then this becomes clear. Of course the eurozone governments are fiscal agents, just as they were under the gold standard. What else could they be?

          • Derivatives_Trader says:

            “When a national government deficit spends it credits accounts in the
            private sector without offsetting those credits with liabilities”.

            I respectfully disagree. When a national government deficit spends, it credits other accounts (at a bank presumably) and debits its own (at the same bank). It cannot create new euros into existence. The government is just another private sector agent and it has to earn its money (or borrow it) before it spends it.

            “It’s irrelevant whether the
            national government is a currency user. Its status as a currency user is
            only relevant in terms of solvency, just as with the gold standard. If
            one thinks of the euro as gold and the national currencies as fixed to
            it, then this becomes clear. Of course the eurozone governments are
            fiscal agents, just as they were under the gold standard. What else
            could they be?”

            When I refer to fiscal agent, I mean from a monetary system point of view, otherwise the currency creator, the only entity in the system with the ability to decifit spend without limit. I don’t want to go to semantics so let’s stick to currency user/creator terms.

            And let’s start from the one common point we have so far: that the national governments are currency users. With that in mind, can you please tell me who is the currency creator in the Eurozone?

          • The government is not a just another private sector agent. It is the public sector. The currency user status does not alter its function in society. There is no fiscal agent from a monetary point of view.

            Think about it for a second; the mechanics of government spending in Italy under the euro are largely the same as they are in the US or the UK, and largely the same as they were under the gold standard. Government’s fiscal role of adding and subtracting net financial assets is not about the currency user status. The fiscal role doesn’t change because of the currency. All that has changed with the euro is the potential for national bankruptcy. Everything else is the same.

          • Derivatives_Trader says:

            But this (the potential for bankruptcy) and the fact that they are not currency creators changes the whole game. It’s not a small difference, it’s a fundamental one.
            And how are the mechanics the same? When the US government spends $100, it credits the payee’s account and debits its own account at the Fed (an effective overdraft and at the same time an increase in the base money and the NFA in the system). On the other hand, when the Italian or Greek government spends, it has to actually have the money in hand (from the money that already exists in the system) in order to spend. In Greece in particular this has already reached a point where the government does not have money and therefore it can’t spend. CAN’T. Spending in certain school facilities stopped, some suppliers are not paid etc. This is black and white compared to the US or the UK situation.
            And I repeat my previous question: with governments being currency users, who is the currency creator in the Eurozone?

          • What you’re saying about net financial assets is not correct. I can’t keep going around in circles on it.

            At a minimum we agree that this currency user thing is dramatic and fundamental,turning the euro area countries into something more akin to US states and that this has created a crisis.

          • P.S. the US federal government is legally prohibited from running overdrafts at the Federal Reserve.