The Euro, Currency Sovereignty and Adopting a Foreign Currency
A country might choose to use a foreign currency for domestic policy purposes. As mentioned in a previous blog post, even the US government accepted foreign currencies in payment up to the mid nineteenth century, and it is common in many nations to use foreign currencies for at least some purposes. Here, however, we are examining a nation that does not issue a currency at all.
Let us say that some national government adopts the US Dollar as the official currency—accepted at public pay offices, with taxes and prices denominated in the Dollar. Banks make loans and create deposits in Dollars. Government spends in Dollars. While the nation cannot create US Dollars, it is clear that households, firms, and government can create IOUs denominated in Dollars.
As discussed earlier, these IOUs are part of the debt pyramid, leveraging actual US Dollars. Some of the IOUs (such as bank deposits) are directly convertible to US Dollars. The currency in circulation is the US Dollar (US coins and notes), but many or most payments will be done electronically. Check clearing will be done at the country’s central bank, by shifting central bank reserves that are denominated in Dollars.
Note, however, that withdrawals from banks are made in the form of actual US Dollars. Further, international payments will be made in Dollars (a current account deficit will require transfer of Dollars from the country to a foreign country). How is that accomplished? The domestic central bank will have a Dollar account at the US Fed. When payment is made to a foreigner, the central bank’s account is debited, and the account of some other foreign central bank’s account is debited (unless, of course, the payment is made to the US).
Because this nation does not issue Dollars, but rather uses Dollars, it must obtain them to ensure it can make these international payments and can meet cash withdrawals so that Dollar currency can circulate in its economy. It obtains Dollars in the same way that any nation obtains foreign currency—because the Dollar really is a foreign currency in terms of ability to obtain cash and Dollar reserves. Hence, it can obtain Dollars through exports, through borrowing, through asset sales (including foreign direct investment) and through remittances.
It is apparent that adoption of a foreign currency is equivalent to running a very tight fixed exchange rate regime—one with no wiggle room at all because there is no way to devalue the currency. It provides the least policy space of any exchange rate regime. This does not necessarily mean that it is a bad policy. But it does mean that the nation’s domestic policy is constrained by its ability to obtain the “foreign currency” Dollar. In a pinch, it might be able to rely on US willingness to provide foreign aid (transfers or loans of Dollars). A nation that adopts foreign currency cedes a significant degree of its sovereign power.
The Euro. The analysis in this Primer so far (with the exception of the previous subsection) has concerned the typical case of “one nation, one currency”. Until the development of the European Monetary Union (EMU) examples of countries that share a currency have been rare. They were usually limited to cases such as the Vatican in Italy (while nominally separate, the Vatican is located in Rome and used the Italian Lira), or to former colonies or protectorates. However, Europe embarked on a grand experiment, with those nations that join the EMU abandoning their own currencies in favour of the Euro. Monetary policy is set at the center by the European Central Bank (ECB)—this means that the overnight interbank interest rate is the same across the EMU. The national central banks are no longer independent—they are much like the regional US Federal Reserve Banks that are essentially subsidiaries of the Federal Reserve’s Board of Governors that sets interest rates (in meetings of the Federal Open Market Committee in Washington).
There is one difference, however, in that the individual national central banks still operate clearing facilities among banks and between banks and the national government. This means they are necessarily involved in facilitating domestic fiscal policy. But while monetary policy was in a sense “unified” across the EMU in the hands of the ECB, fiscal policy remained in the hands of each individual national government. Thus, to a significant degree fiscal policy was separated from the currency.
We can think of the individual EMU nations as “users” not “issuers” of the currency; they are more like US states (or, say, provinces of Canada). They tax and spend in Euros, and they issue debt denominated in Euros, much like US states tax and spend and borrow in Dollars.
In the US the states are required to submit balanced budgets (48 states actually have constitutional requirements to do so; this does not mean that at the end of the fiscal year they have achieved a balanced budget—revenues can come in lower than anticipated, and spending can be higher). This does not mean they do not borrow—when a state government finances long-lived public infrastructure, for example, it issues Dollar denominated bonds. It uses tax revenue to service that debt. Each year it includes debt service as part of its planned spending, and aims to ensure that total revenues cover all current expenditures including debt service.
When a US state ends up running a budget deficit, it faces the possibility that credit raters will down-grade its debt—meaning that interest rates will go up. This could cause a vicious cycle of interest rate hikes that increase debt service costs, resulting in higher deficits and more down-grades. Default on debt because a real possibility—and there are examples in the US in which state and local governments have either come close to default, or actually were forced to default (Orange county—one of the richest counties in the US—actually did default). Economic downturns—such as the crisis that began in 2007—cause many state and local governments to experience debt problems, triggering credit down-grades. This then forces the governments to cut spending and/or raise taxes.
To reduce the possibility of such debt problems among EMU nations, each agreed to adopt restrictions on budget deficits and debt issue—the guidelines were that nations would not run national government budget deficits greater than 3% of GDP and would not accumulate government debt greater than 60% of GDP. In reality, virtually all member nations persistently violated these criteria.
With the global financial crisis that began in 2007, many “periphery” nations (especially Greece, Portugal, Ireland, Spain, and Italy) experienced serious debt problems and down-grades. Markets pushed their interest rates higher, compounding the problems. The EMU was forced to intervene, taking the form of loans by the ECB (and even by the IMF). The US Fed even lent dollars to many of the European central banks. Nations facing debt problems were forced to adopt austerity packages—cutting spending, laying-off government employees and forcing wage cuts, and raising taxes and fees.
The nations like Germany (also Finland) that largely escaped these problems pointed their fingers at “profligate” neighbours like Greece that purportedly ran irresponsible fiscal policy. Credit “spreads” (the difference in interest rates paid by the German government on its debt versus the rates paid by the weaker nations; a good indicator of expected default is the spread on “credit default swaps” that are a form of insurance against default) soared as markets effectively “bet” on default by the weaker nations on their government debt.
To put all this in context it is important to understand that the Euro nations actually did not have outrageously high budget deficits or debt ratios, compared with those achieved historically by sovereign nations. Indeed, Japan’s deficits and debt ratios at the time were very much higher; and the US ratios were similar to those of some Euro nations now facing debt crises. Yet, countries that issue their own floating rate currency do not face such a strong market reaction—their interest rates on government debt are not forced up (even when credit rating agencies occasionally down-grade their debt, as they did earlier in the decade in the case of Japan, and threatened to do against the US).
So what is the difference between, say, Japan versus Greece? Why do markets treat Japan differently?
The key is to understand that when Greece joined the EMU, it gave up its sovereign currency and adopted what is essentially a foreign currency. When Japan services its debts, it does so by making “keystroke” entries onto balance sheets, as discussed weeks ago. It can never run out of the “keystrokes”—it can create as many Yen entries as necessary. It can never be forced into involuntary default.
A sovereign government with its own currency can always “afford” to make all payments as they come due. To be sure, this requires cooperation between the treasury and the central bank to ensure the bank accounts get credited with interest, as well as a willingness of elected representatives to budget for the interest expenditures. But markets presume that the sovereign government will meet its obligations.
The situation is different for members of the EMU. First, the ECB has much greater independence from the member nations than the Fed has from the US government. The Fed is a “creature of Congress”, subject to its mandates; the ECB is formally independent of any national government. The operational procedures adopted by the Fed ensure that it always cooperates with the US Treasury to allow government to make all payments approved by Congress. The Fed routinely purchases US government debt as necessary to provide reserves desired by member banks. The ECB is prohibited from such cooperation with any member state.
From the point of view of the EMU, this was not perceived to be a flaw in the arrangement but rather a design feature—the purpose of the separation was to ensure that no member state would be able to use the ECB to run up budget deficits financed by “keystrokes”. The belief was that by forcing member states to go to the market to obtain funding, market discipline would keep budget deficits in line. A government that tried to borrow too much would face rising interest rates, forcing it to cut back spending and raise taxes. Hence, giving up currency sovereignty was supposed to reign-in the more profligate spenders.
We will not explore in detail this week what went wrong. Briefly, we can say that the combination of fixed exchange rates and sectoral balances, as well as a bit of data manipulation and a global financial crisis created a monstrous government debt problem that spread around the edges of the EMU, threatening to bring down the whole union.
Since each nation had adopted the Euro, exchange rates were fixed among countries within the EMU. Some nations (Greece, Italy) were less successful at holding down inflation (especially wages) and thus found they were increasingly less competitive within Europe. As a result, they ran trade deficits, especially with Germany.
As we know from our macro accounting, a current account deficit must be equal to a government budget deficit and/or a domestic private sector deficit. Thus, Germany could (rightfully) point to “profligate” spending by the government and private sector of Greece; and Greece could (rightfully) blame Germany for its “mercantilist” trade policy that relied on trade surpluses. Effectively, Germany was able to keep its budget deficits low, and its private sector savings high, by relying on its neighbours to keep the German economy growing through exports. But that meant, in turn, that its neighbours were building up debts—and eventually markets reacted to that with credit downgrades.
Unfortunately, some of these governments engaged in creative accounting–concealing debt—and when that was discovered, the finger-pointing got worse. The global financial crisis also contributed to problems, as jittery markets ran to the safest debt (US government bonds, and within Europe to German and French debt). Bursting real estate bubbles hurt financial markets as well as indebted households. Bank problems within Europe also increased government debt through bail-outs (Ireland’s government debt problems were due largely to bail-outs of troubled financial institutions). The economic slowdown also reduced government tax revenue and raised transfer spending. To avert default, the ECB had to abandon its resolve, arranging for rescue packages. Officials began to recognize that a complete divorce between a nation and its currency (that is separation of fiscal policy from a sovereign currency) is not a good idea.
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