Why the euro gets weaker when national governments deficit spend

Marshall Auerback here again.  A lot of good questions surrounding my piece on the euro. Many of them seem to revolve around the issues of why the euro gets weaker when national governments deficit spend, and the issue of whether my proposal is legally compliant with the Treaty of Maastricht.  On the latter point, I believe it is.  When the ECB makes a profit, much like the Fed, it passes it on in its national accounts as a "payable" to the European Parliament.  If the ECB spends more than its profits, the central bank could simply book it as a negative payable in its ‘payable to the EP’ account? (Which makes it a receivable).

No question, this action would likely weaken the euro, as the ECB creates more euros, which in turn can be used to adjust downward the debt ratios of the nation states and thereby facilitate their ability to do more spending to support aggregate demand and incomes.

By definition, deficit spending "creates" more euros, making them "easier to get".  Assuming constant demand, the increased supply should naturally weaken the euro.

But as I said before, even though this ultimately helps the external sector (by promoting exports via devaluation  – the old Italian solution), that takes time to impact on economic activity. Additionally, there’s the relative newness of the currency. While Americans go to insured banks and buy US Treasuries when they get scared,

Europeans exit the currency as they have a lot more history of hyper inflation. 

That means a non virtuous cycle can set in with a falling euro making National government funding problematic, which makes the euro continue to fall.  

This happened a little over a year ago due to a dollar funding liquidity squeeze.

The Fed bailed them out with unlimited dollar swap lines and the euro bottomed at something less than 130 to the dollar.

This time it’s not about dollars so the Fed can’t help even if it wanted to.

My proposal (actually, it’s Warren Mosler’s idea, but we discussed the mechanics of it together extensively), creates a solution.  It’s not a bailout for Greece (which isn’t allowed under the Maastricht Treaty) because the ECB gives funding to all of the euro zone countries on a per capita basis.

There’s another element, which I just thought about this morning:  Greece is now in persistent violation of the constraints under the Stability and Growth Pact.  The ECOFIN (European Council of Finance Ministers) can fine them (or the Italians, Portuguese, other PIIGS countries), but it’s like getting blood out of a stone.  They can’t pay.  So an economically illiterate law becomes a law which invites non-compliance and delegitimises the monetary union (and, ultimately, the euro).

Under the proposal I’ve put forward, if the ECOFIN wants to punish Greece for persistent violations of the SGP, it can withhold a certain amount of the money that it would normally pay to Greece, and thereby add credibility to the SGP.

Now, I’ve already said that I think all of these self-imposed political constraints on government spending are insane, but I’m offering a practical way of sorting out the euro zone’s current difficulties within these perverse institutional constraints.

The alternative is that this could get very messy. Already, Fitch Ratings is warning that major Greek banks’
reliance on European Central Bank (ECB) funding, amid a gradual withdrawal of exceptional liquidity support measures and potential changes in ECB collateral rules, will make rebalancing the banks’ funding mix more difficult and could lead to negative rating pressure in the medium-term.  According the Greek news website capital.gr, €3.3bn was withdrawn from Greek Bank deposit accounts in October/November, and senior bank sources indicate that the October to Jan figure is over €8bn…

Things are getting messier, and this could really explode if the ECB doesn’t move proactively.

Marshall Auerback

About 

Marshall Auerback, has 29 years experience in the investment management business, serving as a global portfolio strategist for Madison Street Partners, LLC, a Denver based hedge fund. He also has also worked as an economic consultant to PIMCO, the world’s largest bond fund management group. He is a Fellow at the Economists for Peace and Security, a Research Associate at the Levy Institute, and a non-executive director of Pinetree Capital in Toronto, Ontario, Canada.