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.
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.