Eurozone countries would be wise to have a backup plan for the Euro
Summary:
Why the Euro is fragile
A brief and recent history of taxation and debt in the Eurozone
How inflation makes the Euro more fragile
A new avenue for using dollars in the EU
What should Eurozone governments, like Ireland, do?
Plan for multiple eventualities
Why the Euro is fragile
It’s a mistake to have a Eurozone currency when taxation and debt are at a national level. Without consolidation of taxation and debt to Brussels – which many people and countries would not want – the Euro will remain fragile. This is the big systemic risk that the Euro has and the US dollar does not. In the US, all states must run a balanced budget, there is taxation at the federal level, and government debt is held at the federal level. In the EU, taxation is done by each country, and each country has their own debt and borrows on the market at a different interest rates.
Basically, the Euro is as strong as the weakest country in the Eurozone – the one that is least capable of paying its government debt. This has been seen before with Eurozone authorities coming in to bail out Ireland, Portugal, Greece and Spain.
Now, there is the additional threat of inflation. Persistent inflation is putting the European Central Bank under pressure to increase interest rates. However, rising interest rates make it harder for governments to service their debts, especially those already least capable of paying those debts.
A brief and recent history of taxation and debt in the Eurozone
To a significant degree, the Eurozone unofficially has federal taxation and debt. When Italian government interest rates go much above German rates – as is happening now – the European Central Bank works to reduce this difference. Any approach to reducing the difference in Italian and German interest rates involves buying Italian debt (to drive interest rates down). This eventually true whether the approach is immediate (actually buying debt today) or signalled (announcing the central bank will “do what it takes”, which means buying debt in the future). So, there is a real transfer of wealth from other Eurozone countries to Italy (and others being shored up) and it means that the burden of each Eurozone country’s debt is shared.
Given that making government debt rates equal (or at least keeping them close to each other) involves a real transfer of wealth between countries, there is naturally a demand from the Eurozone authorities for something in return. This leads to the unhealthy dynamic whereby the Eurozone, represented by the European Central Bank, the European Commission and (somewhat oddly?) the International Monetary Fund influence – through bailouts – how national governments should govern. This was seen in Ireland after the 2009 housing crisis from my first hand experience and is well known by those in Greece, Portugal, Spain and Cyprus. Why – populations ask then in local elections – should this troika of Eurozone powers get to decide how our national government spends money?
The political reactions in these Eurozone countries are understandable. The core issue is the mismatch between having a shared currency but not (officially) having shared taxation and debt.
How inflation makes the Euro more fragile
As I mentioned above, the Euro is as strong as the Eurozone country that is least able to service its debts. So, if the interest rate on government borrowing for that country, say Italy, goes up relative to Germany, that’s a problem.
It’s also a problem if the absolute level of interest rates goes up, i.e. both in Germany and in Italy, because that also makes it harder for the Italian government to repay its debt.
With inflation today, the European Central Bank is under pressure to increase interest rates and get inflation under control. However, increasing interest rates puts pressure on countries with high debt burdens, which plays to the Euro’s fragility.
So, the options I see playing out could include:
Inflation naturally comes down without the European Central Bank needing to increase interest rates much. The Euro lives to fight another day. Taxation and debt continues at the Eurozone level in a real but unofficial way. The Euro remains fragile.
The European Central Bank rapidly increases interest rates in order to combat inflation. It’s tricky to predict what the effects are here. Certainly, there would be increased pressure on national governments with high levels of debt to GDP. This would be politically divisive – as it was in the past with Ireland, Greece, Portugal, Spain and Cyprus. How much appetite is there in Eurozone countries for austerity imposed by a Eurozone troika? Probably not much.
Double digit inflation persists, but the European Central Bank does not increase interest rates for fear of destabilising the Euro. In this scenario, the Euro continues to devalue strongly against the dollar (see Fig. 2 below) – as it already has over the past year. Eurozone citizens see that their currency is weakening and increasingly start to use US dollars as their main currency. This is a new – technology driven – phenomenon, for reasons I’ll now describe.
A new avenue for using dollars in the EU
As I mentioned above, I use bank apps – for personal and business use – that give me access to a very wide range of currencies and allow me to spend in virtually any currency at close to the prevailing market exchange rate. Nearly all of the cash that I hold, personally and in my businesses, is held in dollars*. True, this is partly because I have business expenses that I pay in dollars, but it’s also because:
i) My bank (really the European Central Bank) charges negative interest for Euro balances above a certain threshold.
ii) While the inflation situation isn’t good in the US, at least there isn’t the problem of balancing the interests of 19 national governments with different taxation systems and debt burdens.
Here’s the critical technological change: It’s much easier for European citizens to just hold some other currency – like the dollar – and only convert to Euro when they need to spend. Perhaps ironically, this is due to the EU’s liberal approaches towards allowing eMoney licenses and (some) deregulation of banking.
*Of course, I do have spending (including taxes) that are paid in Euro and I have to be careful of exchange rate changes going against me, so I hold some Euro.
What should Eurozone governments, like Ireland, do?
The baseline scenario here is that the Euro weathers this crisis and things move along as they have been. However, it seems negligent not to have a plan if the Euro does get into trouble. I see two options:
One option is to allow the Irish economy to use US dollars – fully or partially, officially or unofficially. Perhaps there’s an argument for using British Pounds, as is the case in Northern Ireland. That said, the dollar does provide the advantage of being the world’s reserve currency. Ultimately, the US dollar or the British pound may not be that much worse (or better) than the Euro in terms of the appropriateness of interest rates and exchange rates for the Irish economy. Interestingly, if the Euro were to really weaken, the Irish government may find it cheaper to borrow money in US dollars or in British pounds (or in Chinese Yuan? ouch) than to borrow in Euro.
A second option would be for the Irish government to re-establish the Irish pound, which was called the “punt”.
A sketch of a new (automated) Irish currency
The standard, and most likely, way to bring back an Irish currency would be to have the Irish Central Bank set interest rates based on targeting inflation (or perhaps nominal GDP) – much like most central banks do today.
A more ambitious approach would be to implement a national currency with an automated interest rate – meaning that the interest rate would be controlled by a computer program. Since complicated human systems aren’t often well represented by simple mathematical models, I’m always skeptical this this can work. However, there is a technological update that addresses one of the previous problems with the automated approach, and so I think renewed attention to how interest rates could be automated is deserved.
The history of automated monetary policy
Automatically setting interest rates is not a new idea. It was written about in 1977 by Edward Prescott. One core problem of automating monetary policy is that – if the automated machine gives results that government doesn’t like, there is an incentive to change the program. So, it’s hard to make an automated monetary policy that is credible because there is always the risk of it being changed. If the monetary policy can be changed, then markets will have to factor in a risk premium for the effects of those changes. This key insight was explained to to me by John Fletcher and Ying Chan of Cambridge Cryptographic, and I think is worthy of consideration by central banks.
How to make an automated policy credible?
If the program for automating monetary policy – instead of being deployed to a government computer – were deployed to a blockchain like Ethereum, it would no longer be possible to intervene as the policy is automatically implemented. This may not solve all challenges with automating monetary policy, but it does make the policy robust to political interference.
Already, there is a currency on Ethereum called RAI, whose price (currently around 3 Euro or 3 US dollars) is kept stable by an automated controller. You can see the price history of RAI here:
This is getting technical, but the goal of RAI is not to stay stable relative to the dollar, but rather to make equal the difference between the current market price (specified with respect to the price of any reference asset) and the controller’s target price (also priced in any reference asset). This has the effect, in my opinion, of making RAI stable relative to other liquid stable currencies at large.
In principle, a national government could establish a currency like RAI by making the currency backed by the government’s taxation power, and then implementing an automated controller that aims to constantly bring together the market price and the redemption price – the rate of change of both being the implied interest rate for the currency.
Importantly – and to the matter of whether an automated monetary policy requires an accurate model of the underlying economy – a characteristic of the “RAI” approach is that it doesn’t make any assumptions about how the underlying economy works, it lets markets decide where the interest rate should be.
Plan for multiple eventualities
Central banks can function well as a means of controlling monetary policy. Still, they require a benevolent dictatorship/oligarchy of sorts (the board of the bank), that is competent and independent. As with the earliest of central banks, The Bank of Amsterdam, monetary policy goes well when an economy is strong, growing and prospects are bright for making good on its debt. Ultimately though, the independence of Central Banks is prone to coming under political pressure (e.g. to keep interest rates of national government debt under control) in times of economic uncertainty and weakness. There is then strong pressure to keep interest rates down in order to keep debts manageable. This results in devaluing of the currency.
As of June 2022, we are in a time of inflation and economic uncertainty. This brings to the fore the significant challenge the European Central Bank has in supporting countries who may struggle to service debt, while also act to avoid devaluation of the Euro currency. Eurozone countries would do well to plan for multiple eventualities.
Disclosures. I own Ether, the token used to pay for transactions on the Ethereum blockchain. I also own FLX, a token that serves to govern a limited set of controller parameters for RAI until they are fully automated.
Afterthoughts:
Does the ECB need to narrow Italian-German spreads? Despite strong ECB rhetoric emphasising that they will act to ensure spreads stay narrow – there is no official mandate for the ECB doing this. Some readers have asked whether the ECB really needs to intervene if the borrowing rates of certain countries get high. Maybe rising borrowing rates in certain countries are not a threat to the Euro. Of course, not intervening would mean allowing countries to default on their debt – if things got that bad – and leave the Eurozone. Interestingly, I don’t believe a country leaving the Euro is formally contemplated in legislation. Clearly the ECB is a) taking a cautious approach to raising interest rates (and slowing down quantitative easing) and b) providing strong rhetoric (although not actions) to try and minimise spreads. Why? Why is the ECB so concerned with the spreads if not concerned about the Euro? Is it a concern with keeping all countries in the Eurozone? Is it to satisfy certain national governments? Are these concerns one and the same as a concern with the future of the Euro?Setting aside the Eurozone’s goal of keeping each member country, is it possible for a monetary union to work if it does not also have unified tax and debt? Many European authorities and figures have, in the past, viewed the European Union as going in the direction of increasingly strong ties between countries, which is consistent with a need to unify tax and debt.