The Eurozone is insolvent

The most worrying aspect of the Eurozone crisis is there is no sign that anyone with significant influence in the Eurozone even understands what the fundamental problem is at the moment. The level of ignorance about how the Eurozone functions as a monetary system, and how different this is from states with their own sovereign currency, is alarming. Few seem to appreciate that a currency system in which all money is created through bank credit (because the ECB may not support deficit spending) will eventually become insolvent. This is result of the fact that all new money created through bank lending has a matching debt. Add the money that has to be found to pay interest on these debts and it is obvious (at least to me) that the currency system as a whole cannot accumulate net financial assets. What happens instead is that some parts (e.g. Germany) accumulate net financial assets at the expense of others, who accumulate matching net debts. It has nothing to do with Greece, Ireland or Spain being profligate, uncompetitive or badly run. If they did not exist it would simply be another country with a Euro balance of payment deficit (and there must always be at least one in the Eurozone) that was forced into insolvency and penury. The Eurozone as currently structured is a zero-sum game where countries have to fight to the death to avoid insolvency. This was predicted, by the way, in the 1990's by economist such as Wynne Godley, who remains ignored by the mainstream to this day.

Admittedly, even if the problem was recognised the solution - for the ECB to restore the system to solvency by injecting debt-free money via supporting deficit spending - would be difficult to implement in a way seen to be fair to all Eurozone members.

Probably the best we can hope for may be for the ECB to provide unlimited liquidity to the banking system, but this won't solve the solvency problem. At the moment I think the paralysis and/or incompetence on display makes we wonder whether they will do that. They may well be prevented from intervening by Germany and other creditor states, in which case we can expect another global meltdown as banks collapse across Europe and beyond and payment systems freeze up.

What is amazing is hearing suggestions by the mainstream that debts should be written off and inflation induced in the Eurozone. These solutions seem a strange preference to the more constructive and far less damaging one of central banks allowing and supporting fiscal deficit-spending through tax cuts and/or spending increases. Recall that deficits are opposed because of self-imposed rules designed to reduce the RISK of inflation. Now policymakers and economist are proposing inducing CERTAIN inflation and having debt write-downs. Surely it would be better to allow central banks to support deficit spending to enable growth driven by increased demand and employment. That way debts could be paid off and inflation probably avoided.

Excuse the rant but I find it dispiriting that the obvious solutions are not even being discussed by the mainstream. It is a sad comment on the collective blindness of the financial and economics profession.

Amazing ignorance!

These comments from the managing director of International Institute of Finance reveal astonishing ignorance.

The European Central Bank’s exposure to Greek liabilities is more than twice as big as the ECB’s capital, said Dallara, who represented banks in their negotiations with the Greek government on its debt restructuring. As a result, he predicted the bank would be unable to provide liquidity and stabilize the euro-area financial sector.“The ECB will be insolvent” if Greece were to exit the euro, Dallara said. “Europe would have to first and foremost recapitalize its central bank.”

He apparently fails to grasp the elementary fact that the ECB, like any central bank, is empowered to create fiat money at will, and so can NEVER become insolvent!

Scared witless by imaginary demons

Christine Lagarde, head of the IMF, made a revealing aside last week by commenting in an interview that when she thinks what would have happened in the UK if the government had not embarked on its recession-inducing deficit reduction programme, 'I shiver'. I find it revealing because I have been struggling to work out to what extent what the stated views of mainstream policymakers are a product of sincere ignorance or calculated dishonesty. I think this fairly frank admission of fear shows that ignorance plays an enormous role. Also revealing has been the open discussion by many commentators, including some in Germany, of inducing inflation as a solution to the stagnation induced by the global financial crisis. What this reveals is a genuine fear of sovereign debt and default that is so great that they are willing to tolerate inflation to resolve the problem.

This is deeply ironic because the only reason that sovereign default is considered to be a possibility is that we run our monetary systems according to self-imposed rules that are there to PREVENT inflation. It seems we have forgotten that these rules are self-imposed and/or why they were adopted in the first place.

A useful analogy would be a community that introduce traditions of not eating desert and avoiding alcohol to prevent common problems of obesity and alcoholism. Both policies make sense because they remove temptation. Eventually these self-imposed dietary rules are adopted as strict customs by their descendants. One day these descendants are faced with a catastrophic disaster as a result of which the only food available is desert and the only drink is beer. Do they stick to their customs at the risk of starvation or dehydration? Or do they recognize that, as these customs originated from self imposed rules designed to avoid problems that are far less threatening, they should ignore them.

This is the situation we face now with government deficits and debt. Countries that issue their own currency can never run out of money. They can never be forced to default voluntarily on debts in their own currency, as they can and do create money in unlimited amounts. Because this power, if abused, carries the risk of inflation we have adopted rules to restrain it.

The first rule is that we should raise taxes to match government spending. These taxes are not strictly necessary because fiat money is created through the act of spending. What they do is remove from circulation money that the government introduced by spending. These rules give the appearance that governments have to raise revenue before they spend it. The truth is that they don't have to. The main reason for taxation is to prevent excessive money creation, which could lead to excessive demand and thus inflation.

The second rule is that if the revenue raised by taxes (or the money removed from circulation by taxes) is less than the money created by government spending, the government is required to sell bonds to the market to a value that matches the deficit. While the sale of bonds serves some useful purposes there is no real need to borrow to fund government spending. However requiring governments to sell bonds to match deficits gives the appearance of mounting government debt. Because excessive private sector or personal debt is dangerous and therefore something to be feared, having a rule that means that deficit spending leads to growing government debt provides a powerful psychological restraint on deficit spending.

Recall that the real danger of deficit spending is inflation. For currency-issuing governments debts are self-imposed and voluntary, and they can never be forced to default on them. The fact that mainstream policymakers are considering actually inducing inflation rather than embracing policies (deficit spending) which carry a small risk of inflation reveals that irrational fear of debt underlies their policy error.

Data entry problems versus real problems

It is a tragic irony that around the globe people are enduring unnecessary misery just because there is too little money in circulation. This money shortage is causing individuals, companies and governments to hoard money to repay debts rather spend on consumption or investment. It has resulted in vast amount of idle spare capacity and labour. It is the global equivalent of the malfunctioning babysitting cooperative described by Krugman.

This misery is self-imposed. Now that we have fiat currencies with floating exchange rates it is ridiculously easy to create money to introduce into the economy. Central banks could simply add numbers to the spreadsheets they keep which represent the government's 'bank account'. Governments could then increase spending and/or cut taxes so that people and businesses have more money available to spend, which will get all this idle spare capacity back to work. We have the people, the skills, the technology and the raw material that we need for a thriving economy. All that is missing is sufficient money. But we refuse to create it because of bad economic ideas that the global financial crisis has discredited.

Make no mistake there are genuine problems that we face that cannot be solved by creating money. Climate change. Species extinction. Peak oil. Disease. Conflict. Underdevelopment. Inequality. Discrimination. Persecution. These are difficult problems. The global shortage of money is, by comparison, a trivial problem to solve, because it is self-imposed. We have handcuffs on for which we have the key, but we refuse to use the key. We have created rules which effectively forbid governments and central banks from creating money, and instead leave all money creation to commercial banks. Banks create almost all new money when they make loans. But since this money needs to be paid back we can't all accumulate 'net' money - money somewhere is always matched by debt elsewhere. Huge amounts of money (and matching debts) were created by banks over the past three decades, generating an enormous asset price bubble. When this popped in 2007 all this private debt started being paid back, which 'destroys' the money. So the money we have available for spending is contracting as we pay back out debts accumulated during the boom. That is why demand is so low and the economies are stagnating.

In some countries (USA, Japan, the UK) central banks have countered this contraction in demand by creating money and using it to buy debt, to keep interest rates down (quantitative easing). They hope that by making borrowing cheaper they will stimulate more lending by banks. But people and businesses don't want to take on more debt. They want to pay off their debts. So this central bank-created money is not really entering the economy and restoring demand. When the economy is not growing and there is already spare capacity, and when companies and people are trying to pay back excessive debts, it is difficult and surely somewhat foolish to try to persuade them to stop saving and renew their borrowing. After all, that is what caused this problem in the first place. It is why sensible measures have been introduced to prevent banks lending too much in future. We are trying to do two contradictory things: pay off excessive private debt and increase lending by banks. This is absurd and impossible.

Fortunately there is another way to create money which bypasses this problem of high levels of private debt. Indeed it both solves the debt problem and restores demand. This is for the governments to use the created money to reduce taxes and/or increase their spending - i.e. increase their budget deficit. Unfortunately governments have been reluctant to to this because of misplaced fear that a government deficit is intrinsically bad. Political leaders and mainstream economists reinforce this view. How often has David Cameron said 'You can't solve a debt problem with more debt'. This sounds sensible, but it is wrong. There are two key facts you need to know to understand why. Firstly, it is impossible for the the private sector as a whole to accumulate savings without the government sector running a deficit. This is a unavoidable accounting reality. Think of it this way. A government deficit means it is spending more money into the economy than it is removing in taxes. So deficit spending actually ENABLES the private sector to pay off its debts and save. Secondly, deficit spending only results in government debt because of self-imposed rules that require governments to sell bonds equal in value to its deficit. What this means, in effect, is that the extra money that governments spend into the economy is kept by the private sector in savings accounts at the treasury. Government debt represents savings of the private sector. Unlike private debt, this 'government debt' can be sustained for ever, since there is no limit on overall private net wealth and the treasury can always repay these debts (by central banks creating more money). Governments with their own currency can never be forced to default on debts in their own currency

However, in the Eurozone, where governments do not have their own currency, deficits and debt are not sustainable unless the ECB steps in to support deficit spending and government borrowing in the way that other central banks support their own governments. The catch is that this requires the consent of all Eurozone governments, most notably Germany's, and they are dead against it. The ECB is creating very little money because of an obsessive German fear of inflation. This is ridiculous, like refusing water in case you drown. This is the main reason why things are much worse in the Eurozone than elsewhere. But this is still not appreciated. Instead the focus is on lack of competitiveness or a fiscal union. These are important but secondary issues. The key one is shortage of money. Make no mistake, if the ECB does not start creating money in massive quantities to support government spending the Eurozone is doomed. And no amount of structural reform to increase competitiveness or fiscal union could save economies in which the money supply is being allowed to contract. It the Great Depression all over again.


The problems threatening to unravel the Eurozone and damage the global economy are easily solved data entry problems. They could be solved within minutes at zero cost by allowing central banks to support deficit spending by adding number to spreadsheets. It is so trivial it is hard to believe it has not been tried. 

Ponzi economics

I will argue in this post that the monetary system that we have adopted is effectively a Ponzi system.

My claim is based on two simple facts.

1. In the current system governments are required to balance their budgets over the economic cycle. All money spent into the economy is removed by taxation. What this means is that they do not create money.

2. Conversely, commercial banks create almost all the new money. They do this by making loans, which involves adding credit to borrowers' bank accounts.

This combination of policies, whereby there is little or no money creation by the state and almost all new money is created by commercial banks, is doomed to fail because money created by commercial banks is always matched by an equivalent debt. So commercial bank lending CANNOT create NET financial assets within a currency zone. For anyone to accumulate profits or savings, someone else has to accumulate losses or debt. The economy becomes a zero-sum game. For there to be winners there HAVE to be losers.

It makes no sense in such a system for the wealthy to castigate the indebted. Wealth accumulation is only possible if some people borrow money to fund purchases that enable wealth accumulation by sellers. If no new borrowing took place then it would be impossible for someone to accumulate new wealth.

Such a system is clearly not sustainable, but it can persist for a surprisingly long time on the back of asset price bubbles, especially if central banks intervene to support credit creation, as they have done repeatedly in the past 30 years.

This is how it works. Banks preferentially create money for the purchase of assets such property. They are happy to make these loans because the are secured against the property. Because there few external limits on money-creation by banks, and their profits increases with the amount they loan, there is a tendency for house prices to start rising, driven by excessive money creation by banks. Over time sustained increases in house prices leads, paradoxically, to INCREASING demand for houses as banks are happy to make secured loans for the purchase of assets the price of which increases. This bubble continues to inflate. All the while this injects more money into the economy and the economy grows.

The problem is that this growth is accompanied by massive increases in private (mainly mortgage) debt. Furthermore, this debt can never be fully paid off, because all new money being created is created by commercial banks and so is always matched by an equivalent debt. In fact if the debt is all paid off the money supply would contract dramatically as debt repayment 'destroys' this money.

People with mortgages to pay off rely on a continuous supply of new purchasers, most of whom will need to take out new loans to buy their houses at inflated prices. So debt can only be paid by new debt. Those first in the market can profit (since their house price increased), but only at the expense of new entrants. The most recent entrants into the market depend on house prices continuing to rise, which depends on further borrowing. That is the essence of a PONZI system.

When prices start coming down the whole debt edifice comes crashing down. The bubble pops. All the debts can only be paid off when the money created with the debts is destroyed. Once the process of debt creation reverses itself the money supply begins shrinking, which has a devastating effect on the wider economy. One effect is rising government budget deficits. This happens because of increasing spending (on unemployment benefits, bank rescues etc) and collapsing tax revenues (as income and profits collapse).

At this stage central banks has to step in and create (debt free) money which it injects into the banking system, typically by quantitative easing. That is essentially what central banks have been doing around the world. It was absolutely essential to prevent a complete collapse of our economies. The question is what do we do now.

The sensible approach would seem to be to change the way we create money. Instead of depending on commercial banks to create most new money, and allowing them to do so even when this money creation is resulting in house price-inflation, we should introduce a balanced approach. Allow much, if not all, of the new money to be created by central banks. The amount should be tightly regulated using consumer prices and asset prices to judge the amounts. The power of banks to create money should by tightly regulated and possibly even eliminated. If eliminated banks could only lend on money they already have on deposit. In other word they would only be able to act as intermediaries between savers and borrowers. This should not be controversial since it is how most people, even economists, think banks actually do work! It is described in more detail in a previous post.

The advantage of this process is that money created by central banks is debt free. This means that the private sector AS A WHOLE can increase its financial wealth, unlike the current system in which wealth can only be accumulated somewhere at the expense of debt elsewhere. Economic growth is no longer a zero-sum game as net financial assets increase in line with economic growth.

Such a system is sustainable as growth does not absolutely depend on ever increasing debt. We would no longer have a PONZI system.

There may well be other sustainable alternatives to the current monetary system. Before they are seriously considered, however, mainstream economists need to recognise the PONZI-like nature of our current system.