Barry Eichengreen has a stimulating recent essay at Spiegel Online (English version) on the differences and similarities between the debt crisis in the US Territory of Puerto Rico and the Eurozone Territory (sorry—sovereign state) of Greece.
So Puerto Rico is, in a literal sense, Greece in another guise. But can you imagine the United States putting all other domestic and foreign policies on hold while it attempts to resolve the crisis? The idea is ludicrous. But that is precisely what Europe has done.
Point well taken. Puerto Rico’s problems (like Detroit’s not too long ago) will be resolved in bankruptcy courts. Greece’s, in contrast, have led to a five-month marathon reenactment of Luis Buñuel’s 1961 surrealist film The Exterminating Angel. That there are fundamental governance differences between the Eurozone and the United States is something I examined some time ago.
But there is another, more fundamental, difference between the Greek and the Puerto Rican cases that has become glaringly apparent since the European Central Bank (ECB) unleashed the Guns of Navarone on Greece, that Eichengreen doesn’t address. Can you imagine the Federal Reserve Board cutting off its financial backstop (discount window) to all Puerto Rican banks because their local government was insolvent on its municipal bonds, thus imposing bank holidays and capital controls on the islands? For that is what the ECB, the Eurozone’s equivalent of the Federal Reserve, has done in Greece.
Why is it inconceivable for the Federal Reserve Board to do so but already tough love (though not uncontroversial) between the ECB and Greece? To obtain central banking liquidity, Greek banks have to put up collateral (rediscounting). But what does their collateral consist of? In the US it would be US Treasury Securities, bonds issued by the Federal Government. The Fed has never accepted state or municipal bonds as collateral (although it traditionally, i.e., before the 1930s, and perhaps even today, accepted best commercial paper as collateral, whatever that is), and that’s why banks do not hold them as capital reserves. The corresponding instrument in the Eurozone would be Eurozone central sovereign debt, but, alas, no such thing exists (except for a small amount of European Investment Bank paper). What does exist? National bonds of the 19 constituent member states of the Eurozone, i.e., in American terms, municipal and state bonds, something the Fed would never dream of discounting. Since the EZ banks largely hold bonds of their own country (increasingly so since the 2008 crisis), this has created the famous bank-sovereign debt doom loop. As long as the ECB is unwilling to act as lender of last resort using any of the 19 national sovereign debt instruments equally, we will get the famous “fragility of the Eurozone” centrifugal self-destruction feedback loop described by Paul De Grauwe in 2011. But in doing so, the ECB opens itself up to the objection of the German Bundesbank’s President Jens Weidmann that the ECB would be thereby engaging in illicit monetary financing of governments (to the point where the Bundesbank sued the ECB before the German and European Constitutional Courts). It was probably the threat of more of this Bundesbank blackmail that induced the ECB to deploy the Guns of Navarone against Greece.
This hamstrung construction of the Euro derives from a fundamental misconception of what a currency is. A currency is not merely circulating notes and coins (and central bank deposits)—what economists call the monetary base—issued by a central authority and deemed legal tender. In a system of fractional reserve banking, it must be a whole gamut of debt instruments of a wide spectrum of maturities and (fixed-income) returns guaranteed by this selfsame issuer. Notes and coins, what I call money of order 0, constitute the most liquid component and are also a form of sovereign debt. But banks normally want to keep their reserves in something interest bearing, rather than in cash, which means that they must also be supplied with “risk-free” instruments of maturities of all orders (1, 3, 6, 12 month T-bills, 2-10 year T-notes, 30 year T-bonds, and in the past perpetual bonds like British consols). It is the obligation of the central bank to do this in a way that is non-inflationary and serves the other macroeconomic goals of policy-making (e.g., full employment), by influencing the yield curve with open-market operations, discount rate adjustments, reserve and capital requirements, etc. I call this the Spectral Theory of Money.
From this point of view the national debt is not an evil to be eliminated, but a necessary service the central bank provides to operate a modern economy. Not a subterfuge the profligate government foists on society to finance evil wars and a wasteful welfare state (although it can and historically has indeed done both), but a necessary supply of a range of lubricants to keep a monetary economy running smoothly. And if we examine the history of the longest continuously running modern currency system in the world, the Bank of England, this is exactly what we find. In 1694 a group of merchants bought up the poorly managed debts of the English king and obtained the privilege of issuing pound notes and coins, and bonds and later consols, as the Bank of England (then still a quasi private enterprise). And while the national debt of England subsequently only ballooned while the country gorged on a successful but expensive program of imperial expansion, its financing costs fell radically. Something the French kings, who failed to establish a viable central bank and state finance after the South Sea/Mississippi Bubbles, could only regard with envy.
If Eurobonds had existed, and all Eurozone banks were capitalized by statute with them, this problem could never have arisen, and the Guns of Navarone could never have been fired. Alexander Hamilton, the first American Secretary of the Treasury, understood this clearly in 1791 when he bought up the outstanding debts of the thirteen revolutionary states, and consolidated them into a single national debt serviced by national tariffs and taxes.
Until such time as the Eurozone catches up with Hamilton and begins issuing Eurobonds, and exclusively capitalizing its banks with them, it will never be a viable currency zone, as the Greek debt crisis has amply demonstrated. At best it will degenerate into a German protectorate cowering under the Guns of Navarone.