When the euro was introduced in 1999, few people suspected that the new monetary union the countries were entering would fundamentally change the nature of national governments in the euro countries. I will argue in this chapter that this change in the monetary regime made it much more difficult for national governments to stabilize the market system. The flipside of this was that the power of the financial markets increased to fill the gap. The euro further enhanced the trend mentioned in Chapter 1 for governments to be placed under ever more pressure from the rising market. In order to understand this it is necessary to outline a few fundamental insights into the function of a currency union.

The Eurozone Weakens National Governments

When a country becomes a member of a monetary union, it loses its own national currency and takes on the common currency. In the case of the eurozone that currency was the euro. The currency is managed by a common central bank (in the eurozone the European Central Bank, the ECB). This means that national governments, including the national central banks, lose control over the money, with several implications.²² Here we will focus on one of those implications, possibly the most important.

The governments of countries in a monetary union have to issue their debt in a currency over which they have no control. The Belgian and Dutch governments, for example, now issue their debt in euros. (p.118) From the perspective of the national governments the euro is like a foreign currency, because they have no control over its issue. This is important because the national governments cannot offer any guarantee to bond holders that the cash (euros) will be available to pay them on the maturity date.

This contrasts with governments in countries which have their own currency. The British government (or Swedish, American, and so on) is able to give bond holders this implicit guarantee. The British government issues bonds in pounds, a currency over which the government has complete control, so in the event of a lack of pounds, it would compel the Bank of England to supply more to pay the bond holders. There is no limit to how many pounds the Bank of England can create. The British government can offer its bond holders a cast-iron guarantee. It will never end up in a situation in which it has no cash, because it is unconditionally supported by the Bank of England. This applies to stand-alone countries which issue their own currency.

The governments in the eurozone cannot offer this kind of guarantee, with the important implication that the financial markets can push national governments into insolvency against their will. This will not be immediately clear, so let us set up a scenario. We will take Spain as an example, comparing it with the United Kingdom.

Imagine that a negative economic shock affects Spain, as it did in 2010, when a deep recession was coupled with a banking crisis. The result of the shock is that the Spanish government deficit rises, also causing government debt to increase. Investors worry when they see this happen, wondering whether the Spanish government has sufficient liquidity to pay back the debt. What do investors do when they are afraid of something like this? They sell the Spanish government bonds. This sale has a dual effect. Firstly it raises the interest rate on Spanish government bonds, resulting in the Spanish government incurring higher costs when borrowing money to cover its deficit. Secondly the investors who have sold Spanish government bonds receive euros in return. They will want to reinvest those euros somewhere else and will probably go in search of bonds they have (p.119) confidence in, such as German government bonds. This means that euros leave Spain and end up in Germany to be invested in German government securities, resulting in the Spanish money market drying up and the Spanish government having no money to pay out on bonds as they mature. The Spanish government finds itself in a liquidity crisis, which may force it to default.

Figure 11.1. Government debt (in % GDP)

Source: European Commission, AMECO

In this scenario we encounter a self-fulfilling prophecy. Investors fear that the Spanish government will have payment problems. This leads to activity (selling) which will make their fear come true. If they had not panicked, the liquidity crisis would not have happened. This self-fulfilling process is not possible in the UK. Let us examine the same scenario. In 2010 the country was affected by a similar shock to that in Spain: a deep recession and banking crisis led to a large budget deficit and substantial rise in government debt. The development of the government debt in both countries is shown in Figure 11.1. We can see that after the deep recession of 2008–9 government debt in both (p.120) countries began to rise steeply. We also see that government debt in the UK rose even more than that in Spain, so investors had good reason to be concerned about the British government and its capacity to pay back debt. Like the Spanish investors, they will sell their British government bonds. What effects does this have?

The first effect is parallel to what we have seen in the Spanish scenario. The interest rate on British government bonds rises. Investors who now acquire pounds for selling bonds will want to invest in government bonds they trust. In this case, however, the second effect is completely different. We assume that the choice in this scenario would also be German government bonds. In order to buy German government bonds, investors will have to sell their pounds for euros on the exchange market. This will cause the price of the pound to drop (a depreciation of the pound).

The existence of an exchange market also prevents the pounds from disappearing from the UK. The pounds which investors have sold to acquire euros now go to other investors in the same country. In contrast with Spain there is therefore no liquidity squeeze. Of course it may be that the owners of the pounds are not willing to buy British government bonds. Could the British government have liquidity problems in that case? The answer is no. The British government still has the Bank of England as backup. If it does not succeed in finding cash in the market to redeem the bonds when they mature, it will compel the Bank of England to supply those pounds, and as we stated earlier, the Bank of England can fulfil all the liquidity needs of the British government because it creates the pounds from nothing.

When we compare Spain with the UK, we see the following. Both were confronted with a similar negative shock which caused government debt to rise steeply. The difference is that the financial markets can push the Spanish government into a liquidity crisis and insolvency, whereas the same markets cannot have this effect on the British government, which has a superior weapon in the form of its own central bank to create as much money as it wants. The financial markets can push Spain or any other eurozone member state into (p.121) bankruptcy, but they cannot do this to countries like the UK which issue debt in their own currency.

The difference in the way the financial markets treat the Spanish and British governments in a debt crisis is also illustrated in Figure 11.2. We can see that during the crisis the Spanish government suddenly had to pay very high interest on its bonds because investors panicked and sold Spanish bonds en masse. This did not happen in the UK, despite the fact that the British government’s budget situation was no better than that of the Spanish government. Investors knew that their British government bonds were safe, so they did not sell them and the interest rate on British government securities even began to drop.

Figure 11.2. Interest rate on Spanish and UK ten-year government bonds

Source: Datastream

But, the reader will object, will the Bank of England’s willingness to buy up British government bonds en masse and thus pump money into the economy not lead to currency depreciation (inflation)? We will return to this question in Box 11.1 at the end of the chapter.

Figure 11.3. Cumulative growth in GDP and budgetary austerity 2009–12

Source: IMF, Fiscal Observer and European Commission, AMECO

(p.122) The panic which broke out in Spain (and other eurozone countries) in 2010 had another important consequence. The governments of the countries which encountered liquidity problems had to assemble money as quickly as they could. They were compelled to apply budgetary austerity measures as quickly as possible: taxes were raised drastically and spending was cut. This resulted in the demand for goods and services imploding and the countries concerned ended up in a new recession. The effect of austerity on output growth can be seen in Figure 11.3, with the drop in output largest in the countries where the government made the deepest spending cuts. For every percentage cut (on the horizontal axis), output dropped 1.4 per cent (vertical axis).

We are reaching the core of the problem. In a monetary union such as the eurozone the national governments are vulnerable to movements driven by fear and panic on the financial markets. This fear is fed when a country is affected by a recession. Market movements can push the governments into a liquidity crisis, which compels them to make radical spending cuts. They thus have to make cuts just when things are going badly for the economy.

(p.123) One of the achievements of recent decades is that modern government budgets have automatic stabilizers, so that when the country enters a recession the budget automatically goes into the red because tax revenues drop and benefits payments rise. This is a stabilizing property in the budget, since during a recession the government spends more than it makes in tax revenues, ensuring that buying power in the economy is pumped up. This mitigates the recession and reduces the human suffering.

In a currency union this automatic stabilizer is switched off. The cyclical movements, the booms and busts which are so much a part of capitalism, become deeper, creating a great deal of misery. In some eurozone countries unemployment has risen to thirty per cent or higher since the euro crisis, an untenable situation, which turns many people against the market system, as was the case in the 1930s. In this sense the eurozone is a danger to the free market.

Figure 11.4. Increase in government debt/GDP (in %) and budgetary austerity (in % GDP) 2009–12

Source: IMF, Fiscal Observer, and European Commission, AMECO

Some will say that the cold-hearted austerity programmes were necessary to restore the ‘health’ of government finances in those countries. In fact that has not happened, as we can see in Figure 11.4. The more extensive the austerity measures, the higher the debt ratios (the ratio of government debt to GDP). A rise in spending cuts was coupled with a rise in the debt ratio. This is related to the effect we noted previously: spending cuts lead to a sharp drop in GDP (the denominator in the debt to GDP ratio).

So the results of austerity measures (imposed by the financial markets) were not only a deep recession and a dramatic increase in unemployment, but also a steep rise in government debt ratios. The misery these countries imposed on themselves under pressure from the markets has achieved nothing. Their government debt position is worse than ever. It would take far less than this to bring the market system into discredit.

So the eurozone has a structural problem. It has seriously weakened national governments vis-à-vis the financial markets. This leads to a dangerous supremacy of the latter, which in time will undermine social consensus as to the advantages of the market system. The risk (p.124) is that capitalism is racing towards its limits, with all the consequences mentioned in Chapter 10.

How can we find our way out of this, saving not just the eurozone but the market itself? Here are the elements of a solution. Firstly the role of the ECB as a supporting mechanism for national governments must be tightened up. Secondly we must create a government at the level of the eurozone to take over the responsibilities of the weakened national governments.

The ECB as Lender of Last Resort

We have seen that the structural weakening of the nation states in the eurozone is caused among other things by the fact that they are no longer backed by a central bank which supports the national government in times of crisis. This means that these governments must accept the diktat of the financial markets, which would not be so bad if those markets were always right. Experience, however, shows (p.125) that they are often driven by collective processes of optimism and euphoria alternating with pessimism and panic. This is not a good guide for macroeconomic policies.

Figure 11.5. Ten-year eurozone government bond spreads

Source: Datastream. The spread is the difference between the interest rate on a country’s government bonds and the interest rate on German government bonds, so it is a measure of a country’s risk compared with Germany.

It is therefore essential that the ECB take on the task fulfilled by national central banks in America and Britain. The ECB should be willing to buy up government bonds in times of crisis, when the markets panic, as they did in 2010–11. Initially the ECB was not prepared to do this. When the crisis became so intense as to threaten to destroy the eurozone, the president of the ECB, Mario Draghi, announced in 2012 that the ECB was willing to buy unlimited quantities of bonds. This purchasing programme was called Outright Monetary Transactions (OMT). This announcement had an enormous effect. Interest rates in the problem countries, which had reached record levels, dropped spectacularly (see Figure 11.5). The announcement alone was sufficient to pacify the eurozone financial markets. The ECB did not in fact need to buy any government bonds; simply announcing the policy was enough to convince many investors that it was safe to invest in Greek, Portuguese, or Spanish government bonds. This illustrates how financial markets are driven by feelings of confidence and mistrust.

There can be no doubt on this point. The ECB rescued the eurozone from collapse in 2012 by fulfilling the role of a modern central bank and supporting the national government when the financial markets were driven by fear and panic.

Sadly this is not viewed in the same light everywhere. At the beginning of 2014 the German Federal Constitutional Court decided that OMT was unconstitutional and demanded that the European Court of Justice impose strict conditions on the programme. The European court in turn ruled in 2015 that OMT does not violate the European Treaty. How the German court will react to this ruling is unclear today. A clash between the two constitutional courts is not to be excluded.

Whatever the outcome, the situation remains structurally weak. The ECB is an independent institution which cannot be controlled (p.126) by national governments, in contrast with the Bank of England and the American Federal Reserve. Although these institutions are independent in outlining monetary policy, it is clear that this independence is limited. The British and American governments will not permit their own central banks to refuse support in times of financial crisis. In these countries the national governments have authority over the central banks, as they should.

In the eurozone the opposite is the case. The ECB is placed above national governments. It cannot be compelled to offer support in times of crisis. The governments are completely dependent on the good will of unelected officials. In the long run this is untenable.

(p.127) The Euro is a Currency without a Country

There are only two options for solving the problem of structural weakness of national governments in the eurozone. Either we create a European government, legitimized by a European parliament, to which the national governments transfer significant budgetary authorities. This forms a political union with a European government which can directly spend money and levy taxes, and thus can issue its own debt. A government of this kind will also have the power to oblige the central bank to offer financial support. This solution makes Europe a federal state.

Willingness to realize a political union of this kind in Europe is extremely weak. Many countries are suffering from serious ‘integration fatigue’. If we do not succeed in creating political union, there is only one alternative: a return to national currencies. This solution will emerge automatically because many countries will reject a system in which vital decisions are taken by anonymous and unreliable markets and unelected officials.

In Conclusion

The creation of the eurozone has led to a great shift in the power of national governments relative to the financial markets. It has seriously weakened the eurozone national governments with respect to the financial markets, leading to a dangerous supremacy of the markets, which have forced many countries in the eurozone to introduce excessive budgetary austerity measures. This in turn has led to a substantial rise in unemployment and the breakdown of parts of the social security system.

Box 11.1. Lender of Last Resort and Inflation

When a central bank buys government bonds, it does so by issuing new money. Will this not lead to inflation and currency depreciation? This is a question asked by many people.

The answer is that in normal times excessive money creation does lead to inflation, but the times we have seen since the financial crisis of 2008 are not normal. The financial crisis was characterized by reticence on the part of the financial institutions, after the excesses of the wild bubble years, in providing credit to businesses and households. All they want is to accumulate as much liquidity as possible in order to be armed against the next crisis. They therefore sell many assets they are not 100 per cent confident about, including government bonds. This causes the prices of those assets to drop, leading to problems for many other financial institutions because the value of their assets drops too. This can result in a downward spiral, landing the economy in recession, with rising unemployment as a consequence. This is the moment at which the central bank should step in as lender of last resort. Buying assets, including government bonds, can stop the downward spiral.

The risk of inflation during a financial crisis is minimal, as is clear from Figure 11.6, which shows the development of the eurozone money base and money supply since 2004. Some explanation as to the concepts used here will be required. The money base is defined as all liquidity created by the central bank. Concretely this means banknotes and deposits which banks maintain with the central bank, the latter forming the banks’ liquid reserves. The money supply consists of banknotes and deposits which businesses and consumers keep with the banks. This is the money with which payments are made. If there is excessive money supply, that can lead to inflation.

Let us now look in more detail at Figure 11.6. Until October 2008 the money base and money supply rose at the same pace. In October 2008 the financial crisis erupted. The ECB took its responsibility at the time and lent enormous amounts of liquidity (money base) to the banks. As we can see from Figure 11.6, the money base exploded. This was necessary in order to stop the downward spiral described above.

(p.129) What happened in the meantime to the money supply (M3)? Nothing. Banks did not use the extra financial resources to grant more credit to businesses and households. They were too traumatized by the crisis and piled up the extra resources as a buffer for possible future crises. The result was that the money supply barely increased, if at all, as is clear from Figure 11.6. At no point was there a risk of increased inflation, simply because the money supply in the hands of the general public (businesses and households) did not rise.

Figure 11.6. Monetary base and money supply (M3) in the eurozone (December 2009 = 100)

Source: ECB

This point is also clear from the fact that inflation in the eurozone has been dropping for several years, although the money base has increased. In 2014 inflation in the eurozone had dropped below one per cent. We now understand why. The increase in money base was necessary to prevent a deflationary spiral, but this did not lead to more credit, nor to a rise in the money supply. Most economists who work on this problem understand this. Milton Friedman, the champion of monetarism, understood this when he stated that in a financial crisis the central bank must be ready to provide liquidity for the financial system in order to prevent a deflationary spiral.²³

(p.130) The risk of inflation increases as the economy begins to grow faster again. At that moment the banks may use their extra cash reserves to grant too much credit. This could lead to a rapid rise in the money supply. Central banks, however, have ways of combating this effect. For instance they can sell the assets they bought during the crisis (including government bonds) back into the market, or raise the banks’ minimum reserve requirements to prevent them from using their cash reserves to grant too much credit.

This is a dangerous tendency because in time it undermines social consensus as to the advantages of a market system. Capitalism in the eurozone threatens to reach its limits at an alarming speed, with all the consequences mentioned above. (p.128)