Toolkit for eurozone survival.

Andrew Smithers.
Central Banking Journal, 1st March 2012


The eurozone's short-term outlook depends on markets, voters, bureaucrats and politicians. Its longer term future requires radical change.
Andrew Smithers considers the conditions that are needed for the eurozone to survive.


Central banks managing a fiat currency must be able to print money. Even under the gold standard, countries had the options of suspension or devaluation. The Bank of Japan, the Bank of England and the Federal Reserve are owned by their governments whose bills and bonds they can buy and sell. They have no credit risk in doing so. They may appear to have a price risk if they buy long-dated bonds, but they are part of the government and, if the activities of government are considered as a whole, no additional risk is being run. Central banks’ usual activities are simply part of the overall funding of government debt. Governments can borrow by issuing bonds or by printing money, and they can do this directly or via their central banks. The risks being run by the holders of the bonds and the currency are those of devaluation and inflation.
Funding is the usual way in which central banks ensure that short-term interest rates are at the level they desire. They can extend this beyond short-term interest rates by quantitative easing. Depending on which assets they choose to buy, they can flatten the yield curve, support the bond or mortgage markets or depress the exchange rate. The result of these activities may improve output or change inflationary expectations and, unlike the usual activities of central banks, they may involve credit and exchange rate risks, but losses can always be financed by printing money.

If there is a European Central Bank (“ECB”) a decade from now, it will need to be owned by a government which can print and borrow its own currency. The Eurozone will therefore, in effect, either have to be a country, or a set of currency boards anchored to one country. Hong Kong’s pegging of its dollar to the US dollar is an example that could be followed by several countries within the Eurozone, with the Deutsche Mark being, obviously, the most likely currency to act as the anchor.
There will of course be local governments within the Eurozone. They will either have their borrowing tightly controlled by the central government, as in the UK today, or will be able to default, as in the US. In the UK’s example the central government has power to step in and run a local authority that fails to control its spending. I doubt whether such draconian powers will be wanted by the central government or the member states of any future Eurozone. If that is the case, the ability of member states to go bankrupt will therefore have to be acknowledged and the pretence that this can be prevented by sanctions will be dropped in practice, even if rules on borrowing remain in place.
With this change will go the pretence that the debts of member states are without credit risk. The ECB must then, for the most part, ignore these debts in its discounting and open market operations. It cannot otherwise avoid putting risks on its balance sheet and thus on its shareholders, who should by then have learnt from experience that this is highly undesirable. They will have grasped the nature of these risks and be unwilling to accept them.

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Toolkit for eurozone survival.
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