The Greek question once more: back to ‘Central Banking 101’ …

Very, very basic hints on how a fractional reserve and fully centralised monetary reserve monetary system works

It seems to be unnecessary but, given all it’s being said by all and sundry in the last two weeks, may I remind the kind readers of this blog that the current monetary crisis in Greece is just a textbook example of how a fully centralised monetary system works. I would have thought that the members of the recently appointed new government in Greece were well aware of the institutional and economic constraints of the euro, as well as the very much restricted range of manoeuvre a monetary union allows to its members. Let’s start with the very basics:

Under a fractional reserve and fully centralised monetary system such as ours, the ultimate source of liquidity is under the control of a central bank, the single issuer of the currency with legal tender power. The Greek economy (along with quite some other countries in the euro area) has been running persistent and quite significant current account deficits and, particularly since the outbreak of the 2007-08 financial crisis, has required the extraordinary assistance of the ECB. When no one was willing to lend out money to Greece, the ECB has not only taken part on the bail-out successive plan(s) granted to Greece but also, and most importantly, has been accepting Greek government bonds as collateral in its main refinancing operation with Greek commercial banks. The latter has been key to maintain a regular source of liquidity to the Greek economy and thus to avoid the collapse of its national monetary system and a run on Greek banks.

Along with the loans, the ECB (actually the so-called Troika with the other two institutional lenders, the EU Commission and the IMF) has imposed conditionality on the provision of the loans granted to Greece. And of course, this is the (natural) expected behaviour of any lender: those willing to lend out their money would like to be sure the borrower will be able to honour his debts. Needles to say that successive Greek governments have accepted the deal because no other international creditor was willing to make a loan to the country or to accept Greek bonds as collateral. Who else but your central bank could take such a high risk and keep on hoarding in its portfolio assets nobody wants? (By the way, all the shareholders of the ECB are contributing to these loans and supporting this continuous financial assistance in accordance to their percentage in the capital of the bank).

Now a new government in Greece is playing a quite risky game, with potentially disastrous consequences for the country. All along the campaign, Syriza has been denouncing the ‘imposition’ of the bail-out programmes and the loss of sovereignty of the Greek government in favour of the interests of the international creditors (let us leave aside the meaningless and populist rhetoric used by its dealers to refer to the bankers, capitalists and free marketeers as those wickedly pulling the strings in the shadow … ). They claim that the debt is unfair and needs to be restructured, if not partially or totally written off (may I remind one more time that a more than 50% ‘voluntary’ haircut was already accepted by private bondholders in 2012). Actually the new finance minister has been very busy in his recent road trip throughout   Europe to demand a change in the rules of the game; as if he was in a position to do so. Let me remind again few very basic facts in this regard:

– The more radical the demands of the Greek governments the more difficult it will become to find any other source of liquidity in international markets and thus the more dependent the Greeks will be on the single source of money available, the ECB. Actually the risk premium of Greek bonds has already exploded in the last two weeks and thus this situation has already materialised.

– The message that the Greek government couldn’t be willing to fulfil the conditions of the bail out programme has already increased capital flights out of the country and this shouldn’t be surprising at all (as it already happened back in 2012). And again, in this financially stressed scenario Greek banks are even more fragile and exposed to high liquidity constraints, which can only be sorted out by the assistance of the ECB (if willing to accept Greek bonds as collateral).

In this context we may well understand last week’s Mr Draghi’s reaction to the demands of the Greek government; in particular, his announcement that since next Wednesday Greek banks will no longer have access to the regular financing operations of the ECB via the ordinary discount of Greek bonds as collateral. This can only mean two things: either (hopefully) the precipitation of a new mutually beneficial deal between the new Greek government and the Troika or, if not feasible, the most likely sudden collapse of Greek banks as soon as the ECB stops providing liquidity to them on a regular basis. Well, perhaps another alternative might happen, which is the return to the national (devalued) currency (see an alternative in line with the introduction of more monetary competition in Europe here).

I do not know who advices the new Greek government on these matters but it would help to familiarise first with the very basics on money and central banking. All my best wishes to the Greeks of course!

Juan Castaneda

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A plea for good economics: Pedro Schwartz vs Paul Krugman

(Originally published in GoldMoney Research, 18th July 2012)

 

“The trouble with some Nobel Prize-winners is that they are tempted to pontificate on matters outside the speciality in which they have excelled. When Professor Krugman expatiates on macroeconomics, he tends to oversimplify complicated questions of theory and policy, and to misrepresent crucial periods of the past, all to suit his political pre-conceptions”.

These were part of Professor Pedro Schwartz’s opening words in his critical comment on Paul Krugman’s presentation of his new book in Madrid (End This Depression Now!, Norton ed. 2012). As Krugman’s book title suggests, we are going through one of the worst economic crises since the 1930s Great Depression. But does this mean, as Krugman argues, that more government intervention in the economy is the solution?

Following his own rationale (see video, minutes 10-30), it is as if we are faced with an easy choice: do we want to overcome the crisis with expansionary demand policies at the cost of a little more inflation? Or do we prefer instead painful austerity measures that condemn us to a long recessive and stagnated economy, but not much inflation? Well, the answer is easy then. Let’s have some inflation!

During the so-called Keynesian years of the 1950s and 1960s, we were told that there was a trade-off between inflation and unemployment, that is, easy money promotes employment while hard money does the opposite. Yes, those were the years of the traditional Phillips Curve. But the recession and inflation that accompanied the oil crises in the 1970s and the stagflation of that decade – the dreaded combination of high unemployment and high inflation – showed that inflation is, after all, a monetary phenomenon; in other words the result of excessive money creation. Regardless of past evidence, Krugman keeps on saying that fiscal and monetary expansion is the only way to fill the gap left by the bursting of the housing bubbles in countries like Spain. In addition, he supports this inflationary policy mix as it would result in an improvement of the economy’s competitiveness, as it would be a feasible way to cut real wages and prices. Throw in a call for increased financial regulation, and et voila: the neo-Keynesian brew is complete.

Professor Schwartz’s intervention (see video here, minutes 35-48) was a blessing. He refuted Krugman’s recipes and rejected the expansion of aggregate demand as an effective way to address the current recession. As he remarked, were not expansionary fiscal and monetary expansionary policies large contributors to the present crisis? How then are they going to be the solution now? As Menger pointed out many years ago, economics must deal with the unintended consequences of human decisions; so a good economist must not be tempted to just please the public with popular solutions. He must be prepared to stick his neck out in favour of difficult decisions. I fully share Professor Schwartz’s views and think that more spending would be myopic and counterproductive in the long term. We have learnt painfully in the past that increased public deficits financed by a loose monetary policy is neither an effective nor a sustainable long-term solution to such crises.

Juan Castañeda

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