A countrymight choose to use a foreign currency for domestic policy purposes. Asmentioned in a previous blog, even the US government accepted foreigncurrencies in payment up to the mid nineteenth century, and it is common inmany nations to use foreign currencies for at least some purposes. Here,however, we are examining a nation that does not issue a currency at all.
Let us saythat some national government adopts the US Dollar as the officialcurrency—accepted at public pay offices, with taxes and prices denominated inthe Dollar. Banks make loans and create deposits in Dollars. Government spendsin Dollars. While the nation cannot create US Dollars, it is clear thathouseholds, firms, and government can create IOUs denominated in Dollars.
Asdiscussed earlier, these IOUs are part of the debt pyramid, leveraging actualUS Dollars. Some of the IOUs (such as bank deposits) are directly convertibleto US Dollars. The currency in circulation is the US Dollar (US coins andnotes), but many or most payments will be done electronically. Check clearingwill be done at the country’s central bank, by shifting central bank reservesthat are denominated in Dollars.
Note,however, that withdrawals from banks are made in the form of actual US Dollars.Further, international payments will be made in Dollars (a current accountdeficit will require transfer of Dollars from the country to a foreigncountry). How is that accomplished? The domestic central bank will have aDollar account at the US Fed. When payment is made to a foreigner, the centralbank’s account is debited, and the account of some other foreign central bank’saccount is debited (unless, of course, the payment is made to the US).
Becausethis nation does not issue Dollars, but rather uses Dollars, it must obtain them to ensure it can make theseinternational payments and can meet cash withdrawals so that Dollar currencycan circulate in its economy. It obtains Dollars in the same way that anynation obtains foreign currency—because the Dollar really is a foreign currencyin terms of ability to obtain cash and Dollar reserves. Hence, it can obtainDollars through exports, through borrowing, through asset sales (includingforeign direct investment) and through remittances.
It isapparent that adoption of a foreign currency is equivalent to running a verytight fixed exchange rate regime—one with no wiggle room at all because thereis no way to devalue the currency. It provides the least policy space of anyexchange rate regime. This does not necessarily mean that it is a bad policy.But it does mean that the nation’s domestic policy is constrained by itsability to obtain the “foreign currency” Dollar. In a pinch, it might be ableto rely on US willingness to provide foreign aid (transfers or loans ofDollars). A nation that adopts foreign currency cedes a significant degree ofits sovereign power.
The Euro. The analysis in this Primer so far (with theexception of the previous subsection) has concerned the typical case of “onenation, one currency”. Until the development of the European Monetary Union(EMU) examples of countries that share a currency have been rare. They wereusually limited to cases such as the Vatican in Italy (while nominallyseparate, the Vatican is located in Rome and used the Italian Lira), or toformer colonies or protectorates. However, Europe embarked on a grandexperiment, with those nations that join the EMU abandoning their owncurrencies in favour of the Euro. Monetary policy is set at the center by theEuropean Central Bank (ECB)—this means that the overnight interbank interestrate is the same across the EMU. The national central banks are no longerindependent—they are much like the regional US Federal Reserve Banks that areessentially subsidiaries of the Federal Reserve’s Board of Governors that setsinterest rates (in meetings of the Federal Open Market Committee inWashington).
There isone difference, however, in that the individual national central banks stilloperate clearing facilities among banks and between banks and the nationalgovernment. This means they are necessarily involved in facilitating domesticfiscal policy. But while monetary policy was in a sense “unified” across theEMU in the hands of the ECB, fiscal policy remained in the hands of eachindividual national government. Thus, to a significant degree fiscal policy wasseparated from the currency.
We canthink of the individual EMU nations as “users” not “issuers” of the currency;they are more like US states (or, say, provinces of Canada). They tax and spendin Euros, and they issue debt denominated in Euros, much like US states tax andspend and borrow in Dollars.
In the USthe states are required to submit balanced budgets (48 states actually haveconstitutional requirements to do so; this does not mean that at the end of thefiscal year they have achieved a balanced budget—revenues can come in lowerthan anticipated, and spending can be higher). This does not mean they do notborrow—when a state government finances long-lived public infrastructure, forexample, it issues Dollar denominated bonds. It uses tax revenue to servicethat debt. Each year it includes debt service as part of its planned spending,and aims to ensure that total revenues cover all current expenditures includingdebt service.
When a USstate ends up running a budget deficit, it faces the possibility that creditraters will down-grade its debt—meaning that interest rates will go up. Thiscould cause a vicious cycle of interest rate hikes that increase debt servicecosts, resulting in higher deficits and more down-grades. Default on debtbecause a real possibility—and there are examples in the US in which state andlocal governments have either come close to default, or actually were forced todefault (Orange county—one of the richest counties in the US—actually diddefault). Economic downturns—such as the crisis that began in 2007—cause many stateand local governments to experience debt problems, triggering creditdown-grades. This then forces the governments to cut spending and/or raisetaxes.
To reducethe possibility of such debt problems among EMU nations, each agreed to adoptrestrictions on budget deficits and debt issue—the guidelines were that nationswould not run national government budget deficits greater than 3% of GDP andwould not accumulate government debt greater than 60% of GDP. In reality,virtually all member nations persistently violated these criteria.
With theglobal financial crisis that began in 2007, many “periphery” nations(especially Greece, Portugal, Ireland, Spain, and Italy) experienced seriousdebt problems and down-grades. Markets pushed their interest rates higher,compounding the problems. The EMU was forced to intervene, taking the form ofloans by the ECB (and even by the IMF). The US Fed even lent dollars to many ofthe European central banks. Nations facing debt problems were forced to adoptausterity packages—cutting spending, laying-off government employees andforcing wage cuts, and raising taxes and fees.
The nationslike Germany (also Finland) that largely escaped these problems pointed theirfingers at “profligate” neighbours like Greece that purportedly ranirresponsible fiscal policy. Credit “spreads” (the difference in interest ratespaid by the German government on its debt versus the rates paid by the weakernations; a good indicator of expected default is the spread on “credit defaultswaps” that are a form of insurance against default) soared as marketseffectively “bet” on default by the weaker nations on their government debt.
To put allthis in context it is important to understand that the Euro nations actuallydid not have outrageously high budget deficits or debt ratios, compared withthose achieved historically by sovereign nations. Indeed, Japan’s deficits anddebt ratios at the time were very much higher; and the US ratios were similarto those of some Euro nations now facing debt crises. Yet, countries that issuetheir own floating rate currency do not face such a strong marketreaction—their interest rates on government debt are not forced up (even whencredit rating agencies occasionally down-grade their debt, as they did earlierin the decade in the case of Japan, and threatened to do against the US).
So what is the difference between, say, Japanversus Greece? Why do markets treat Japan differently?
The key isto understand that when Greece joined the EMU, it gave up its sovereign currencyand adopted what is essentially a foreign currency. When Japan services itsdebts, it does so by making “keystroke” entries onto balance sheets, asdiscussed weeks ago. It can never run out of the “keystrokes”—it can create asmany Yen entries as necessary. It can never be forced into involuntary default.
A sovereigngovernment with its own currency can always “afford” to make all payments asthey come due. To be sure, this requires cooperation between the treasury andthe central bank to ensure the bank accounts get credited with interest, aswell as a willingness of elected representatives to budget for the interestexpenditures. But markets presume that the sovereign government will meet itsobligations.
Thesituation is different for members of the EMU. First, the ECB has much greaterindependence from the member nations than the Fed has from the US government.The Fed is a “creature of Congress”, subject to its mandates; the ECB isformally independent of any national government. The operational proceduresadopted by the Fed ensure that it always cooperates with the US Treasury toallow government to make all payments approved by Congress. The Fed routinelypurchases US government debt as necessary to provide reserves desired by memberbanks. The ECB is prohibited from such cooperation with any member state.
From thepoint of view of the EMU, this was not perceived to be a flaw in thearrangement but rather a design feature—the purpose of the separation was toensure that no member state would be able to use the ECB to run up budgetdeficits financed by “keystrokes”. The belief was that by forcing member statesto go to the market to obtain funding, market discipline would keep budgetdeficits in line. A government that tried to borrow too much would face risinginterest rates, forcing it to cut back spending and raise taxes. Hence, givingup currency sovereignty was supposed to reign-in the more profligate spenders.
We will notexplore in detail this week what went wrong. Briefly, we can say that thecombination of fixed exchange rates and sectoral balances, as well as a bit ofdata manipulation and a global financial crisis created a monstrous governmentdebt problem that spread around the edges of the EMU, threatening to bring downthe whole union.
Since eachnation had adopted the Euro, exchange rates were fixed among countries withinthe EMU. Some nations (Greece, Italy) were less successful at holding downinflation (especially wages) and thus found they were increasingly lesscompetitive within Europe. As a result, they ran trade deficits, especiallywith Germany.
As we knowfrom our macro accounting, a current account deficit must be equal to agovernment budget deficit and/or a domestic private sector deficit. Thus,Germany could (rightfully) point to “profligate” spending by the government andprivate sector of Greece; and Greece could (rightfully) blame Germany for its“mercantilist” trade policy that relied on trade surpluses. Effectively, Germanywas able to keep its budget deficits low, and its private sector savings high,by relying on its neighbours to keep the German economy growing throughexports. But that meant, in turn, that its neighbours were building updebts—and eventually markets reacted to that with credit downgrades.
Unfortunately,some of these governments engaged in creative accounting–concealing debt—andwhen that was discovered, the finger-pointing got worse. The global financialcrisis also contributed to problems, as jittery markets ran to the safest debt(US government bonds, and within Europe to German and French debt). Burstingreal estate bubbles hurt financial markets as well as indebted households. Bankproblems within Europe also increased government debt through bail-outs(Ireland’s government debt problems were due largely to bail-outs of troubledfinancial institutions). The economic slowdown also reduced government taxrevenue and raised transfer spending. To avert default, the ECB had to abandonits resolve, arranging for rescue packages. Officials began to recognize that acomplete divorce between a nation and its currency (that is separation offiscal policy from a sovereign currency) is not a good idea.