Paul De Grauwe is Right: All Roads Lead Back to the ECB

By Marshall Auerback

We’ve always been a fan of Professor Paul De Grauwe from University of Leuven, who has consistently pointed out the structural flaws inherent in the original structures of the EU. Recently, Professor de Grauwe wrote an excellent analysis explaining why the latest “rescue plan” cobbled together by the Eurozone authorities is destined to fail.

The key points:

1) ECB is not currently a ‘lender of last resort’. The ECB was set up with fundamental flaws, where “… one of the ECB’s main concerns is the defense of its balance sheet quality. That is, a concern about avoiding losses and showing positive equity- even if that leads to financial instability.” This is a profoundly misconceived idea. As we have noted many times, a private bank needs capital – clearly because there are prudential regulations requiring that – but because it can become insolvent. It has not currency-issuing capacity in its own right. While the ECB has an elaborate formula for determining how capital is from the national member banks at an intrinsic level, it has no need for capital. It could operate forever with a balance sheet that if held by a private bank would signal insolvency. There are no comparable concepts for a currency issuer and a currency user in terms of solvency. The latter is always at risk of insolvency the former never, so the ECB’s focus on profitability is not only misguided, but leading to inadequate policy responses.

2) The creation of the European Financial Stability Facility (EFSF) and the ESM has been motivated by the overriding concern of the ECB to protect its balance sheet and to avoid engaging in “fiscal policy”. The problem again goes back to the creation of the euro: no supranational fiscal authority to go with a supranational central bank, which means that the only entity that can conceivably carry out “fiscal transfers” of the sort exemplified by a bond buying operation is the ECB. Sure, the actual fiscal transfers can be ‘subcontracted” to the EFSF and ultimately the ESM, but it can only work if the latter’s balance sheet is linked to the ECB’s, giving it the same unlimited capacity to buy up the bonds and thereby deal with the insolvency issue. As things stand now, per de Grauwe: “The enlarged responsibilities that are now given to the ESM are to be seen as a cover-up of the failure of the ECB to take up its responsibility of the guardian of financial stability in the Eurozone; a responsibility that only the ECB can fulfill”.

3)   Related to this problem is the fact that the ESM has been given only finite resources as per Germany’s stipulation the minute it begins. It is capitalised at 500bn euros. And it’s unclear that Germany can go much further, given that there are currently 3 constitutional challenges which the ESM is now facing within Germany’s courts. This will delay ratification of the vote taken last week by Germany’s parliament to ratify the ESM’s existence, as well as limiting its firepower going forward. The ESM’s “bazooka” is in effect a pop-gun. Consequently, as de Grauwe argues, “Investors will start forecasting the moment when the ESM will run out of cash. They will then do what one expects from clever people. They will sell bonds now rather than later.”

As is clear from every FX crisis in the past, “A central bank that pegs the exchange rate and has a finite stock of international reserves to defend its currency against speculative attacks faces the same problem. At some point, the stock of reserves is depleted and the central bank has to stop defending the currency. Speculators do not wait for that moment to happen. They set in motion their speculative sales of the currency much before the moment of depletion, triggering a self-fulfilling crisis. “

Until Europe’s authorities have this figured out, the crisis will continue. All roads lead back to the ECB.

9 responses to “Paul De Grauwe is Right: All Roads Lead Back to the ECB

  1. I predicted this in a June 5, 2005 talk, in which I said, “Because of the Euro, no euro nation can control its own money supply. The Euro is the worst economic idea since the recession-era, Smoot-Hawley Tariff. The economies of European nations are doomed by the euro.”

    That was 7 years ago, and the EU still has not come to terms with the fact that a monetarily non-sovereign nation can survive long term only if it has money coming in from outside its borders. This means either having a positive balance of trade or euros coming from the EU.

    Germany survives by being a net exporter, but all euro nations cannot rely on being net exporters — nor can Germany, long term. When Germany begins to fail, which it will, then the EU may at long last, give (not lend) euros to its member nations.

    Rodger Malcolm Mitchell

  2. I’m not convinced that the ECB as a “lander of last resort” will better or save situation within the Eurozone. The federalization of EC is impossible to achieve due to strong opposite interests between the Germany and peripheral countries. There is no cooperation or will to cooperate which is the base of federation. There will never be a political consensus on how much resources to allocate for countries in difficulty. The crisis of the Euro become acute after 2008 ‘ shock from USA but has origin in his flaw concept. Nota bene* that government debt across the peripheral countries was under control form 2001-2008 but external private debt risen to unsustainable level. When the creditors stopped the funding of it the banking system failed and was bailed out with government, public money. In that way the private debt became a public debt. I would like to read more about relationship between the private debt and public debt in MMT.

    • Zaratino,

      “I would like to read more about relationship between the private debt and public debt in MMT.

      The issue is complicated by the difference between monetary non-sovereignty (the euro nations) and Monetary Sovereignty (the other EU nations, the U.S. et al). The issue also is complicated by the different sorts of “public” debt, even in the U.S. State, county and local debt is the public debt of monetarily non-sovereign, U.S. entities.

      For MS governments, “debt” means something entirely different than for mn-s governments. For the U.S., federal “debt” merely is the total of T-security accounts, which essentially are savings accounts at the Federal Reserve Bank. They are not a burden for the federal government, which by slightly tweaking current law, easily could eliminate all T-securities in one day, leaving no so-called “debt.”

      Contrary to popular intuition, federal deficits are not functionally related to federal debt. Given that same legal “tweaking,” we could have deficits without debt, and we could have debt without deficits. Strange but true.

      By contrast, Greek (for instance) debt is an enormous burden on Greece, just as personal debt is a burden on a private debtor. Greece cannot rid itself of debt by eliminating its debt instruments.

      Greek debt (as well as U.S. state and local debt) really is taxpayer debt, while U.S. federal debt is not taxpayer debt.

      I know this is all so counterintuitive, the knee-jerk response will be that it can’t be so, and I expect to receive some outraged disparagement, but anyone who understands Monetary Sovereignty will recognize these facts.

      Rodger Malcolm Mitchell

  3. Thank you Roger,

    I understood very well all about fiat money, vertical-horisontal money flow, monetary sovereignty, ect. but my concern is not government debt but private external debt. The USA dollar is a special case of monetary sovereignty because if you import whatsoever you do it paying in USA dollars, in other terms there is no foreign capital involved. Please put aside USA and imagine the case of whatsoever developing country. If you run the trade deficit you increase the private debt until the external sector stop to found your trade deficit. You can have a monetary sovereignty and fiat currency maybe but your country risks a default on that private debt. Moreover, the condition imposed to developing countries is very often some kind of pegged exchange rate which generates the increasing private debt. This puts the local banks in crisis and the government bails out them. In this way the private debt becomes the government debt. This is the scenario of all crisis of developing countries. I would like to hear from MMTers more about that aspect. Maybe I didn’t found it jet. I hope so.


  4. Rodger,

    thank you again for your kind interest. Everything is clear with USA. Please just forget about the USA case. What I pointed out is that the same situation is not applicable to developing countries. I mean if such a country has a private debt in foreign currency due to the current account imbalances that country can have a default even with sovereign monetary system. It cannot just pump up the domestic deficit because it doesn’t work. What I am trying to see is how MMT explains that kind of situation of and what could be the guidelines for achieving a full employment and economic growth in that conditions. Please don’t be so US centric.

    • I’m not clear about whether you’re referring to a Monetarily Sovereign (MS) nation (Canada, Australia, Japan, China, UK et al) or a monetarily non-sovereign (mn-s) nation (euro nations, nations that peg their currency, et al).

      A MS nation can “pump up the domestic deficit” at will, and never will be forced into bankruptcy. It can pay any bill denominated in its own sovereign currency. For bills denominated in some other currency, it merely can exchange its currency for the other currency, then pay the bills.

      By contrast, a mn-s nation cannot “pump up the domestic deficit” at will. To survive long term, mn-s nations must have currency coming in from outside their borders. Germany, for instance, is a mn-s nation that survives on its exports, which bring in euros.

      Other than a positive trade balance, the euro nations need euros to come in from the EU, or they need to revert to MS. There are no other solutions.

      Rodger Malcolm Mitchell

  5. Roger,

    allow me to put my concerns in this way:

    a full monetary sovereign, that is the power of a country to issue a non-convertible currency that is fully accepted for domestic and foreign payments, is not, with the exception of the U.S.A, a full prerogative of all countries and, therefore, it must be something unclear within MMT.

    The MMT fits very well for the USA and explains Eurozone problems. I like it but for developing countries there is no possibility to have a full monetary sovereign even if desired. My question is how to applicate the MMT if there is no possibility to have a full monetary sovereign?

    • I do not know why any country cannot be Monetarily Sovereign. If you go to, you will see 40 different currencies, all exchangeable for the U.S. dollar and for each other, including such currencies as the Trinidad/Tobago dollar, the Romanian Leu and the Croatian Kuna.

      Any nation that imports has the power of a customer, and that customer — that buyer — will find sellers who wish to export to it, and many of those exporters will accede to demands that they be paid in the buyer’s currency.

      That said, I imagine there could be rare nations so tiny and so impoverished that they have no buying power. But even Haiti, reputedly the poorest nation on earth, uses the Haitian Gourde, which can be exchanged for U.S. dollars at the rate of 1.00 HTG = 0.0237812 USD. They are Monetarily Sovereign.