Mario Draghi and the Holy Grail

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In a reply to a comment on my recent post about Target2 and ELA, I said this:

There are no "Greek euros" or "German euros". There are only European euros. So the ECB is not exchanging Greek and German euros at par. Both countries are using the same currency, which is produced by the Eurosystem. The NCBs are not autonomous entities, they are part of the Eurosystem. They do not create their own currencies : collectively, they create the single currency.

This is how a single currency works. If there are multiple "central banks" within a single currency area - as there are in the United States, for example - they do not produce their own currencies. St. Louis Federal Reserve does not produce St. Louis Dollars. It produces United States dollars. As does the Minneapolis Fed, and the New York Fed, and the Atlanta Fed, and so on. The twelve Federal Reserve banks collectively produce one currency, the US dollar.

So the person who argued that Greek and German euros are exchanged at par by the ECB, which is the wrong price, is wrong, isn't he?

If the Euro were genuinely a single currency, he would be wrong. And that was the assumption I made in my answer.

But on reflection, something doesn't quite add up. The structure of the Eurosystem is not that of a single currency. No other currency area has individual "central banks" for every one of its member states. The US has twelve Federal Reserve banks, not fifty. The UK - probably the oldest and most stable currency union - has four "member states" but only one central bank, despite the fact that two of its member states produce their own banknotes. A single currency does not need a "central bank" for every member state. But a system of pegged exchange rates does. The Eurosystem is constructed as if the Eurozone were using a pegged exchange rate system, not a single currency.

For a single currency, where banknotes are issued is irrelevant. The US does not mark its banknotes with the identifier of the state where they were issued. In the UK, Scottish banknotes are different from sterling banknotes - but really they are a parallel currency that is pegged at par to sterling and fully reserved with physical sterling banknotes in a sort of currency board arrangement. But Euro banknotes are marked with their currency of origin. Again, this is not what we would expect for a genuine single currency.

The construction of Target2 reflects the Eurosystem structure. Target2 records credit and debit balances between Eurosystem "national central banks". It charges interest on debit balances, and pays interest on credit balances. This arrangement is frankly bizarre. The interest is created by one entity in the Eurosystem then transferred to another. It neither enters nor leaves the Eurosystem: it is simply creation and movement of reserves within the system. It is, in short, seigniorage. Eurosystem entities with debit balances create interest and pay it to the ECB: Eurosystem entities with credit balances receive interest from the ECB. Because debit and credit entries within a closed system have to balance, the net effect is that Eurosystem entities with debit balances create and transfer reserves to Eurosystem entities with credit balances. But it's all funny money. The "national central banks" in the Eurosystem are not independent, nor are they representatives of member states: they are simply branches of the Eurosystem. And within Target2, they aren't even real. They are just representations of the Eurosystem structure. The interest payments are symbolic. So are the balances.

But for Hans Werner Sinn, the Target2 balances are not symbolic. They are real debts between Eurozone member states. And the interest paid is real. So a country leaving the Eurozone must settle its Target2 balance with a real transfer of Euros obtained through taxation or sovereign borrowing.

Sinn's view is widely supported, even though it seriously undermines the concept of the Euro as a single currency. But there is an even bigger problem - and that was identified not by Sinn but by the person who probably has most to lose from a Euro collapse. Mario Draghi.

It took me a while to identify what was odd about this statement from a speech made by Draghi in Helsinki in November 2014 (my emphasis):

....if there are parts of the euro area that are worse off inside the Union, doubts may grow about whether they might ultimately have to leave. And if one country can potentially leave the monetary union, then this creates a replicable precedent for all countries. This in turn would undermine the fungibility of money, as bank deposits and other financial contracts in any country would bear a redenomination risk. 

This is not theory: we all have seen first-hand, and at considerable costs in terms of welfare and employment, how fears about euro exit and redenomination have fragmented our economies.

So it should be clear that the success of monetary union anywhere depends on its success everywhere. The euro is – and has to be – irrevocable in all its member states, not just because the Treaties say so, but because without this there cannot be a truly single money.

On the face of it, this looks like a call for commitment to the single currency. But wait. Draghi says, in effect, that a genuine single currency cannot accommodate membership changes. This is not true.

In 1922, Southern Ireland left the United Kingdom, becoming first the Irish Free State and later the Republic of Ireland. It adopted its own currency, the Irish pound, in 1928. At no point did it ever occur to anyone that Ireland adopting its own currency would threaten the existence of sterling. Indeed, sterling continued to be used in the independent Ireland alongside its own currency.

Last year, Scotland held a referendum to decide whether to remain in the United Kingdom. It narrowly chose to remain. Sterling was indeed a contentious issue in the referendum, but not because Scotland leaving the union would threaten its existence. Even those who claimed that Scotland's departure would mean the end of the United Kingdom, and those who said that Scotland would inevitably be followed out of the union by Wales and Northern Ireland, did not argue that sterling would cease to exist. On the contrary. Passionate advocates of Scottish independence claimed sterling as their own and demanded to share it with the rest of the UK after independence. Unsurprisingly, since the rest of the UK had no voice in this referendum (and were highly sceptical of Eurozone-style currency union arrangements, with good reason), the demand was rejected by the UK government.

In the "velvet divorce" of the Czech Republic and Slovakia, both sides eventually chose a new currency. But this is unusual. More often, when currency areas break up, the dominant state retains the single currency: for example, the rouble - which was the currency of the Soviet Union - remains the currency of Russia. Genuine single currencies may change their allegiance, but they don't disappear. They are maintained through history, custom and above all by identity. The rouble has been the currency of Russia for a very long time: satellite states come and go, but the currency remains a mark of Russian identity.

In an interesting interview with Jacobin magazine, the Greek economist and MP Costas Lapavitsas - speaking about the Greek crisis - says that the currency of a country is intimately bound up with the identity of its people:

This crisis demonstrates beyond dispute that money is much more than an economic phenomenon. Fundamentally, of course, it is an economic phenomenon. But it’s much more than that. It has a lot of social dimensions and one dimension it has, which is critical, is that of identity.

Money, for reasons that are not for this moment but which I develop in my work, is associated with beliefs, customs, outlook, ideology, and identity. Money becomes identity more than capitalism. 

He adds that for periphery countries, Euro membership is about far more than just money. It is a mark of belonging - of being accepted as full members of a large, wealthy club called "Europe":

People have to appreciate that for Greeks, joining the monetary union and using the same money as the rest of Western Europe was also a leap in identity. In popular consciousness, and given the history of Greece, it allowed Greeks to think that they had become “real Europeans.” In a small country on the southern end of the Balkans, that had a very turbulent history, through the Ottoman period and what happened afterwards, this was a very, very important thing.

This attitude is not limited to Greece. When I wrote about Latvia recently, I was struck by how Euro membership was viewed as some sort of Holy Grail - a wonderful prize to be won through hardship and privations. For Latvians, like Greeks, Euro membership was a mark of being accepted into this wonderful club called Europe, leaving behind the terrible legacy of their Soviet past. That by accepting the Euro they have once again surrendered their sovereignty appears lost on them.

The tragedy is that the "European identity" that so appeals to Greeks and Latvians alike does not exist. True, it could develop - after all, America managed to forge a common identity from a warring collection of disparate states. But Europe has 3,000 years of conflict and bloodshed to overcome, including the two most terrible wars in the history of the planet and some of the greatest atrocities. Fear of another war is not sufficient to overcome the deeply rooted differences of culture, custom and identity between - and indeed within - the countries of Europe. And locking into an artificial currency that has no foundation in history or custom is not going to create a European identity. As we have seen all too frequently in recent years, when a crisis hits, European solidarity vanishes like the morning mist. European identity is a fair-weather friend.

The Euro is founded on lies. It claims to promote European unity, but it is set up to create and maintain fragmentation and distrust. It claims to preserve sovereignty, but to ensure its own survival it requires its member states to relinquish control of their economies and, increasingly, their politics. It claims to bring prosperity, but its legacy is depression.

And because it is founded on lies, it is fragile. Draghi is indeed correct that if one country leaves, others may follow, and that may result in the whole thing unwinding. But this is not because irrevocable membership is a necessary characteristic of a single currency. Clearly, it is not: in other currency unions, member states come and go, but the currency survives. No, irrevocable membership is necessary because the Euro is NOT a single currency. It lacks the underpinning of history, custom, identity and trust that characterises genuine single currencies. And its institutional construction is that of a pegged system of exchange rates, not a single currency. We saw in 1992 how pegged exchange rate systems can unravel when one member leaves.....

As I write, there is much discussion about whether Greece will leave the Euro. And as default draws closer and no deal is made, the fear spreads from Greece to other countries. If Greece defaults and leaves, what of Portugal? Spain? Italy?

We have played this scene before. It's called "contagion". We were told this would not happen again: the ECB has a battery of financial artillery to protect other Eurozone countries from the effects of a Greek disaster, and the banks have been fixed. It seems markets think otherwise. Stock markets are falling, bond yields in periphery countries spiking, business investment collapsing....Contagion is back, with a vengeance.

Draghi is widely credited with ending the market panic that threatened to destroy the Euro in 2012. "We will do whatever it takes", he said. Market participants interpreted this as meaning that the ECB would act as a proper lender of last resort, and this was backed up with the OMT programme. So why are markets panicking again now?

I do not think Draghi deserves as much credit as he is given for the calming of the 2012 panic. The real reason why markets calmed down was that no-one left the Euro. Greece was rescued. Again. And that was enough to reassure markets that the Euro would not unravel. But now, we are back where we were before the 2012 restructuring. Greek debt/gdp is 180% of GDP, its primary surplus is going up in smoke and it has an uncooperative and belligerent left-wing government that refuses to do what creditors want. Greek default and exit is once more on the agenda, and markets are increasingly doubtful that it will be rescued this time. If it leaves, others may well follow....

For my money, Greece should have left long ago - indeed it should never have joined. We know that Greece lied its way into the Euro. But equally, it was lied to. It was promised a golden future. Instead, it got destruction of competitiveness, unsustainable debt and a deep, prolonged depression. The trouble is that for such a damaged economy, leaving the Euro would now be very painful. And more importantly, at present the Greek people do not seem to want to leave. I can totally understand this, given the emotional charge that Euro membership appears to carry for periphery countries. Voluntarily leaving would be an admission of failure: being expelled would be even worse.

So although I think that in the longer term Greece would do better out of the Euro, I respect the desire of its people to hang on to their dream. Unilateral departure is not the solution - and nor is forcing Greece out, since that would just make the Euro unravel even faster (are you listening, Germany?). Winding up the Euro in an orderly fashion is the right thing to do.

But that won't happen while people continue to believe that it will bring them prosperity. Somehow, the Euro must be shorn of its faux glister. It is fool's gold.Image from Monty Python and the Holy Grail, obviously.