This article was written in collaboration with Professor Tim Congdon.
In a jurisdiction which has one central government, one currency and one central bank the credit of the government depends on its ability to borrow from the central bank in its own currency. The government holding the coercive power of the State ensures that its securities are honoured and bank deposits repaid.
This power is virtually unlimited. If the rate of increase in central bank money is too rapid this will result in depreciation of deposits and government securities in real value but not in nominal amount – there is no ‘default’.
In the Eurozone there 17 governments but no central government. Nothing was provided for in Maastricht as to defined responsibilities of the ECB as lender of last resort to governments and banks. In the Eurozone responsibility for deposit protection is with the individual national governments and not with the ECB and beyond it with central government – there is no such government. Without a Eurozone government it is impossible to set the criteria for tax and spend policy and monetary growth which are essential to maintain the stability of any currency as a medium of exchange.
In the period to 2008 Eurozone banks did not need to borrow heavily from the ECB since they could borrow on the global inter-bank market including from central banks in leading Asian economies. So not only were such banks able for fund domestic private lending but also to buy Eurozone government securities. The shutdown of the interbank market in late 2007 revealed the black hole in entire Euro project – the absence of a lender of last resort backed by central government. ECB facilities to banks were cut off for fear of an uncontrollable expansion of the ECB’s balance sheet. Assets were thus sold by banks starting with low quality assets including Greek government bonds. This in turn caused a rise in the cost of borrowing for Greece and then Ireland and Portugal (PIGs).
The only institution that governments and banks in the Eurozone can appeal to is the ECB. But the ECB is not permitted to lend on overdraft to governments. Nor can it lend to banks without limit as this would cause an explosion of the monetary base and risk of major inflation. Nor can it have 80% of its assets in loans to PIGs with only 20% of Eurozone GDP.
Sudden massive recapitalisation of the banks with the higher capital-asset ratios under EU and Basle rules will cause a grave loss in money growth – essential for return to long term stability. That was the lesson of 2008/9. Only real economic growth can achieve this – not further debt in whatever form.
There is no resolution of the crisis that does not establish a central bank acting as banker to government and to banks. This can only be done in the Eurozone by political union or by the individual member states restoring such regimes – that is by leaving the Euro. It is a project that is doomed.