How the Eurozone should've been set up.

[crypto-fascist superhero]

There has been a lot of talk about how the Eurozone presented a moral hazard, in which countries like the PIIGS could deficit spend and borrow cheaply with Euro-denominated bonds, taking advantage of the fiscal rectitude of other Euro members (specifically Germany), then expecting to be bailed out once their profligate ways caught up with them.

It seems to me that this was entirely predictable, and could've been entirely prevented merely by setting up the Eurozone in a more sensible way.  Here's how I would have done it:

1. The Euro would've been pegged at 1 Euro = 1 Deutschmark, as in real life.

2. The paper versions of other currencies (Francs, Drachmas, Liras) would be phased out, but they would remain at their pre-Euro values as virtual electronic currencies used only by their country's respective central banks.

3. Euros would then have to be purchased by national central banks from the European Central Bank using "virtual Francs," "virtual Drachmas" etc.  (And, yes, virtual Deutschmarks too).

In this way a single currency could be implemented without compromising national sovereignty, and each country could have its own monetary and fiscal policies, but without any moral hazard as they would have to face the real-world consequences of inflationary policies.

[Gustaf]

Huh?

Your idea is for those countries to have 2 currencies where only one can actually be used for purchases?

How would currencies remain at pre-Euro values? Would they be pegged? Traded on markets?

This sounds a lot like third-world countries using someone else's currency because their own one sucks.

I think that if you knew anything about economics you'd realize that this is...well, I hope this is a joke. If it is, it's pretty decent, I'll give you that.

[crypto-fascist superhero]

They would be central bank-only currencies like IMF Special Drawing Rights, and could only be bought and sold by central banks or national governments.  I suppose it wouldn't really be defeating the purpose if they were used by commercial banks or even traded in the market either.

That's not really a far out-there suggestion.

[Beet]

How would you prevent a country like Greece from creating an endless amount of "virtual Drachmas" and using it to 'purchase' euros from the European Central Bank?

[Gustaf]

They would be central bank-only currencies like IMF Special Drawing Rights, and could only be bought and sold by central banks or national governments.  I suppose it wouldn't really be defeating the purpose if they were used by commercial banks or even traded in the market either.

That's not really a far out-there suggestion.

So what about what Beet said?

I'm a bit confused as to how this either differs from a currency union or alternatively from a currency peg.

[crypto-fascist superhero]

How would you prevent a country like Greece from creating an endless amount of "virtual Drachmas" and using it to 'purchase' euros from the European Central Bank?

For the same reason they couldn't create an endless amount of real Drachmas prior to entering the Eurozone.

[Beet]

How would you prevent a country like Greece from creating an endless amount of "virtual Drachmas" and using it to 'purchase' euros from the European Central Bank?

For the same reason they couldn't create an endless amount of real Drachmas prior to entering the Eurozone.

What reason is that?

[crypto-fascist superhero]

How would you prevent a country like Greece from creating an endless amount of "virtual Drachmas" and using it to 'purchase' euros from the European Central Bank?

For the same reason they couldn't create an endless amount of real Drachmas prior to entering the Eurozone.

What reason is that?

Because they would become worthless, obviously.

[True Federalist]

Other than being tied to a Deutschmark denominated Euro and having a fixed peg rather than trading bands, this sounds pretty much like the ECU that was the precursor to the Euro.

[Beet]

How would you prevent a country like Greece from creating an endless amount of "virtual Drachmas" and using it to 'purchase' euros from the European Central Bank?

For the same reason they couldn't create an endless amount of real Drachmas prior to entering the Eurozone.

What reason is that?

Because they would become worthless, obviously.

Not really. Prior to entering the Eurozone, if they kept on creating Drachmas, the Drachma would lose its value quickly, but its value would never fall to zero. Even Zimbabwe's currency never fell to zero; it only fell to a very, very small amount approaching zero. The cost that this imposed on society was through inflation.

But now you're talking about a currency that is not traded on the market. If I understand correctly, it would only be traded between the Bank of Greece and the European Central Bank, two government actors, who could then set the price at whatever level they wished. Thus, the Bank of Greece could still print endless Drachmas, and use it to buy Euros, so long as the European Central Bank allowed any exchange rate.

[crypto-fascist superhero]

How would you prevent a country like Greece from creating an endless amount of "virtual Drachmas" and using it to 'purchase' euros from the European Central Bank?

For the same reason they couldn't create an endless amount of real Drachmas prior to entering the Eurozone.

What reason is that?

Because they would become worthless, obviously.

Not really. Prior to entering the Eurozone, if they kept on creating Drachmas, the Drachma would lose its value quickly, but its value would never fall to zero. Even Zimbabwe's currency never fell to zero; it only fell to a very, very small amount approaching zero. The cost that this imposed on society was through inflation.

But now you're talking about a currency that is not traded on the market. If I understand correctly, it would only be traded between the Bank of Greece and the European Central Bank, two government actors, who could then set the price at whatever level they wished. Thus, the Bank of Greece could still print endless Drachmas, and use it to buy Euros, so long as the European Central Bank allowed any exchange rate.

Well yes, I meant "worthless" as a figure of speech, obviously.  And the ECB would presumably not be willing to sell Euros at any exchange rate, though your point that it would be too open to manipulation is fair; I'll probably amend my original proposal to allow them to be forex traded.  (I came up with this at like 1 AM, so I can be forgiven for not having thought everything through that well).

[Politico]

How the Eurozone should have been set up: Common market without monetary union, not to mention a lot of the regulations (Don't even get me started on CAP, which is the cause of the largest amount of wasted food in the history of mankind).

[crypto-fascist superhero]

How the Eurozone should have been set up: Common market without monetary union, not to mention a lot of the regulations (Don't even get me started on CAP, which is the cause of the largest amount of wasted food in the history of mankind).

Well yes, I agree.  I'm just saying that if they had to have a multinational currency, they should've set it up differently.  It's funny that certain types are always insisting that having common markets must always come with surrender of sovereignty, whether it be "unions" as in the EU or simply international "commissions" that for some reason have the power to legislate in their "oversight" of trade (as in NAFTA).

[Gustaf]

So, if I understand correctly what you're proposing is that there is an electronic currency for each country that isn't Germany that can be traded freely on markets. What does this achieve?

There is nothing this currency can be used for other than to buy euros. And it can't really be used for that either, since there is a given exchange rate which will move depending on how many drachmas or whatever are created.

Also, it's unclear for me why anyone would want to trade the drachmas. If I have euros that I can use to buy stuff with, why would I ever trade them for drachmas that can't be used to buy anything? Put differently, the drachmas would be worthless to the ECB so the "trade" would pretty much just be giving the countries money like under any system, wouldn't it?

It doesn't seem to make any relevant difference for the situation of these countries.

[Wonkish1]

There has been a lot of talk about how the Eurozone presented a moral hazard, in which countries like the PIIGS could deficit spend and borrow cheaply with Euro-denominated bonds, taking advantage of the fiscal rectitude of other Euro members (specifically Germany), then expecting to be bailed out once their profligate ways caught up with them.

It seems to me that this was entirely predictable, and could've been entirely prevented merely by setting up the Eurozone in a more sensible way.  Here's how I would have done it:

1. The Euro would've been pegged at 1 Euro = 1 Deutschmark, as in real life.

2. The paper versions of other currencies (Francs, Drachmas, Liras) would be phased out, but they would remain at their pre-Euro values as virtual electronic currencies used only by their country's respective central banks.

3. Euros would then have to be purchased by national central banks from the European Central Bank using "virtual Francs," "virtual Drachmas" etc.  (And, yes, virtual Deutschmarks too).

In this way a single currency could be implemented without compromising national sovereignty, and each country could have its own monetary and fiscal policies, but without any moral hazard as they would have to face the real-world consequences of inflationary policies.

I try to avoid getting harsh towards a post where the poster is trying to throw out new original ideas, etc. because I wish more people would do that instead of regurgitating other people's ideas, but...

this isn't going to work for hundreds of reasons. So...

back to the drawing board. Others on here have already nailed a few of the issues so I wont go into the laundry list of things you would need to address in coming up with your next proposal.

But I'll point out one thing that is some food for thought. When it comes to currency the goals of  most sane people who understand the topic is well understood. The goals are: price stability, the absence of monetary imbalances, and stability in the money supply. Now they all tend to go hand and hand, but being able to actually accomplish these things(especially the 1st and 3rd) are very challenging on any monetary system. So the interesting question here is given the challenge of accomplishing this do you think you are better served by having one currency that could end up doing things very well or very badly *or* by having competition among many currencies?

So if I were you I would look at trying to think up a structure that attempts to make ease of doing cross currency business easier(the goal of the Euro) under a competitive currency system vs. taking the assumption of single currency and then trying to add some multi-currency addition onto it. So yeah just some food for thought.

[Gustaf]

One of the main point in the euro debate is the so-called trilemma. You can't have 1) free capital markets, 2) exchange rate stability and 3) counter-cyclical monetary policy all at the same time.

You can be China and have 2 and 3. You can be Denmark and have 1 and 2. Or you can be Sweden and have 1 and 3. For example.

Most countries in the West have moved towards giving up 2. Except for the EU, of course, who are always trying to run away from the future.

[Wonkish1]

One of the main point in the euro debate is the so-called trilemma. You can't have 1) free capital markets, 2) exchange rate stability and 3) counter-cyclical monetary policy all at the same time.

You can be China and have 2 and 3. You can be Denmark and have 1 and 2. Or you can be Sweden and have 1 and 3. For example.

Most countries in the West have moved towards giving up 2. Except for the EU, of course, who are always trying to run away from the future.

Lets just call a spade, a spade here. There is really no such thing as true long term exchange rate stability without a uniform taxing authority and similar economic circumstances. Even in the case of China we're seeing their idea fall apart as the imbalances just grew to large.

They may have thought they could control the exchange rate through their peg and restrict capital flow, but in times of great crisis that suppression of volatility comes crashing down with great affect. Today the *real* on shore vs. off shore exchange rates are very different numbers indeed(and getting worse) and somehow capital is finding its way out of China even with some of the most draconian laws and enforcement in the entire world.

Not even China can defy the markets and change the laws of gravity by PSC edict.



And of course, besides flipping between barely accommodative and barely restrictive who wants counter cyclical monetary policy? Not me! But I'm also not one that is willing to buy a lot of future pain in exchange for selling a small amount of the pain today. But I guess we've become a "right now", "this moment" world that doesn't care about the consequences of anything long term as long as we can get some benefit today even if its a small one.

[Gustaf]

I'm not a fan of exchange rate stability either because I agree that it can't be upheld anyway.

I do like stabilizing the real economy though and I'm not sure why you aren't. You think Schumpeterian destruction should be allowed to run its course completely unfettered?

[Wonkish1]

I'm not a fan of exchange rate stability either because I agree that it can't be upheld anyway.

I do like stabilizing the real economy though and I'm not sure why you aren't. You think Schumpeterian destruction should be allowed to run its course completely unfettered?

No actually quite the contrary. I personally believe the medicine causes more "Schumpeterian destruction" over the long term than trying to artificially encourage bad investment for the purpose of stimulating and economy.

Think about it. You lower interest rates and increase the money supply so people will take out more debt. Now if the debt is taken out for productive investment its a good thing, but the dirty little secret is that if its propuctive enough to generate a net positive return under historical average interest rates the credit will be taken out anyway and the investment made. The only thing you get out of artifically accomodative monetary policy is investment that looks reasonable under the artificially low interest rate, but will blow up the moment interest rates revert to the mean(let alone higher to try to "cool things down").

So in a practical sense let's say mean prime is 5.5%. Now if you lower the FFR to let's say 3% you'll probably see prime borrowers willing to make investment for anything over a 5-6% return generating ~3%+ spread on FFR. And at least breaking even when interest rates rise back to normal. Today the FFR is sitting at 0% and mortgage rates are 4% fixed. Do you actually think that 4% 30 year fixed is sane investment from a bank? Or do you think its at least a worthy point to acknowledge that we have effectively bought our banking system future pain because 4% today is so sexy for a lender given our overly accomodative policy today.

So yeah if you didn't artificially create situations where dumb investment is so temporarily profitable then you probably wouldn't have much in the way of large downturns that would actually result in calls for countercyclical monetary policy. The only reason why you see them calling for it is because you got the pain from the last time you did it and goosed stupidity into the system.

[Gustaf]

I'm not a fan of exchange rate stability either because I agree that it can't be upheld anyway.

I do like stabilizing the real economy though and I'm not sure why you aren't. You think Schumpeterian destruction should be allowed to run its course completely unfettered?

No actually quite the contrary. I personally believe the medicine causes more "Schumpeterian destruction" over the long term than trying to artificially encourage bad investment for the purpose of stimulating and economy.

Think about it. You lower interest rates and increase the money supply so people will take out more debt. Now if the debt is taken out for productive investment its a good thing, but the dirty little secret is that if its propuctive enough to generate a net positive return under historical average interest rates the credit will be taken out anyway and the investment made. The only thing you get out of artifically accomodative monetary policy is investment that looks reasonable under the artificially low interest rate, but will blow up the moment interest rates revert to the mean(let alone higher to try to "cool things down").

So in a practical sense let's say mean prime is 5.5%. Now if you lower the FFR to let's say 3% you'll probably see prime borrowers willing to make investment for anything over a 5-6% return generating ~3%+ spread on FFR. And at least breaking even when interest rates rise back to normal. Today the FFR is sitting at 0% and mortgage rates are 4% fixed. Do you actually think that 4% 30 year fixed is sane investment from a bank? Or do you think its at least a worthy point to acknowledge that we have effectively bought our banking system future pain because 4% today is so sexy for a lender given our overly accomodative policy today.

So yeah if you didn't artificially create situations where dumb investment is so temporarily profitable then you probably wouldn't have much in the way of large downturns that would actually result in calls for countercyclical monetary policy. The only reason why you see them calling for it is because you got the pain from the last time you did it and goosed stupidity into the system.

Well, but that's just assuming that monetary policy is done stupidly.

Let's say average inflation is 2% (the goal of the Swedish Riksbank). Let's say the average nominal interest rate is 4%. That yields a real interest rate of 2%. If the economy starts overheating and inflation goes to 4%, you raise interest rates to 6%, thus maintaining the same real rate and preventing further overheating. Vice versa in downturns.

Or do you think there would be no business cycle if there was no monetary policy?

[Wonkish1]

I'm not a fan of exchange rate stability either because I agree that it can't be upheld anyway.

I do like stabilizing the real economy though and I'm not sure why you aren't. You think Schumpeterian destruction should be allowed to run its course completely unfettered?

No actually quite the contrary. I personally believe the medicine causes more "Schumpeterian destruction" over the long term than trying to artificially encourage bad investment for the purpose of stimulating and economy.

Think about it. You lower interest rates and increase the money supply so people will take out more debt. Now if the debt is taken out for productive investment its a good thing, but the dirty little secret is that if its propuctive enough to generate a net positive return under historical average interest rates the credit will be taken out anyway and the investment made. The only thing you get out of artifically accomodative monetary policy is investment that looks reasonable under the artificially low interest rate, but will blow up the moment interest rates revert to the mean(let alone higher to try to "cool things down").

So in a practical sense let's say mean prime is 5.5%. Now if you lower the FFR to let's say 3% you'll probably see prime borrowers willing to make investment for anything over a 5-6% return generating ~3%+ spread on FFR. And at least breaking even when interest rates rise back to normal. Today the FFR is sitting at 0% and mortgage rates are 4% fixed. Do you actually think that 4% 30 year fixed is sane investment from a bank? Or do you think its at least a worthy point to acknowledge that we have effectively bought our banking system future pain because 4% today is so sexy for a lender given our overly accomodative policy today.

So yeah if you didn't artificially create situations where dumb investment is so temporarily profitable then you probably wouldn't have much in the way of large downturns that would actually result in calls for countercyclical monetary policy. The only reason why you see them calling for it is because you got the pain from the last time you did it and goosed stupidity into the system.

Well, but that's just assuming that monetary policy is done stupidly.

Let's say average inflation is 2% (the goal of the Swedish Riksbank). Let's say the average nominal interest rate is 4%. That yields a real interest rate of 2%. If the economy starts overheating and inflation goes to 4%, you raise interest rates to 6%, thus maintaining the same real rate and preventing further overheating. Vice versa in downturns.

Or do you think there would be no business cycle if there was no monetary policy?

I think that countercyclical monetary policy grossly exasperates the business cycle. Without it and you have minor recessions that continue to get less severe as time goes on and economies get more and more diversified.

In theory the biggest natural downturns should happen when your economy is reliant on a single industry...like the potato famine in Ireland a few centuries ago when agriculture was the vast majority of the Irish economy. Fast forward a few hundred years and we now have hundreds of industries in an economy. A crash in one should only produce a minor blip in others. Instead we have large increases in the money supply that show up in only a hand full of industries and the business cycle becomes more pronounced.


And if you see a doubling of the inflation rate because your nominal interest rates are to low then increasing interest rates to maintain the same real interest rate isn't going to cool things down in countercyclical monetary policy. You would likely have to raise to 7% therefore increasing the real interest rate from 2% to 3% in order to produce a sufficient pain level to cool down the economy. But when it comes to me the idea of raising interest rates to 7%+ territory to cool down the dumb$hit decision to have things artificially low before is stupid. In an ideal world monetary policy would approach a level of talent where interest rates barely move over the long term and that it remains remarkably consistent because they are high enough to discourage bad investment and excessive money creation, but low enough that true strong growth is unabated by excessively higher interest rates. Instead we are now living in a world where countercyclical monetary policy produces bigger peaks in interest rates and bigger troughs in interest rates. That isn't a good thing for long term investment planning and decisions.