Arnold Kling  

Time for Cryptonomicon

Strange Moments in Marginalism... The Best Policy for the Sovere...

Martin Feldstein writes,

In the end, Greece, the eurozone's other members, and Greece's creditors will have to accept that the country is insolvent and cannot service its existing debt. At that point, Greece will default.

Feldstein points out that there are a number of ways in which Greece can repay its current bondholders less than what they are owed. Bear in mind that Feldstein is a long-term skeptic of the euro. Other economists used to be less skeptical, but we are not hearing much from them these days.

Paul Krugman makes Feldstein sound like a euro-bull. Krugman writes,

the Greek government cannot announce a policy of leaving the euro -- and I'm sure it has no intention of doing that. But at this point it's all too easy to imagine a default on debt, triggering a crisis of confidence, which forces the government to impose a banking holiday -- and at that point the logic of hanging on to the common currency come hell or high water becomes a lot less compelling.

Nick Rowe thinks that the European Central Bank will be constrained by its internal procedures to permit a contraction of the money supply.

If the ECB won't create enough money, some Eurozone governments will eventually start creating their own.

Feldstein, Krugman, and Rowe are focused on the problems with the euro as a common monetary unit. But how does the monetary problem relate to the fiscal crises? Peter Boone and Simon Johnson explain,

The underlying problem is the rule for printing money: in the eurozone, any government can finance itself by issuing bonds directly (or indirectly) to commercial banks, and then having those banks "repo" them (i.e., borrow using these bonds as collateral) at the ECB in return for fresh euros. The commercial banks make a profit because the ECB charges them very little for those loans, while the governments get the money - and can thus finance larger budget deficits. The problem is that eventually that government has to pay back its debt or, more modestly, at least stabilize its public debt levels.

This same structure directly distorts the incentives of commercial banks: they have a backstop at the ECB, which is the "lender of last resort"; and the ECB and European Union (EU) put a great deal of pressure on each nation to bail out commercial banks in trouble. When a country joins the eurozone, its banks win access to a large amount of cheap financing, along with the expectation they will be bailed out when they make mistakes. This, in turn, enables the banks to greatly expand their balance sheets, ploughing into domestic real estate, overseas expansion, or crazy junk products issued by Goldman Sachs. Just think of Ireland and Spain, where the banks took on massive loans that are now sinking the country.

Given the eurozone provides easy access to cheap money, it is no wonder that many more nations want to join. No wonder also that it blew up. Nations with profligate governments or weak financial systems had a bonanza. They essentially borrowed funds from the less profligate elsewhere in the eurozone, backed by the ECB.

Neal Stephenson's Cryptonomicon has a plot that revolves around an attempt to create a private money backed by gold, not by governments. I would say that if an entrepreneur could create a credible private money, now would be a really opportune time to bring it to market.

COMMENTS (12 to date)

What about legal tender and other laws hampering such money creation?

rik writes:

why nobody talks about the USA be in bankrupcy? that's the real issue, that and the fact that there are no great diferences between what Peter Boone and Simon Johnson explain about the ECB and what the FED (a Private bank) does in the US.

""Thanks to the endless barrage of feel-good propaganda that daily assaults the American mind, best epitomized a few months ago by the “green shoots,” everything’s-coming-up-roses propaganda touted by Federal Reserve Chairman Bernanke, the citizens have no idea how disastrous the country’s fiscal, monetary and economic problems truly are. Nor do they perceive the rapidly increasing risk of a totalitarian nightmare descending upon the American Republic. One stark and sobering way to frame the crisis is this: if the United States government were to nationalize (in other words, steal) every penny of private wealth accumulated by America’s citizens since the nation’s founding 235 years ago, the government would remain totally bankrupt."

"Putting Fiscal Year 2009’s $9,000,000,000,000.00 ($9 trillion) deficit another way, 17% of America’s private wealth, accumulated over a period of 235 years, was wiped out by just one year’s worth of government deficit spending insanity. "

Nick Firoozye writes:

I think you misunderstand the ECB repo process. Money is not free there. Under normal (non QE) conditions, the ECB will accept a wide range of collateral but will not provide 100% allotment. It is usually done through variable rate auctions for a pre-announced target operation. Then further fine tuning.

The ECB has not had the floodgates open for years, being serious inflation targeters (and I put serious there to make them stand opposite the Fed, which has run a much more inflationary policy).

Recently, the ECB has allowed the carry trade on a regular basis, and this is effectively how EUR ABS markets and covered bond markets are financed. And, increasingly how certain sovereigns are financed.

Now, I have to admit I am teribly shocked at both Krugman and Feldstein. I am not an economist but I learned long ago that it is rare that one would have a justification for Certainty Equivalence (let's say we need normal innovations and quadratic optimization only!). I am shocked that trained economists speak in terms like they know something with all certainty.

Seriously now, Greece can get a package and if it adheres to stringent terms and the package is extended, there is a significant probability that they can cure their debt hangover. Again, nothing is known with certainty. The doubledip scenario could push them over the brink...but at least I'm being honest in showing alternative possibilities, unlike the Eurosceptics out there.

roversaurus writes:

I still don't get what is happening.
I really don't undertand the whole central bank thing.

Is this correct:
The government of Greece prints a bond. I think
I got that. It is a certificate that promises to pay X Euros on Y date to the person Z who owns the bond. They print an IOU, right?

They Give? Foist upon? Sell? a big bank this bond.
The bank gives Greece money. Some amount of money LESS than the bond. So this looks a lot like a loan to me, right?

So what does the bank do with this bond? Where did the bank get the actual bills to give the government? They aren't really bills that they give but since this is real money it came from somewhere, right?

Some of it came from depositers? Some from investers? And I think some (the majority) comes from the European Central Bank? How does the big bank get that money from the central bank? Does the big bank just borrow it from the Central Bank and say, "Hey we've got these Greek bonds as collateral for the loan?" That must mean that the big bank is getting a lower interest rate for the money they are borrowing from the ECB than the interest rate they are charging Greece, right? How in the world does that happen? And if the ECB is willing to loan money at a lower interest rate why doesn't Greece just borrow the money from the ECB directly???

Can someone explain this for idiots?

Nick Rowe writes:

Arnold: "I would say that if an entrepreneur could create a credible private money, now would be a really opportune time to bring it to market."

I totally agree! But I would add that when *you* say that, you are implicitly admitting that there is a shortage of aggregate demand. A shortage of aggregate demand, in a monetary exchange economy, is the same thing as an excess demand for money. That's why people are more likely to resort to barter, or to alternative monetary systems, or private monies, during a recession. ;)

Doc Merlin writes:

"Neal Stephenson's Cryptonomicon has a plot that revolves around an attempt to create a private money backed by gold, not by governments. I would say that if an entrepreneur could create a credible private money, now would be a really opportune time to bring it to market."

1. It existed, it was called egold. It was shut down by the FBI, although I hear its running again.

2. A problem with metalic based non-government currencies is that when the government expands their currency, you have to pay capital gains taxes on the difference between the nominal price of your currency and its uninflated price.

3. The federal reserve makes over 99% in seignorage when it prints money, no gold backed currency could get anywhere near that, and could be easily driven out of business or at least marginalized.

4. A large part of the housing bubble was caused because houses and money were highly substitutable for store of value.

BZ writes:


I'm with you, this is confusing. The story you told seems to match Dr Kling's-- the big bank borrows from the central bank with the government IOUs as collateral. The big bank gets a cut off the top, and would have NO trouble turning over worthless IOUs to the central bank if the government should default. The central bank prints the money to buy the IOUs, so, no skin off it's nose.

The government gets money for nothing. The Big Bank gets money for the governments nothing. The central bank enables it all.

Like Rover, I'm convinced I *must* be missing something.

mulp writes:

Why would anyone agree to repay any new debt in gold if everyone was going to move to repaying debt in gold. That is a sure fire path to foreclosure.

The only way switching to gold as money would be reasonable would be if the process of extracting gold from sea water were improved so the price of the wind energy to power gold extraction resulted in gold production equal to the market price of gold. Then the supply of gold tracks the return on capital - if the return on capital increases, gold production will stay constant as the gold extraction capital falls in value, and that will limit the rate of gold supply increase limiting economic growth. If the return on capital falls, investing in gold extraction capital will be increasingly rewarded and the supply of gold will increase more rapidly, spurring economic growth. Or causing inflation.

Of course, if gold extraction from water becomes a big industry, the process will become more efficient and inflation will result, with the calls to switch to something else, like paper money, to bring prices under control.

The only reason gold is priced about twice the cost of extraction is the cost of opening a new mine is incredibly high, and serious mining companies know that increasing gold production is a sure fire way to lose money on a massive capital investment. Half of gold mining output is a bonus of copper mining, or other related metals mining.

ricardo writes:

I've long (OK, for the last couple of years) told (tongue somewhat in cheek) my students that the paypal would be the dominant global currency in my lifetime.

rico writes:

I was under the impression that Paypal was intended (if not put into practice appropriately) to function as an alternative currency. I'll have to investigate how exactly I came to that impression and how valid it really is, but now you've gone and caused me to want to read Cryptonomicon.
Don't you realize how big that book is? While you're at it, push Atlas Shrugged as well!

Kai writes:

Ok I'll try to recapture from my monetary polica classes to solve some of the questions poses earlier. I write about the ECB, but I guess the Fed will be at least similar.

At first it is important to distinguish between different kinds of money supply. Money is not solely created by the central bank. Private banks can borrow money from the central bank, and they have to provided collaterals for that. However under normal circumstance most of the money is borrowed from other private bank, which is called the interbank market.
This way the private banks can create money, the only restriction is that they have to hold a certain percentage of their credit volume, the minimum reserve rate, at the central bank. However competition between central banks has driven down minimum reserve rates to above 2% in most countries.

So what makes up the monetary supply?
The central bank actually provides cash C
The overall credit volume of private banks is labelled D.
The central bank therefore controls the cash part C, and the percentage r*D that has to be hold as Reserves. The other factor determining monetary supply are all consumers (citizens) and their preference for cash. This c = C/D is the second part of the multiplicator m = (1+c)/(1+r). They determine the relationship between the central bank money and the monetary supply.

What is important about this? First of all it shows that the central bank doesn't have all control over monetary supply. In the Euro area different kinds of money tenders are used, in which money is offered in an auction. The tenders are either interest rate of quantity based, and normally they are restricted to a certain amount of money. If private banks want to buy more money than is available, the available amount is splitted among them. This had only changed in the financial crises, when the ECB decided to give up the quantity restrictions for a certain time to help the economic recovery.

Under normal conditions banks don't borrow that much money from the ECB, as criteria are quite strict and only high class collaterals are accepted. The best collaterals are usually bonds issued by states, which increases the demand for these. That is, why it is so problematic when the states are downgraded. If the ECB follows their own guidelines they can no longer accept them as collaterals, thereby further reducing the attractiveness of greek bonds, thereby further increasing the rates Greece has to pay.

if you wonder how the central bank does influence the interest rates in this system, think of it this way. They can introduce a certain range in between which interest rates will lie. No one will borrow money for a price significantly above what he has to pay the central bank. So the central bank price serves at an upper bound for the debit rates. And as you can also deposit money at the central bank, they can also set a minimum credit interest.
However most of the central bank loans are short term, a week up to a month. Hence the central bank can influence short term interest rates, but the rates for longer loans are also influenced by other factors.

Why is all this important? A private bank could borrow money from the central bank, but the overall amount is normally restricted and the maturity would be about 1 month. On the other hand a greek government bond will likely have a maturity of 10-20 years and bear a risk of default (among others). The financial crisis has shown that a strategy of finance short term and invest long term will pose a serious risk to every business!

Sorry for any mistakes, it's quite late but I hope it helped

Andrew T writes:

I think the part of the Maastricht Treaty intended to deal with the opportunism described is Article 104 (see below). The intent of Article 104 seems to be that the ECB will not bail out EMU member states. Paragraph 2 could provide an out, but I am not sure of how it is interpreted. Even so, Article 104a appears to put limits on what financial institutions can do to help out any specific member nation.

If monetary policy was invoked to accommodate profligate spending of the member states, I would think we would see inflation at some point ... Greece may be too small to cause serious inflation, but adding on some others (Portugal, Spain, etc) may make the impact large enough to notice.

All that being said, the EMU member nations can decide to disregard their monetary constitution (the Maastricht Treaty). It appears some portion are prepared to do so by providing a bailout to Greece. The fiscal bailout prohibition is in Article 104b.

1. Overdraft facilities or any other type of credit facility with the ECB or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Community institutions or bodies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments.
2. Paragraph 1 shall not apply to publicly-owned credit institutions which, in the context of the supply of reserves by central banks, shall be given the same treatment by national central banks and the ECB as private credit institutions.
1. Any measure, not based on prudential considerations, establishing privileged access by Community institutions or bodies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States to financial institutions shall be prohibited.

1. The Community shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of any Member State, without prejudice to mutual
financial guarantees for the joint execution of a specific project. A Member State shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law or public undertakings of another Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project.
2. If necessary, the Council, acting in accordance with the procedure referred to in Article 189c, may specify definitions for the application of the prohibitions referred to in Article 104 and in this Article.

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