Editor’s Note: Greece is looking at defaulting on its debts yet again, the EMU remains in crisis mode. In this article from 2001, Philipp Bagus, author of The Tragedy of the Euro, suggests that such crises are inevitable:
Although the external effects of a monopolistic money producer and a fractional-reserve banking system regulated by a central bank are common in the Western world, the establishment of the euro implies a third and unique layer of external effects. The institutional setup of the Eurosystem in the EMU is such that all governments can use the ECB to finance their deficits.
A central bank can finance the deficits of a single government by buying government bonds or accepting them as collateral for new loans to the banking system resulting. Now we are faced with a situation in which several governments are able to finance themselves via a single central bank: the ECB.
When governments in the EMU run deficits, they issue bonds. A substantial part of these bonds are bought by the banking system. The banking system is happy to buy these bonds because they are accepted as collateral in the lending operations of the ECB. This means that it is essential and profitable for banks to own government bonds. By presenting the bonds as collateral, banks can receive new money from the ECB.
The mechanism works as follows: Banks create new money by credit expansion. They exchange the money against government bonds and use them to refinance with the ECB. The end result is that the governments finance their deficits with new money created by banks, and the banks receive new base money by pledging the bonds as collateral.
The incentive is clear: redistribution. First users of the new money benefit. Governments and banks have more money available; they profit because they can still buy at prices that have not yet been bid up by the new money. When governments start spending the money, prices are bid up. Monetary incomes increase. The higher the deficits become and the more governments issue bonds, the more prices and incomes rise. When prices and incomes increase in the deficit country, the new money starts to flow abroad where the effect on prices is not yet felt. Goods and services are bought and imported from other EMU countries where prices have not yet risen. The new money spreads through the whole monetary union.
In the EMU, the deficit countries that use the new money first win. Naturally, there is also a losing side in this monetary redistribution. Deficit countries benefit at the cost of the later receivers of the new money. The later receivers are mainly in foreign member states that do not run such high deficits. The later receivers lose as their incomes start to rise only after prices increase. They see their real income reduced. In the EMU, the benefits of the increase in the money supply go to the first users, whereas the damage to the purchasing power of the monetary unit is shared by all users of the currency. Not only does the purchasing power of money in the EU fall due to excessive deficits, but interest rates tend to increase due to the excessive demand coming from overindebted governments. Countries that are more fiscally responsible have to pay higher interest rates on their debts due to the extravagance of others. The consequence is a tragedy of the commons. Any government running deficits can profit at the cost of other governments with more balanced budgetary policies.
