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Monday, January 24, 2011

Is EMU a new Rouble zone?

An interesting fact revealed by the Irish Independent has gone almost unnoticed.

The newspaper reported this less than two weeks ago:
The Irish Independent learnt last night that the Central Bank of Ireland is financing €51bn of an emergency loan programme by printing its own money... ...A spokesman for the ECB said the Irish Central Bank is itself creating the money it is lending to banks, not borrowing cash from the ECB to fund the payments. The ECB spokesman said the Irish Central Bank can create its own funds if it deems it appropriate, as long as the ECB is notified.

News that money is being created in Ireland will feed fears already voiced this week by ECB president Jean-Claude Trichet that inflation is a potential concern for the eurozone.
Jack Barnes, a retired professional trader comments:
This is a form of hyperinflation if you will, at least in context that a Central Bank, with no actual printing press, or a functioning bond market, has now electronically printed up new currency units for their banks without issuing debt behind these actions.

While this has happened before in history, it has not happened in the Euro currency project officially before today. This act is going to move the monetary policy of the union, to the individual capitals. The capacity to print electronic credits, with out the creation of cash currency or debt, is a new wrinkle in the economic landscape.
Citi chief economist Willem Buiter, who, as late as 2009, called for the UK to adopt the euro, has now published a paper looking at these operations. He makes a not so flattering comparison to another monetary union, which fell on hard times:
A monetary union with multiple independent centres of money creation will end up looking like the Rouble zone that survived the collapse of the Soviet Union at the end of 1991 for a bit, until it collapsed in a series of chaotic hyperinflations.
Meanwhile, Yale Phd Ed Dolan, who was a professor in Moscow from 1990 until 2001, provides some background in a new briefing, "The Breakup of the Ruble Area (1991-1993): Lessons for the Euro ":
The Central Bank of Russia claimed a monopoly on the issue of paper currency, but each of the 15 central banks of the ruble area could inflate the money supply through creation of bank credits. Each government was able to gain the full seigniorage benefit of financing its deficit through its own central bank, while spreading the resulting inflation among the whole group of 15.

(...) This gave rise to a free rider problem: Each country could use central bank credit to finance its budget deficit The resulting inflation was transmitted among all 15 member countries Each country had an incentive to act as a free rider, enjoying the benefits of credit expansion while shifting the inflationary costs to its neighbors.
Interestingly, as others before him, he sees Germany leaving the euro as the more preferable option:
It is hard for countries with weak economies to leave a stable currency area because doing so can trigger defaults and bank runs. These exit barriers do not apply to countries with strong economies that want to leave a weak, inflation-ridden currency area.
Similar inflation concerns are now forcing the ECB to choose: increase interest rates to promote a hard currency, satisfying Germany; or keep rates low to help out struggling economies on the eurozone's periphery.

Perhaps the first chapter of the eurozone crisis is over. Another one is about to begin.


Ed Dolan said...

There is a parallel between ELA operations and the operations of national central banks within the ruble area, but the latter were much more brazen than ELAs have been (so far). The post-Soviet central banks did not limit themselves to offering liquidity support. They created new reserves and then used those as a basis for loans directy to governments and state enterprises. The equivalent operation for the euro could work like this: A national central bank advances money to a commercial bank under an ELA AND makes the advance conditional on the commercial bank's purchase of a certain quantity of bonds issued by the national government. THEN you would have a ruble-zone parallel, for sure. Could it be done? Hmm.

Open Europe blog team said...

Ed Dolan, thanks for those very interesting observations. We agree, the eurozone has some way to go before the parallel becomes fully valid (but there are no doubt lessons and similarities).

What's clear is that eurozone leaders/central bankers have already done the "unthinkable" twice, by engaging in bail-outs and buying junk government bonds (speaking of the ECB now). If the crisis fully re-erupts, they might be forced to seek more unthinkable 'solutions'.

Jack H Barnes said...

The events in Ireland remind me of the Latin Currency unit of the late 1865 to 1927 (yes it was actually dead before WW1, but was not formally dead until then).

It was debased when the silver was diluted in the currency coins everyone shared. The Papal State's treasurer, Giacomo Antonelli, began to debase their currency by coining bad money, and expecting to exchange it at equal rates.

The union died with a whimper and not a bang. There is the same possibility that the Euro area returns to its earlier stage of a national currency and a Euro rate.

If so, the Euro will end in the same type of whimper long after the individual states have extracted all they can from the currency and have returned to self printing, instead of group printing.