Not the EMF … anything but the EMF!

What is it about Europeans? Historically, they seem to want to invade each other with regularity with mass carnage the result and sometimes some border re-alignments. They are happy when there is a freezing cold white-out (or do they just say that to avoid acknowledging it is better in the sun by the beach). When they do get to the beach – it is always at some tacky crowded place and they end up looking like cooked lobsters. They love Eurovision pop and … soccer. Need I go on? And then they decide to lumber themselves with a poorly conceived and shockingly designed common currency arrangement that hasn’t a hope of delivering sustained prosperity to all member states and continually requires damaging deflations and reductions in living standards when external crises hit. But then ….

But then … when the common currency system breaks down and its design flaws are exposed for any discerning person to see … what do they do? They start talking about new institutional arrangements to the Eurozone system that will just make things worse for themselves … and especially the weak and disadvantaged that tend to live in the peripheral nations to the south and west.

Editor’s note: before all you Europeans send me bombs in the mail let it be known that I am of European descent, I love cycle racing (particularly cyclo-cross), and I love visiting Europe – unless it is cold … which it seems to be most nearly all the time. 🙂

Anyway, now the geniuses in Brussels and Frankfurt are actually considering institutional changes to their crock of a monetary system.

The Dutch Volkskrant covered the story – Noodfonds voor zwakke eurolanden.

The French covered it – Les initiatives du FMI agacent les banques centrales.

The UK Times covered it twice – Europe set to establish monetary fund to aid stability and Europe plans its own answer to the IMF.

And I am sure if I read other European newspapers (not that I include Britain as part of Europe) on a daily basis they would have covered it too.

What am I referring to?

All the talk this week is that the genuises in Brussels and Frankfurt and elsewhere are discussing the creation of a Eurozone IMF which they are styling as the European Monetary Fund.

The context for these discussions are as follows. At present, with the economic crisis exposing the fundamental flaws in the design of the Eurozone system and Greece under increasing solvency pressure, the EMU bosses do not have many choices available.

As a note, while Greece is in the spotlight at present, even Germany faces solvency risk if a further financial crisis ensues. Solvency risk for all Eurozone member nations is built into the design of the EMU and is one of its largest shortcomings.

So in the short-term there are four options.

First, member countries or the ECB can easily lend funds to Greece. But that would be a major a back down for the mandarins in Brussels and Frankfurt and their pride will stop that happening … well sort of. Ultimately, they will have to lend them the funds but wait for the spin they put on it.

Second, they can allow the Greek government to default – this would seriously destabilise the entire currency zone and they won’t let that happen (unless the whole zone goes under which is possible).

Third, they could allow the IMF to lend Greece the reserves necessary to avoid default. But again the Euro pride will not allow that option and more substantively, it would be a gross admission that the whole currency system had failed.

The UK Times quoted the German Finance Minister as saying in this context:

Accepting financial aid through the International Monetary Fund would, in my opinion, be an admission that the euro countries can’t solve their problems through their own efforts.

I agree with that. The less the IMF has to with anything the better for everyone except their official who enjoy the power trip.

Fourth, the Greek government can do the sensible option and pull out of the EMU and encourage Ireland, Portugal, Italy, Spain and other nations to do so as well. While preferable, it is unlikely to happen in the current period. I cover that option in this blog – Exiting the Euro?.

So while the first option will be the salve in the short-run, they are now leaning towards option three – or their version of the IMF to avoid this problem in the future.

What they do not want to admit is that this is no solution to the underlying problem. It will just introduce additional harshness into an already ridiculous economic and monetary arrangement. This needs some explanation.

The EMF proposal

It seems that the Germans and perhaps the French are pushing for the establishment of a “European Monetary Fund, mirroring the International Monetary Fund, to reduce economic instability in the eurozone” (Source)

The UK Times article – Europe set to establish monetary fund to aid stability – published March 8, 2010 reported that the German Finance Minister:

… said that eurozone countries needed to learn the lessons of the Greek crisis, which has exposed the need for a mechanism for dealing with eurozone members in danger of defaulting on their debts.

So you quickly understand that the creation of this new institution has nothing to do with fixing the glaring weakness in the original design – the absence of a fiscal redistribution mechanism to address asymmetric shocks.

Instead you realise it is about “monitoring and preventing a similar situation arising in the eurozone in the future” so that indebted countries can be bailed out.

In February 2010, two economists (one at the Centre for European Policy Studies and the other from Deutsche Bank) released a discussion paper – How to deal with sovereign default in Europe: Towards a Euro(pean) Monetary Fund – which set out the case for a European Monetary Fund.

You can see a short article based on the discussion paper in the The Economist (print version February 18, 2010).

They recognised that the Greek borrowing difficulties (which extend elsewhere in the Eurozone):

… expose two big failures of discipline at the heart of the euro zone. The first is a failure to encourage member governments to maintain control of their finances. The second, and more overlooked, is a failure to allow for an orderly sovereign default.

Their answer: “a new euro-area institution, which we dub the European Monetary Fund (EMF)”.

They claim that the current IMF serves as a good model of governance. In that regard they said:

The EMF could be run along similar governance lines to the IMF, by having a professional staff remote from direct political influence and a board with representatives from euro-area countries. Just as the existing fund does, the EMF would conduct regular and broad economic surveillance of member countries. But its main role would be to design, monitor and fund assistance programmes for euro-area countries in difficulties, just as the IMF does on a global scale.

So this will be no democratically-elected body. It will be staffed instead by dour time-serving economists who hold mainstream economic views and don’t think twice about inflicting harsh austerity programs on governments who dare step outside their strait-jacketed and erroneous conception of fiscal prudence.

If it acts like the IMF then it will try to force member states into austerity positions before lending them the funds. There is a hint of this in the financing arrangements proposed in the discussion paper noted above.

The authors proposed that to establish the EMF, it would be able:

to borrow in the markets with the full and joint backing of all its member countries. Going forward, however, a simple funding mechanism would also limit the moral hazard that potentially results from the creation of the fund. Only those countries in breach of set limits on governments’ debt stocks and annual deficits would have to contribute, giving them an incentive to keep their finances in order.

So you can see why an economist from Deutsche Bank would recommend this! They will be in their lending funds at excellent rates I am sure.

They outline more specifically how this funding would be achieved (see paper). But ultimately, the plan is preposterous. The nations hardest hit by the inflexibility of the EMU would have to stump up the most funds which would ultimately be used to bail themselves out!

And if all nations remain within the Stability and Growth Pact rules, then there would be no contributions. But a Eurozone nation can become insolvent even if it is running budget surpluses and had low public debt ratios given the absurd nature of the system.

So the proposed funding formula would not deliver the necessary support if there was a widespread run on Euro banks. The system is always exposed to that risk by its very design – whatever institutions they try to create.

They also say that the EMF would only provide support if the nation had already built up the funds and only then if they submit to Euro-boss supervision.

So they want to “tax” the weaker nations initially, then give them their own funds back, but only, if in return the now weaker nation implements a “fiscal-adjustment programme has been approved by the Eurogroup of euro-area finance ministers” – and all because the EMU system can never work in a crisis anyway.

If it wasn’t so tragic one would just have to laugh.

Finally, the undemocratic and draconian nature of the proposal lies in its idea that a Brady bonds scheme be introduced and administered by the proposed EMF.

Brady bonds were introduced during the Latin American crisis of the 1980s. They were offered to creditors in exchange for the sovereign currency liabilities that had been defaulted on. In this proposal:

If a euro-area country loses access to market financing, the EMF could step in and offer all holders of debt issued by the defaulting country an exchange against new bonds issued by the EMF.

The EMF then would hold the creditor claims against the defaulting Eurozone nation and then would put the nation into a “receivership” arrangement whereby it would have to approve all spending etc.

So the bean counters (the EMF) is some luxury office tower in ??? (where are we guessing it would be located?) would be able to bully an entire nation around on a Euro-per-Euro basis. Pathetic.

Apart from the democratic issues, the EMF proposal has a deeper problem.

Here is the rub. The analogy with the IMF is flawed at a fundamental level.

Ultimately, the IMF is a world organisation and there is no such thing as a world currency. It can bully nations around (and it does) with impunity. But if one nation defies the IMF and does default – say as in the case of Argentina in 2002 – then the implications are very different to those which would occur if an EMU nation told the EMF to get stuffed.

In the former case, the Argentinean default caused a lot of strife for the avaricious US and German banks that lost cash and was a major loss of face for the bullying IMF. But ultimately it didn’t do much more than that with respect to the world currency system. Ultimately, it freed Argentina of the penury that its currency board had imposed on them and gave them freedom to pursue its own fiscal and monetary policy according to the political dictates of its democracy.

The point is that the EMF – as an organisation within the EMU and reflecting EMU interests – would always be prone to blackmail by member states. The only logic in creating the EMF is to make sure there are no sovereign defaults because they have realised in the current situation that an event like that would severely compromise the entire EMU system.

So lets say Germany gets itself into major trouble and the EMF tries to bully it around as a condition of gaining liquidity. The German people revolt and the German government tells the EMF to jump in the lake and proposes to default and restore the DM.

What does the EMF do in that case? Kick Germany out? Not a chance. We will be back to the four options I outlined earlier.

And the first option will always be the one chosen as long as the Euro bosses want to hang onto their stupid currency arrangements – that is, bailout with loans independent of what the member state has done.

The relationship that the IMF has with its member states is vastly different from what is being proposed here and the implications of a breakdown in that relationship doesn’t threaten the whole currency system as it would in the case of the EMF.

It is a harebrained scheme which just represents further denial on behalf of the Euro bosses.

The solution to the EMU mess is to scrap the entire system or to centralise the fiscal and monetary arrangements and declare all nations within the are disbanded and create a new place called Euroland with a single government in charge of the economic policy mechanism!

I suspect abandoning the scheme will be more likely! The point is that in between this crisis and the next, millions of Europeans will be subjected to unnecessary attacks on their living standards in an attempt to make a system that cannot work … work.

Why was the IMF conceived?

To help put the EMF concept into context, this section just reviews why the IMF was conceived and why it became irrelevant in 1971. Unfortunately, it seems to be taking some time for the IMF to work out that they should disband?

The International Monetary Fund was created in July 1944 during the Bretton Woods conference (the so-called United Nations Monetary and Financial Conference). It was called the Bretton Woods conference because ot the geographical locality of the hotel it was staged at (in the US).

You can read about its History and Operations.

It was designed to facilitate the fixed exchange rate system that was agreed at Bretton Woods and lasted until 1971. Since that time most nations have run fiat currency systems with flexible exchange rates although mainstream economics hasn’t made the leap. They are a little slow!

Under the Bretton Woods agreement, the parities were pegged against the US dollar and the US government set its currency against gold. So it was a quasi gold standard with convertibility in terms of the US dollar and all US dollar reserves into gold.

Exchange rates could be adjusted but only in extreme situations. The IMF was in charge of the fixed exchange rate system and had to approve realignments in excess of one percent. It was provided financial advice to nations within the system.

Bretton Woods also discussed the question of international liquidity which had brought the global financial system unstuck during the Great Depression.

The IMF was thus conceived as a global central bank with the capacity to create new reserve whenever they were needed and lend funds when required to individual countries. However things didn’t quite turn out that way.

I won’t go into the history of the debates but Keynes’ plan for a world currency was defeated at the Conference in favour of the more limited arrangements relating to access to international liquidity which was proposed by the US government.

The IMF thus developed a quota and subscription system – which saw it holding a pool of member state currencies and gold (subscriptions) rather than being able to create its own currency (as a global central bank). Each nation was assigned a quota based on their relative economic power and had to subscribe that much to the fund. The subscriptions had to be 25 per cent in gold or US dollars and 75 per cent in their own currency.

The IMF then “managed” any chronic trade positions for the member nations so that devaluations (for chronic deficit nations) were avoided. So in the case of a deficit nation, they could reduce the pressure on their parity by drawing from the IMF (up to 25 per cent of their quota on demand).

They were also able to borrow foreign currency to further defend their currencies but had to pay the debts back fairly quickly (within five years).

The plan was intended to avoid forcing nations with balance of payments problems from having to implement domestic austerity programs in order to reduce imports. This was a major problem under the prior gold standard and it led to its eventual downfall.

The arrangements faltered over time and eventually it was the difficulties faced by the US in keeping the US dollar on par at $US35 per ounce of gold that brought the system unstuck.

There were salvage attempts to bolster the position of the US dollar and stop the US bleeding gold to other nations (particularly Europe and Japan) – for example, the so-called Special Drawing Rights (SDRs) system (really just “paper gold”) which provided incentives for nations to hold US dollars.

The Vietnam War brought it unstuck and the US Government introduced various controls over currency movements, foreign investment and import quotas. But still the US dollar fell in value and the US government lost foreign currency reserves.

Finally, with the US dollar hopelessly overvalued with respect to gold, the US Government (Nixon) scrapped the system of convertibility and the currency system collapsed.

This meant that fiat currency systems became widespread and allowed the sovereign government to determine their own domestic policies with the external situation constantly being reflected in the exchange rate movements. So much more flexible and sensible currency arrangements emerged.

Why did the IMF survive? That is another story. But since then it morphed into a venal institution that forced poor nations into harsh domestic austerity programs as blackmail for loans to restore depleted currency reserves.

If we made speculative attacks on foreign currencies illegal then there would be no need for the IMF in its current form. The only thing it should currently do is provide currency support when speculators are attacking. But as an unelected body they should have no influence in domestic affairs of a sovereign nation.

Conclusion

The EMF is another harebrained scheme and represents further denial on behalf of the Euro bosses that their precious currency system does not work.

The solution to the EMU mess is to scrap the entire system or to centralise the fiscal and monetary arrangements and declare all nations within the are disbanded and create a new place called Euroland with a single government in charge of the economic policy mechanism!

But the tragedy of the situation is that between now and the next (inevitable) crisis, millions of Europeans will be impoverished in an attempt to make a system that cannot work … work.

For further information on the MMT treatment of the Eurozone please read the following blogs:

• Euro zone’s self-imposed meltdown
• A Greek tragedy …
• España se está muriendo
• Exiting the Euro?
• Europe – bailout or exit?

And a little reflection on Iceland’s historic vote

As you will have read, the citizens of Iceland told their traitorous (left-wing) government at the weekend that they were not going to be pushed into a deal that would pay debts that they didn’t legitimately or morally incur. Around 98 per cent of voters rejected the deal that the Government had negotiated with the British and Dutch governments to pay the latter blood money.

And all the talk now that Iceland is doomed if it doesn’t find some compromise is I judge more of the same from the big bully countries – just idle blackmail and threats.

I have read a lot of articles from the English and Dutch press and while the style is different – the Brits are more venal and bellicose – the intent is the same. Pay up you fish eaters or we will sink your little frozen island into the sea forever.

This threat was expressed in terms of stopping access to IMF funds (as if that matters) and also blocking Iceland’s entry into the EMU. In fact, the motivation of the out of touch Iceland government in trying to defy its own people was all tied up in the desire of the politicians to enter the EMU despite this also being highly unpopular within the country.

Iceland would be crazy joining the EMU. They have a sovereign currency and a reasonably high standard of living. If they join the EMU they lose the former and the latter will go the way of the Irish or the Greeks.

Anyway, today I read a nice article from a commentator within Iceland and a former central bank board member. It was nice to get some balance in the commentary.

The article – Iceland’s Message: Don’t Bail Them Out – appeared yesterday’s (March 8, 2010) Wall Street Journal and was written by one Hannes H. Gissurarson

Among the selected quotes, were:

In the national referendum Saturday, Icelanders sent a resounding message to the rest of the world: We are not paying the debts of reckless financiers. While we are few and powerless, we refuse to be bullied by our European neighbors …

When the Landsbanki collapsed in October 2008, the British and the Dutch governments rushed in to pay depositors in their respective countries the amount insured under EEA (European Economic Area) regulations. They then demanded reimbursement from the Icelandic government …

there was no legally binding government guarantee of the deposits. The Icelandic government had fully complied with EEA regulations and set up a Depositors’ and Investors’ Guarantee Fund. If the resources of that fund were not sufficient to meet its obligations … then the Icelandic government was not legally bound to step in with additional resources. Thus the British and the Dutch governments had no authority to create new obligations on the part of the Icelandic government by paying their nations’ depositors.

Which is end of story as far as I am concerned.

But Gissurarson makes another good point which I will write about at length some time later:

If you reward recklessness, you will fill the world with reckless people. Why should any government accept the “Too Big to Fail” argument about banks? Why should depositors be able to shift the risk they take over to the public? …

This in turn raises the broader question implicated in all the bailouts around the world during the panic that started in 2008: Should taxpayers have to cover the losses of reckless bankers, and their customers, while not sharing but indirectly in their possible profits?

I will forgive his lapse into mainstream macroeconomics (the reference to “taxpayers” covering losses – taxpayers do not fund anything in a sovereign currency).

But the point has traction. The answer in my view is for government to severely limit the scope for financialisation in their economies and force banks to play a relatively small function – intermediation – with no speculative role at all.

No speculative organisations would be allowed to be deposit-taking and only speculation that was associated directly with real economic activity (for example, some forward hedging etc) would be legal.

Then you would not encounter this dilemma. More on this another time.

That is enough for today!