The Euro money supply

Worthwhile Canadian Initiative:

I agree with Ambrose Evans-Pritchard and Jacques Cailloux. It's what I was trying to say yesterday. And on Thursday. It's probably gotten too big for Germany, France, the IMF, whoever, to fix. Only the European Central Bank has enough money to fix the Eurozone problem; because it can print it. What's ironic is that what they call "The Nuclear Option" is what first year economics textbooks describe as the normal way that central banks increase the money supply. We call it "Open Market Operations". Print money and use it to buy Eurozone government bonds.

But I don't think that will happen.

It's not so much the rules about what the ECB is and is not allowed to buy, or accept as colateral, (which, despite commenter JP's help, I still don't really understand); it's because it is ultimately a political decision. Who has the authority to say that the ECB may risk its seigniorage revenue on buying Greek or other countries' sovereign junk, when that revenue belongs to all Eurozone governments? Nobody. The Eurozone is not a real country. There is no central fiscal authority behind the ECB. That decision would have to be reached by a political consensus of all Eurozone countries, and I don't see that happening.

If Greece had a central bank of its own there is no doubt it would now be buying Greek bonds. But it doesn't; at least, not a real one that can print money.

Eurozone commercial banks hold Eurozone government bonds as assets. With the drop in those bonds' values, many commercial banks (inside and outside the Eurozone) will become insolvent. There will be (and already are) runs on those banks, as depositors seek to transfer their deposits to safer banks, if any can be found, or withdraw currency, if they can't.

The first year textbook says this fall in bank deposits will cause a fall in the money supply, and that this fall in the money supply will cause a recession. And the general fear of financial assets will also cause an increase in the demand for money which will exacerbate the problem of a declining supply. And the solution is for the central bank to do whatever it takes to increase the money supply by however much it takes to eliminate the excess demand for money.

I don't see how the ECB will do this, if it can't buy bonds, can't lend to insolvent banks, and can't lend against junk bond colateral.

Instead, the ECB will point to its nice low interest rate target and say "Look how loose monetary policy is!". And it will be low, because the only people who can borrow at that rate won't need to, and all those who desperately want to borrow at that rate won't be allowed to.

The fall in the Euro money supply will cause a worsening Eurozone recession. As I, Scott Sumner, Bill Woolsey, (and others) have been saying all along, central banks' nominal interest rate targets are not a good measure of the stance of monetary policy. But others will explain the same facts differently: they will say that a recession caused a fall in money demand. Which of course is true, in a way; when the money supply falls, the recession has to get bad enough so that money demand falls enough to match the reduced money supply.

We will know the truth when some Eurozone governments start paying their workers in new monies they have printed themselves, because they have run out of Euros, and can't borrow any more. If there were no shortage of Euros, who would ever accept those new monies as media of exchange? But if there's a shortage of Euros, accepting payment in New Drachmas will be better than nothing, and you will know that others will also be short of Euros and so will accept them from you in turn. When that happens, Greece (and it is unlikely to be alone) will have left the Euro.

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