“Progressive” economist Joseph Stiglitz was on the BBC this weekend talking about the Euro. Despite having both feet firmly planted in mainstream economic theory, I often agree with what Stiglitz has to say. He’s right about one thing here: ”The ECB (European Central Bank) is the one institution that has the flexibility that is necessary to deal with the crisis.” This is true, Europe needs to move to a tighter fiscal framework or it will all fall apart.
But he says something else which misses the mark: ”Issuing bonds should be one part of the fiscal framework.”
Now this is tough, and counter to everything we’ve been taught about economics, but bonds are not a fiscal operation. Bonds are a monetary operation. When the ECB issues Euros, it is already a debt. A Euro is a tax credit which is eligible to be paid by the holder for any local, state or national Euro debt. It’s already a liability of the Central Bank and this is why Europeans are willing to hold them and save them. T hey can pay their taxes with them, among other things.
What issuing bonds does, for the holders of Euros, is to pay them interest on their savings. Additionally, issuing bonds allows the Central Bank to withdraw Euros out of the banking system to meet its target interest rate. I know that’s confusing, so let me lay it out straight.
1. The ECB issues Euros. In doing so, Euro reserves go up in the banking system.
2. When Euro reserves go up in the banking system, banks with excess reserves try to sell them to other banks which are short.
3. If there is a system wide excess of reserves, the price of Euros in the bank market will drop to 0 because there are no banks which need reserves. In this sense, the “natural rate” of interest is zero.
4. If the ECB wants to maintain a positive interest rate, they issue bonds to drain reserves and maintain a positive interest rate.
Now, to make bonds even more useless, all the ECB has to do to make them completely redundant is offer interest to banks on their reserves. This would serve the same function as issuing bonds, which are not necessary to fund the Euro or the Euro states.
In this case, private investors wouldn’t get no-risk interest income from the bonds, but then maybe they would take their excess Euros and do something constructive with them, like take some risk and invest them. Regardless, Europe doesn’t need Euro-bonds. All that does is perpetuate the myth that bonds are fiscal operations, which they’re not.