How the Eurozone should've been set up.

[Wonkish1]

There has been a lot of talk about how the Eurozone presented a moral hazard, in which countries like the PIIGS could deficit spend and borrow cheaply with Euro-denominated bonds, taking advantage of the fiscal rectitude of other Euro members (specifically Germany), then expecting to be bailed out once their profligate ways caught up with them.

It seems to me that this was entirely predictable, and could've been entirely prevented merely by setting up the Eurozone in a more sensible way.  Here's how I would have done it:

1. The Euro would've been pegged at 1 Euro = 1 Deutschmark, as in real life.

2. The paper versions of other currencies (Francs, Drachmas, Liras) would be phased out, but they would remain at their pre-Euro values as virtual electronic currencies used only by their country's respective central banks.

3. Euros would then have to be purchased by national central banks from the European Central Bank using "virtual Francs," "virtual Drachmas" etc.  (And, yes, virtual Deutschmarks too).

In this way a single currency could be implemented without compromising national sovereignty, and each country could have its own monetary and fiscal policies, but without any moral hazard as they would have to face the real-world consequences of inflationary policies.

I try to avoid getting harsh towards a post where the poster is trying to throw out new original ideas, etc. because I wish more people would do that instead of regurgitating other people's ideas, but...

this isn't going to work for hundreds of reasons. So...

back to the drawing board. Others on here have already nailed a few of the issues so I wont go into the laundry list of things you would need to address in coming up with your next proposal.

But I'll point out one thing that is some food for thought. When it comes to currency the goals of  most sane people who understand the topic is well understood. The goals are: price stability, the absence of monetary imbalances, and stability in the money supply. Now they all tend to go hand and hand, but being able to actually accomplish these things(especially the 1st and 3rd) are very challenging on any monetary system. So the interesting question here is given the challenge of accomplishing this do you think you are better served by having one currency that could end up doing things very well or very badly *or* by having competition among many currencies?

So if I were you I would look at trying to think up a structure that attempts to make ease of doing cross currency business easier(the goal of the Euro) under a competitive currency system vs. taking the assumption of single currency and then trying to add some multi-currency addition onto it. So yeah just some food for thought.

[Wonkish1]

One of the main point in the euro debate is the so-called trilemma. You can't have 1) free capital markets, 2) exchange rate stability and 3) counter-cyclical monetary policy all at the same time.

You can be China and have 2 and 3. You can be Denmark and have 1 and 2. Or you can be Sweden and have 1 and 3. For example.

Most countries in the West have moved towards giving up 2. Except for the EU, of course, who are always trying to run away from the future.

Lets just call a spade, a spade here. There is really no such thing as true long term exchange rate stability without a uniform taxing authority and similar economic circumstances. Even in the case of China we're seeing their idea fall apart as the imbalances just grew to large.

They may have thought they could control the exchange rate through their peg and restrict capital flow, but in times of great crisis that suppression of volatility comes crashing down with great affect. Today the *real* on shore vs. off shore exchange rates are very different numbers indeed(and getting worse) and somehow capital is finding its way out of China even with some of the most draconian laws and enforcement in the entire world.

Not even China can defy the markets and change the laws of gravity by PSC edict.



And of course, besides flipping between barely accommodative and barely restrictive who wants counter cyclical monetary policy? Not me! But I'm also not one that is willing to buy a lot of future pain in exchange for selling a small amount of the pain today. But I guess we've become a "right now", "this moment" world that doesn't care about the consequences of anything long term as long as we can get some benefit today even if its a small one.

[Wonkish1]

I'm not a fan of exchange rate stability either because I agree that it can't be upheld anyway.

I do like stabilizing the real economy though and I'm not sure why you aren't. You think Schumpeterian destruction should be allowed to run its course completely unfettered?

No actually quite the contrary. I personally believe the medicine causes more "Schumpeterian destruction" over the long term than trying to artificially encourage bad investment for the purpose of stimulating and economy.

Think about it. You lower interest rates and increase the money supply so people will take out more debt. Now if the debt is taken out for productive investment its a good thing, but the dirty little secret is that if its propuctive enough to generate a net positive return under historical average interest rates the credit will be taken out anyway and the investment made. The only thing you get out of artifically accomodative monetary policy is investment that looks reasonable under the artificially low interest rate, but will blow up the moment interest rates revert to the mean(let alone higher to try to "cool things down").

So in a practical sense let's say mean prime is 5.5%. Now if you lower the FFR to let's say 3% you'll probably see prime borrowers willing to make investment for anything over a 5-6% return generating ~3%+ spread on FFR. And at least breaking even when interest rates rise back to normal. Today the FFR is sitting at 0% and mortgage rates are 4% fixed. Do you actually think that 4% 30 year fixed is sane investment from a bank? Or do you think its at least a worthy point to acknowledge that we have effectively bought our banking system future pain because 4% today is so sexy for a lender given our overly accomodative policy today.

So yeah if you didn't artificially create situations where dumb investment is so temporarily profitable then you probably wouldn't have much in the way of large downturns that would actually result in calls for countercyclical monetary policy. The only reason why you see them calling for it is because you got the pain from the last time you did it and goosed stupidity into the system.

[Wonkish1]

I'm not a fan of exchange rate stability either because I agree that it can't be upheld anyway.

I do like stabilizing the real economy though and I'm not sure why you aren't. You think Schumpeterian destruction should be allowed to run its course completely unfettered?

No actually quite the contrary. I personally believe the medicine causes more "Schumpeterian destruction" over the long term than trying to artificially encourage bad investment for the purpose of stimulating and economy.

Think about it. You lower interest rates and increase the money supply so people will take out more debt. Now if the debt is taken out for productive investment its a good thing, but the dirty little secret is that if its propuctive enough to generate a net positive return under historical average interest rates the credit will be taken out anyway and the investment made. The only thing you get out of artifically accomodative monetary policy is investment that looks reasonable under the artificially low interest rate, but will blow up the moment interest rates revert to the mean(let alone higher to try to "cool things down").

So in a practical sense let's say mean prime is 5.5%. Now if you lower the FFR to let's say 3% you'll probably see prime borrowers willing to make investment for anything over a 5-6% return generating ~3%+ spread on FFR. And at least breaking even when interest rates rise back to normal. Today the FFR is sitting at 0% and mortgage rates are 4% fixed. Do you actually think that 4% 30 year fixed is sane investment from a bank? Or do you think its at least a worthy point to acknowledge that we have effectively bought our banking system future pain because 4% today is so sexy for a lender given our overly accomodative policy today.

So yeah if you didn't artificially create situations where dumb investment is so temporarily profitable then you probably wouldn't have much in the way of large downturns that would actually result in calls for countercyclical monetary policy. The only reason why you see them calling for it is because you got the pain from the last time you did it and goosed stupidity into the system.

Well, but that's just assuming that monetary policy is done stupidly.

Let's say average inflation is 2% (the goal of the Swedish Riksbank). Let's say the average nominal interest rate is 4%. That yields a real interest rate of 2%. If the economy starts overheating and inflation goes to 4%, you raise interest rates to 6%, thus maintaining the same real rate and preventing further overheating. Vice versa in downturns.

Or do you think there would be no business cycle if there was no monetary policy?

I think that countercyclical monetary policy grossly exasperates the business cycle. Without it and you have minor recessions that continue to get less severe as time goes on and economies get more and more diversified.

In theory the biggest natural downturns should happen when your economy is reliant on a single industry...like the potato famine in Ireland a few centuries ago when agriculture was the vast majority of the Irish economy. Fast forward a few hundred years and we now have hundreds of industries in an economy. A crash in one should only produce a minor blip in others. Instead we have large increases in the money supply that show up in only a hand full of industries and the business cycle becomes more pronounced.


And if you see a doubling of the inflation rate because your nominal interest rates are to low then increasing interest rates to maintain the same real interest rate isn't going to cool things down in countercyclical monetary policy. You would likely have to raise to 7% therefore increasing the real interest rate from 2% to 3% in order to produce a sufficient pain level to cool down the economy. But when it comes to me the idea of raising interest rates to 7%+ territory to cool down the dumb$hit decision to have things artificially low before is stupid. In an ideal world monetary policy would approach a level of talent where interest rates barely move over the long term and that it remains remarkably consistent because they are high enough to discourage bad investment and excessive money creation, but low enough that true strong growth is unabated by excessively higher interest rates. Instead we are now living in a world where countercyclical monetary policy produces bigger peaks in interest rates and bigger troughs in interest rates. That isn't a good thing for long term investment planning and decisions.