How To Save The Euro - And Preserve Sovereignty

by: Venkata Subbu

We have a massive financial crisis going on in Europe, that threatens to leave Greece and Italy destitute, and make life miserable for many people all over the world.

At the root of the crisis is a fundamental disconnect between the integration provided by a common currency, and the sovereignty of nations within the Eurozone. Large differences in the attitude of various peoples towards all aspects of life have resulted in major wars on that continent, that have often spilled over worldwide. The Marshall Plan, followed by the European experiment along with its Exchange Rate Mechanism, and now the Euro, have resulted in relative peace and prosperity since World War II. It would be insane to give it up completely and revert to a system of every country for itself. Most individual Europeans know this, even individual Greeks who have every reason to break away today.

A second part of the crisis is the pressure on politicians of individual countries to finance their governments using debt rather than taxes. The current attempt to have Eurozone countries write balanced budget requirements into their constitution is a recognition of the problem, but is prone to failure. Practically, like any other enterprise, a government will need to undertake projects whose financing is beyond what is supportable by current income (taxes on the current population), or by savings (accumulated resources). Increasing taxes often reduces the money available to the government, or more often, does not provide the anticipated increase. This happens for two reasons - the reaction to the tax diverting wealth away from the taxed activity, and because people perceive they have less wealth and curtail their spending. Debt is a trick that allows the debtor to take a creditor's money while not making the creditor feel poorer. More importantly, in a free market where individuals chose to invest in government bonds, it tends to divert capital away from the lowest return activities. So having a law that bars deficits is simply asking for the law to be ignored or sidestepped and is actually detrimental. Also, policing such a rule in an environment of sovereign debtors must be done by the grace of the sovereigns - there is no practical method of enforcing such rules short of military power in the hands of the ECB.

The Bank Illusion

Often, not enough people can be convinced by this bit of chicanery to provide money to the government, or to a significant project. Fractional reserve banking is a further bit of chicanery that enables the decision making power of how to invest a person's wealth to be taken away from the person (as well as the return on investment), while convincing the person that he or she still has it. Such chicanery isn't always bad for society, as long as it does not go too far or take away too much of the return. Banks depend critically on the belief of a person that he or she still possesses and controls the wealth that has been taken away, and that it is safe. A central bank with unlimited power to issue money (but is judicious about using it) and to police banks is very helpful to preserving this illusion. Everybody understands about loss via inflation, and the consequences of liberally using the printing power. To ensure that the central bank does not have to resort to its printing power, it is essential that the rules that banks have to live by not be determined by debtors (in the European case, the individual governments), but by the central bank. A central bank governor who points at its printing power to preserve confidence instead of its police power has already failed at the primary task of the central bank, which is to preserve the "bank illusion". Mr. Bernanke (aka Helicopter Ben) was a failure at his job even before he was appointed! Similarly, a government that borrows from its banks, rather than directly from its people, has already admitted to a failure of confidence in its ability to repay with reasonable ROI.

A third part of the crisis is the need for justice and to preserve the liberty of individuals. A fundamental principle of justice and liberty is that a person is not punished for crimes committed by others, and is not responsible for debts incurred by others; whether they are totally unrelated persons, or even a person's parents, siblings or children. A person may voluntarily assume the debts or obligations of their relatives, but only because they do not want the consequences of not meeting the obligation to fall upon their relative; or to preserve the honor of their family. In the case of government debt, the debt is incurred collectively, presumably with the consent of the governed citizens - and often is for the benefit of current and future citizens. However, it is fundamentally an indirect debt, governments can be irresponsible and can change, and often debt incurred is simply passed onto future generations who did not actually incur that debt. Whatever the history, circumstances may conspire to make the debt so large that servicing the debt is tantamount to slavery. So occasionally, any debtor will need to repudiate, reduce or extinguish onerous debt. Bankruptcy laws deal with private debtors in this situation. People will revolt and resort to arms or the guillotine in the case of sovereigns. In any case, honoring any sovereign debt is done at the grace of the sovereign, so any system must have a way of gracefully handling default by a sovereign.

A free market of direct lenders and debtors handles all of these requirements perfectly. Loans are made voluntarily, knowing that a debtor could renege, and the lender incurs the risk that his or her entire loan could be lost. This risk causes them to properly investigate the debtor's circumstances and to take appropriate steps to manage the risk. However, when a bank gets involved, you no longer have a system of direct lending. The ultimate owner of the capital is disconnected from the loan, and a bank employee makes the decision of whether to invest the money. The owner of the wealth benefits, by spreading the risk of loss across multiple loans as well as the assets of the bank, and because presumably the bank employee as part of their job is required to be proficient in evaluating debtors, and the bank and its employee has some risk of loss (via legal liability) if their employee does not do their job properly. Unfortunately, in the case of government debtors, the debtor is in charge of determining the standards the bank must meet to escape liability, and so the ultimate owner of the wealth really has no protection. This is very obvious in this crisis - government debts were legally treated as having zero risk of default and capital requirements were significantly less than what they would have been if they were properly evaluated. The disconnect is further amplified by the existence of insurance in the form of credit default swaps (CDS), where not only the strength of the debtor has to be evaluated, but also the strength of the insurer, as well as the actual risk coverage provided due to variations in the terms of the CDS.

The Ultimate Goal

What we want is a just and fair society - one you can easily recognize when you see a people that has the means to resort to violence, but simply do not; because they are satisfied with things as they are, or can express their dissatisfaction in other ways.

Governments will always need to run deficits occasionally, and governments will need to be able to default on their debts, hopefully rarely. One needs to recognize the reality that governments will often be corrupt and devise ways to steal from their citizens or others and seek to limit the damage. The policing mechanism needs to be something that governments will voluntarily accept going in and will find it hard to renege on when the going gets rough. Here is one scenario to accomplish this:-

1) The ECB issues euros to meet the transaction needs of the European community consistent with stable prices (in euro terms) as they are chartered to do now. This currency is valid tender for any debt for individuals inside European countries. Euros shall be issued in sufficiently large denominations to make it convenient for individuals to conduct all cash transactions and hold a reasonable all cash reserve. The ECB remains barred from buying government debt - when they do it is highly illegal, and a recognition of their failure at their central task of preserving the illusion of "safe" banks.

2) Each country issues a secondary currency which is the currency that that country's government conducts transactions. Taxes are exacted, salaries of government workers, and other government debts are paid in that currency. Government contracts are denominated in that currency. Government bonds and bank deposits subject to local rules are denominated in the local currency. The ECB can enforce this by the simple expedient of valuing government debt denominated in euros as worth zero (or some very low number) when evaluating the capital adequacy of banks. This is simple recognition of the multiple and creative ways governments can renege on debts. Banks taking euro deposits are subject to ECB rules, one of which is that some accounts exist whose deposits are not available for fractional reserve or investment banking. Citizens or residents of a country can choose to maintain their savings and conduct trade in either the local currency or the euro. A goal is that they choose to do a large part of it in euros.

3) The ECB (not the local country) regulates the currency exchange market, being careful to allow market driven float between the euro and the local currency under normal circumstances. It will use its printing power to deflate runs on any currency when they occur consistent with maintaining euro price stability. A run on the euro would be met by using its accumulated stock of other money, or by draining the system of euros via interest rates.

4) As a condition of being a member of the eurozone, and receiving the ECBs currency protection, each government agrees to not conduct government transactions in anything but their local currency, to allow private citizens to conduct trade in euros, to not tax currency exchanges, to not discourage possession and transport of euro currency notes or foreign euro accounts, and to maintain their local money supply at a level consistent with ECB mandates. Each country agrees to apply local anti-counterfeiting laws equally to all the currencies of the eurozone, including the euro.

How Does It Work

The first thing to notice is that this is a dual currency system. The Romans had it, and it worked for them for a long time. Most control over economics is maintained at the local country level. Governments can borrow, but are kept from causing global havoc by borrowing, taxing and paying in local currency only. If they need to default they can do so without fuss - by devaluing their local currency. If they need to shrink - and the market tells them that - the local currency devalues. They are discouraged from doing so because if they do it too much nobody will lend to them, and government workers and politicians will effectively get less. Allowing a government to have control over its obligations is something any sovereign will accept readily. In this way it resembles the current situation with countries outside the eurozone, with the euro taking the place of SDRs. However, by allowing access to the common currency by the general population for real transactions, it gives real value to the common currency instead of remaining a mere political construct. A government that chooses to issue debt in euros in violation of the rules will get funding only from its own banks or from people.

The second thing to notice is the bar on regulating ownership of euro notes and foreign euro accounts. By allowing and in fact encouraging possession of euro currency notes as opposed to bank balances, governments are restrained from seizing wealth from citizens when they run into difficulties. It essentially takes away a large part of the power of governments to rob their citizens. It basically preserves the voluntary aspect of debt financing, instead of turning it into the compulsory regime of tax financing. People are free to "revolt" - with their money instead of arms. A bar on taxation and regulation of accounts within the euro zone that are outside the eurozone country, enforced by bars on communicating the existence of and balances in any account within this zone to foreign governments would complete this picture.

An essential part is preserving the viability of both currencies when they are simultaneously available to and usable by the general population. Government being a very large player in all countries forces people to keep at least some of their currency and conduct some transactions in the local form. A strong global currency is automatically acceptable where the local currency is weaker. So we make the global currency safer by having strict price stability rules, making physical possession a real option, and subjecting deposits in that currency to the stricter rules. However, if a person wants to accept risk and earn a higher return from a bank account they will need to keep their wealth in the local form.

Joining and leaving the euro currency zone would be a voluntary act. A government can choose to allow euro transactions and deposits within its territory at any time. When its rules and regulations match required ECB rules, and the ECB is convinced of its commitment to the rules, or whenever necessary, the ECB can provide local currency exchange rate protection.


Dual currencies are undesirable. At the heart of the current crisis is the contagion risk imposed by valuing government debt at 100% (or some unrealistic value) when assessing the capital adequacy of banks. Rather than assessing it at some fixed value, or believing the valuation of rating agencies, the ECB could assess the value itself. It would be motivated to provide a realistic valuation by its desire to preserve the "bank illusion" by avoiding rescue via its printing press - ahead of the time a crisis becomes one. Contagion risk via default and CDS would still exist, and so banning CDS on government debt would also be required. Automatic reduction of government expenses is not available with this option.


Fundamentally, the "bank illusion" has been questioned by this crisis. Whatever the actual scheme proposed or implemented as a result, the overall size of the financial sector is likely to be reduced to match its actual value to the economy. Additionally, assessments of its safety are likely to be reduced. One can therefore expect serious shrinkage in its market value, and an investor would be well advised to pick very carefully within this sector over the next decade.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.