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Late in 2010 an ‘alteration to the Euro rules’ was announced around how a default by a euro sovereign would be handled. The ‘new deal’, brokered by Chancellor Merkel, envisaged an orderly liquidation of the bonds of defaulting euro sovereign governments. Since then we have had the creation of the stabilization mechanisms and funds, and the establishment of access to these mechanisms for Greece and Ireland – with Portugal now in the mix.

Throughout these efforts the subtext has been on the one side to test the acceptability of having holders of sovereign debt bonds experience a partial loss of principal if a euro nation defaults, and on the other hand giving reassurance to voters in Germany, Finland, Netherlands… that they  won’t underwrite the obligations of the rest of Europe.

The key point here is that there are no rules to be altered whereby the stronger euro nations are obliged to support the sovereign debts of the weak. All that Chancellor Merkel did was to make clear the existing situation. The fact that there was any doubt about this – and the fact that the EU and eurozone governments have allowed ambiguity to hang around this issue – exposes the fault lines at the heart of the euro as a currency.

A euro-denominated sovereign obligation is as good as the underlying nation’s ability to produce euro out of its own economy. There is no sharing of liability between the euro countries just because they share the currency in which the bonds are denominated. In that sense a euro obligation of theUKorDenmarkhas no different status just because these countries have a different legal tender for daily use, namely pound and kroner.

However, there is a joint underwriting of the legal tender aspect, and this is the crux of the problem: the note and coins are issued under joint and several liability by the European System of Central Banks – each of whom is owned by its nation state. A traditional role of the central bank of a nation state was to produce the currency of the state, in sufficient quantities – on occasions – to cover the nation’s spending deficit.  That link is broken in the euro, so the nation state itself stands (or falls) on its own.

Sovereign obligations in euro are several and not joint, notwithstanding the policy measures and agreements taken to foster convergence and to bring about a situation where the euro economies were so intertwined and successful that the relative sovereign risks evened out.

These policies were firstly the Exchange Rate Mechanism aimed at squeezing out exchange rate fluctuations. Secondly the Maastricht Criteria, the qualifying criteria for a country to join the euro, aimed at convergence of inflation, interest rates and public debt. Thirdly the Stability and Growth Pact, to govern the economies in the euro after its establishment, to control budget deficits and government debt.

In this process euro member handed over control of foreign exchange and monetary policy to EU institutions, those being main policy levers of a sovereign central bank (or Finance Ministry), along with monopoly control over the supply and production of the state’s currency. The central bank could no longer produce currency by issuing bonds to fill a deficit: QE2 is an example of that and it is a lever no longer available to eurozone states.

As with note and coin, so in other areas certain practical aspects remain decentralised while main policies have been centralized. This has led to a lack of clarity as to who is on the hook to pay as primary and secondary obligors, a situation that has benefited the euro and its weaker members.

The grey area at the centre of this is the respective powers and resources of the European Central Bank (ECB), as opposed to the European System of Central Banks, or Eurosystem, as opposed to the eurozone National Central Banks. The Eurosystem consists of the ECB and all the National Central Banks (NCBs) of the whole EU: the eurozone NCBs are a subset of the Eurosystem. While the NCBs are presented as branches of the ECB, in fact they still have an autonomous and sovereign status in national law and are owned by their nation state.

On a banal level the NCBs are the issuers of notes and coins – euro ones if the country is in the eurozone, or national legal tender if it is not. All the euro notes appear identical, whilst the coins have national characteristics, but the curiosity is that the euro notes bear no words, just the abbreviation ECB in several languages, the word Euro and an illegible signature with no name against it.

Contrast that with:

  • Pounds – “Bank of England I promise to pay the bearer on demand the sum of n pounds, signed by Andrew Bailey, Chief Cashier”
  • US Dollar: “Federal Reserve Note The United States of America This Note is Legal Tender for all debts Public and Private, signed by Treasurer of theUnited Statesand by the Secretary of the Treasury”
  • Danish kroner: “Danmarks Nationalbank Issued in accordance with the law governingDenmark’s central bank”

Who has the liability to pay out on euro note and coin? If all eurozone NCBs have equal and shared liability to pay out, then you have a real currency, as long as the backing for the currency is shared.

But it isn’t, because the bullion and currency reserves backing the euro are owned by the eurozone NCBs, not by the ECB. The non-eurozone NCBs have control their own foreign exchange and monetary policy, and their own reserves, and there is no sharing whatsoever.

Against that background it cannot be a surprise that the capital markets are increasingly looking through the currency as a uniting mechanism to each individual sovereign’s ability to pay, and looking past any policy measures that were aimed at economic convergence superseding the issue of variations in creditworthiness.

The policy measures (ERM,Maastricht, Stability & Growth Pact) have not worked; in fact they have backfired. Not least by targeting a measure of inflation that excluded real estate prices (a mistake shared by Gordon Brown with disastrous consequences in the UK as well), the ECB’s interest rate policy has brought about a broad spectrum of real interest rates over a 10 year period across the eurozone: the bid-offer is as much as 5%.Germanyhad real interest rates of +2%,Spainof -3%.

This divergence is now reflected in the “Bund spread”: the difference between the yield on the bonds of each eurozone sovereign compared to the sovereign bonds ofGermany. “Bund spreads” of 4% or more reflect the economic divergence and illuminate the differences in sovereign creditworthiness.

This in turns illuminates what kind of currency the euro really is. It is not a sovereign currency of a single nation state with its own central bank, monopoly of note and coin production, and control of interest and exchange rates. That sovereign also offers a crystal-clear look-through into the coffers of all tax-paying entities in its country. AUKgovernment debt in pounds carries a look-though to the entire tax production capacity of the area in which the pound is legal tender.

Nor is it a completely dematerialized currency as was the EUA (European Unit of Account) and its successor the ECU (European Currency Unit) whose irrevocable exchange rate into the Euro was 1:1. The ECU was a basket currency composed of weightings of the constituent currencies of the EU (including pound and kroner), the weightings being determined by the size of the national economies. When the ECU was converted to the euro, the weightings of the euro-out currencies were backed out.

The answer is that it is a bit of both. The note and coin are underwritten jointly and severally by the eurozone members of the Eurosystem, but a eurozone government debt in euro does not carry a look-though to the entire tax production capacity of the area in which the note and coin are legal tender. That is the point that Chancellor Merkel’s intervention has brought into the foreground: the ambiguities around the Eurosystem kept the issue in the background.

A curiosity in this is that a eurozone nation’s bullion and currency reserves back both the liability for sovereign debt, which is several and not joint, and also the liability under note and coin, which is joint and several.

It is not entirely surprising that the EU politicians prefer this fact to be obscured. The arrangements around the euro and the financing of European institutions are a complex Venn diagram of ownerships and sharing of liabilities. The EU and the eurozone countries have benefited up to now from the magic dust around institutions like the European Investment Bank – where all EU member states are jointly and severally liable for its debts – which facilitated a low “Bund spread” onto other borrowers that their individual capabilities did not support. That era now appears to be ending and the precise nature of each country’s liabilities laid bare, as stronger ones seek to avoid being brought low by the weaker.

In a sense, then, the euro is both a national currency and a foreign currency for all eurozone countries: national because it is legal tender and because the national bank issues notes and coins, foreign because the country has no monopoly of the euro notes and coins and because control of interest and exchange rates has been given up.

The mantra used to be that “governments never default on obligations in their own currencies”; now we are having to refine that again to say “governments never default in their own currencies as long as the currency in question is its own sovereign currency, over which it has control of foreign exchange and monetary policy, and where it owns the bullion and currency reserves that back it directly or through its central bank”.

That is too complex for the markets to deal with so they look through the currency of the debt to the tax raising capacity of each country individually and its individual bullion and currency reserves, regarding the currency issue as a smokescreen, the currency in the case of the euro being synthetic because its usage denotes participation in a patchwork of institutions, policies, resources, rights and responsibilities which do not add up to the same bundle in a currency where the risk on the currency and on the nation associated with it are one and the same.

PDF of article in Future Banking, July 2011