Given the unstable state of the European Monetary Union, European countries need a new sustainable monetary model that is stable.  That system should have mechanisms built into it to deal with imbalances before they become problems.  Also, the monetary system should facilitate full employment, promote economic growth and be conducive to low inflation.  

The system should manage not only the exchange rate between countries, but also interest rates, the money supply, domestic and international debt of both the government and private sectors.  All member states should benefit from the Union.  But while a Euro currency may exist, countries should not be required to use it.  The existence of separate national currencies increases the monetary instruments available to manage the economy to achieve the desired objectives.

Institutions

Each country should have two separate monetary institutions: one to determine monetary policy and the other to implements that policy.  The government should be directly responsible for the policy arm and the implementation arm may be the central bank or other monetary authority.

Similarly, at the international level, the Monetary Union should have two umbrella institutions: a governing council that sets the policy and on which governments are represented.  This should have its own secretariat.  Also, there should be an implementing agency that applies the policy and deals with the national monetary authorities. 

Separating these institutions avoids the current situation in which central banks determine and implement policy.  The close relationship between the central bank and the commercial banks may lead to central banks losing sight of the objective of monetary policy, which is to contribute to the prosperity of the whole economy, not just the banks.

The Reserve Fund

 

To improve the security of the monetary system and manage foreign debt, each member country would be required to issue banking guidelines mandating that banks link the growth of their credit to the growth in their foreign reserves held in a Reserve Fund.  These guidelines must be approved by the governing council of the Union when a country joins the new Monetary Union.    

For example, German authorities may require that German banks hold a minimum of the equivalent of one ounce of gold in foreign currency for every additional 25,000 Euros (or Marks) that they lend.   

These same rules should apply to central banks or other monetary authorities that lend to governments.  Domestic government securities held by banks, including the central bank, would be treated as bank credit.  The reserve requirements applied to them should be similar to those applying to credit provided to the private sector. 

The Reserve Fund should be split into a number of tranches, to be held by: the banks, the national monetary authority and the Monetary Union.   If any banks were to have financial difficulties, they must first draw on their own reserve holdings.  By doing so they would be constraining themselves from raising their credit levels. 

If the banks’ own reserve holdings were inadequate, they may draw on their Reserve Funds held with the national monetary authority.  If those were inadequate, they may, with appropriate safeguards, draw upon the Reserve Funds of other banks held with the national monetary authority.   

If those national Reserves were inadequate, the national monetary authority may draw upon its national reserves within the Monetary Union.  The Monetary Union may apply conditions upon the country if it draws upon these reserves.  

Finally, the monetary authority may request its monetary policy institution to approach the governing council (through its secretariat) to request access to the combined Reserve Funds of the Monetary Union.  The Governing Council would need to give its approval and that approval, if given, is most likely to have conditions attached.  

Linking the growth of bank credit to the growth of foreign reserves ensures that the nation has savings available to be lent.  This avoids the situation in which bank lending may drive an increase in foreign debt.

Inter-bank settlements 

Banks in each nation would be entitled to settle their inter-bank transactions using foreign reserves in their Reserve Fund.  The monetary authority (or central bank) may facilitate these transactions through a special settlements tranche that may form part of each bank’s reserve funds. 

This has the effect of ensuring that a feedback mechanism, in the form of reduced Reserve Funds, is provided to any banks that lend excessively.  This form of feedback would prevent them from further lending until reserves have been restored.

Domestic currency (notes and coins) should be purchased using the Reserve Funds.  Also, currency sold back to the issuing authority (such as central bank) should be purchased using foreign currency that may be added to the reserve fund. This requirement ensures that domestic currency is securely backed with foreign currency. 

Non-bank financial institutions

The Reserve Fund requirements apply only to banks.  To be defined as a bank, the deposits, notes or other financial instruments of the institution must be negotiable.   

The lending of non-bank financial institutions should not be subject to the Foreign Reserve requirements.  Non-bank financial institutions would continue to be exempt from the Reserve Fund requirement, even if the financial institution had an arrangement with a commercial bank to provide a cheque/check book facility linked to that account.

Exchange rates, employment and inflation

Regardless of whether a country has its own currency or uses the common currency (the Euro), the exchange rate for that currency should be set in the market.  This is not a necessary requirement; it improves the speed at which the economy can respond to changed circumstances.  Where the exchange rate is set by the market, incentives need to be applied to ensure that the exchange rate is set at a level that maximizes employment and minimizes inflation. 

For example, if the German government chose to have its own currency, it may determine that the exchange rate should target an unemployment rate of less than 2 per cent and an inflation rate of less than 3 per cent.  It may stipulate that while unemployment is less than 2 per cent and inflation is less than 3 per cent, banks may lend 25,000 German Marks for the equivalent (in foreign reserves) of one ounce of gold.  However, for every 1 per cent that unemployment exceeds 2 per cent or inflation exceeds 3 per cent, the amount that banks may lend per ounce of gold would be reduced by 3,000 German Marks.   

Therefore, if unemployment were 4 per cent and inflation were 5 per cent, the amount German banks would be allowed to lend would be reduced by 12,000 German Marks; that is, to 13,000 German Marks for every additional ounce of gold equivalent in their Reserve Fund. 

To maximize their lending, banks would drive the exchange rate to a level that would achieve full employment and do so in a manner that would minimize inflation.   Similar rules would need to apply to the Euro. 

Note that in this environment where exchange rates are set to achieve full employment, the exchange rate is likely to be more stable than under the current floating exchange rate system in which the exchange rate moves to ensure that international receipts and payments are equal. 

Interest rates

The market would set interest rates.  There is no need for a monetary authority to use interest rates to manage bank lending or monetary growth. The banks within a country would raise interest rates to attract foreign capital to that country and raise their Reserve Funds, thereby enabling them to increase their lending. Eventually, as demand for finance was met, interest rates would fall and stabilize at around the same rate within the monetary union.

Income of the Monetary Union 

To provide financial independence to the Monetary Union, the interest earned on tranches that it holds should be used first to finance its operations together with the operation of the Governing Council and its Secretariat.  The Governing Council would need to authorize the budget and all expenditure of the institutions in the Monetary Union.  Any remaining income could be paid as interest on the deposits.   

 Conclusion

 

The system proposed above has mechanisms built into it to deal with imbalances before they become problems. Any excessive lending by one bank, or many banks, leads to a reduction in their Reserve Fund holdings that would reduce credit growth.  These arrangements ensure that banks may increase their lending only as they increase their holdings of savings.

 

This system facilitates full employment by ensuring that the exchange rate makes domestic products more attractive to domestic consumers and to importing countries.  Also the system is conducive to low inflation.    

The system allows the market to set interest rates so as to manage international capital flows and domestic lending requirements.   It also manages the money supply to achieve sufficient demand to provide full employment, but not so much as to be inflationary. 

The system minimizes reliance on international debt.  It allows the economy to create money by raising income and foreign reserves.  Then it allows the banks to create additional money which raise imports and deplete foreign reserves.  When that money is spent on imports, it is lost to the economy.  The net effect is that the money supply is increased and backed by domestic bank debt in a manner that does not raise foreign debt.  That is, it provides stable balance of payments. 

The rules above apply equally to loans to government and private sectors.  Excessive government borrowing would squeeze out private sector borrowing.  But fiscal deficits should be eliminated.  Government finances are supported by maintaining full employment, thereby maximizing government tax revenue and minimizing social security payments for unemployment relief.

This is a system that benefits all member states.  It uses the combined resources of member states to provide a stable monetary framework in which trade is facilitated for the benefit of all countries.

 

Leigh Harkness

 

Saving the Euro is a paper that takes a more analytical approach to explaining the problems with the Euro monetary system and advocates subtle changes to the monetary that would enable the Euro economy to grow more rapidly and in a sustainable manner.

Growth of Debt and Loss of Income in America

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Last update: 26 September 2011

 

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