The design of an antifragile Eurozone

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This article is a little bit different than the rest of articles in my blog. Most of my articles are about technology, yet this article may seem related to politics or economics matters. But not really; I am not going to talk about politics.

This article is really about design.

The mission of this article is to lay out a system by which countries, banks and citizens in the Eurozone are not exposed to the risks and failures of each other.

The model

“Model” is a technical word. A model is a simplification of reality, simple enough that it can be understood, but complex enough that it provides enough information to be useful. A model is a tool that we use to understand complex matters in a pragmatic way.

Our model of the Eurozone is going to be composed of four entities: Euro (currency), Banks, Governments and Citizens.

  • The Euro is the currency that the Eurozone uses.
  • Banks are all the banks in the Eurozone.
  • Governments are the organizations ruling each country.
  • Citizens are the regular people living in a country.

Each of this entities has a role:

  • The role of the government is to provide a series of services to the citizens.
  • The role of the citizens is to generate value by creating services and goods.
  • The role of the banks is to lend money and keep money safe
  • The role of the currency is to serve as a mean of exchange for services and goods.

And they have interactions with each other:

  • The money that governments have is provided by the citizens (taxes) and banks (sovereign debt).
  • Citizens expect banks to keep their money safe, that is they can withdraw the money from their bank at any time.
  • Citizens use banks to finance their businesses.
  • Banks lend money to other banks.
  • Governments lend money to other governments.

The risks

“Risk” is another technical word. Risk is defined as the possibility of something happening weighted with its cost.

Since banks lend money to other banks, the failure of one big bank to return a loan can have a domino effect and destroy other banks. This is what happened in the financial crisis of 2008. Banks in U.S.A were exposed to loans that were unlikely to ever be collected. When that risk was realized, the bank had a lot of loses to the point were it was insolvent. Other banks that previously lent money to that first bank were exposed to the possibility of losing that money if that bank were to go bankrupt. This situation spread, domino effect, all over world.

The reaction to this problem was for governments to finance the troubled banks with the money that they collect via taxes. Since most governments operate on a deficit, the money lent to banks was actually obtained via another loan. The disastrous nature of this deal is that it exposes the government to be liable for the failure of private companies. The role of the government in this deal was to act as a proxy between the troubled banks and the organizations that actually contributed the money, and act as collateral – pay the cost of a loan not being repaid.

We don’t pay taxes so that the government can expend it in however way it deems necessary. We pay taxes in order to pay for services the community has agreed to finance, and financing failed banks is not one of those. This strategy has exposed governments to heavy loses, unjust treatment of their shareholders (citizens) and provided only the compensation that rescued banks won’t be failing now – but may, in any case, fail in the future.

Most governments are operating at a loss, their budget has a deficit. Governments are not collecting enough taxes to pay for the cost of the services they provide to their citizens. The difference is being meet using credit from banks. If banks are not willing, or able, to lend money to the government, then the government may go bankrupt.

Businesses depend on banks to finance their operations. If banks are not willing, or able, to lend money to the business, then the business may go bankrupt.

If many businesses go bankrupt, the taxes the government collect are going to be diminished and the government will have a bigger deficit.

Since governments lend money to other governments, if one government, for any reason, is unable to return that money, the lending government may go bankrupt or incur in significant deficit. This is one of the aspects in the Greek crisis of 2015. The governments of Spain, Germany and France were exposed to thousands of millions of Greek sovereign debt and thus their ability to make decisions in a fair way was compromised.

The way in which the Eurozone dealt with the Greek crisis was obviously misguided when we consider the fact that those governments lent money they didn’t had (they operated on a deficit, thereby it was financed by issuing new debt) to pay for services that were not enjoyed by their own tax payers, to a country that was unlikely to return it, that used that money to pay back debt they previously acquired. Ridiculous.

Mitigating risk

So what we have here is a system in which the failure of citizens, governments and banks affect the others. They are very intertwined. Is it possible to build a system in which the failure of one is contained?

I think so. And it will be a simple thing actually. Just a matter of adding these rules to the game:

  • Governments are not allowed to lend money to any other government.
  • Banks are not allowed to lend money to other banks.
  • Only the European central bank can lend money to other banks in the Eurozone.
  • Only the European central bank can lend money to governments in the Eurozone.
  • The European central bank decides if a bank should be lent money.
  • The European central bank must always lend the money governments need.

If governments are not exposed to the debt of other countries, then it doesn’t matter – to them – if they fail. If Greece were to go bankrupt, it would have no impact on the finances of the governments of Germany, France or Spain.

If banks are not exposed to the debt of other banks, then it doesn’t matter – to them – if they fail. If one Spanish bank were to go bankrupt, it would have no impact on the finances of other banks in Spain.

Citizens use regular banks to finance their businesses. Banks are fully capable of absorbing loses of a regular business and if for any reason they are not, then it is only fair that they are allowed to fail – as any other business. Governments are not supposed to lend money to banks under no circumstance.

If only the European central bank were to be exposed to the debt of other banks in the Eurozone, then the failure of a bank will be contained, because the European central bank can always cope with any amount of losses because of the fact it can print money.

If only the European central bank were to be exposed to the debt of governments, then the failure of a government will be contained, because the European central bank can always cope with any amount of losses because of the fact it can print money.

The decision making of lending or not lending to a bank is made exclusively by the European central bank. This is not a political decision, this is an economic decision. A bank is a privately owned business, so the possibility of letting it fail should remain. If the central bank judges letting it fail to be better for the Eurozone than to finance it, it should have the option to.

On the contrary, governments are not privately own, and bankruptcy is a dramatic event for a government, so they cannot be allowed to fail. They should always receive the money. Any country in the Eurozone must be allowed to obtain any amount of credit that their country needs.

If we were to let this rule as it is, it is obvious that it could be abused: countries could just obtain an absurd amount of credit and lower taxes. Such a case would be good for the individual country, but bad for the overall economy of the Eurozone, as it may heavily devaluate the currency. I understand the Eurozone to be an economic alliance of governments that trust each other. If a government were to abuse the system in their own benefit at the expense of others then it is only fair that such a country be expelled from the group. This is a political decision and does not belong to the European Central bank, but to the current leaders of the governments of the Eurozone. It is paramount that government understand that operating on a deficit is to be a temporal strategy to cope with the variability of the economy. It is expected that governments do balance their accounts so as to not have any deficit.

The role of the European Central bank can thought as the entity that is designed to absorb and nullify the effects of dangerous debt. Citizens, businesses, governments, they all have, at some point in their life, the need to acquire a debt. Governments acquire it directly from the EU central bank. Businesses and citizens acquire it from regular banks and, should they fail to pay back, the bank can probably take the hit. If that bank were not able to take the hit, the EU central bank can help by lending them money. This is a system that, by design, makes circular debt impossible. All the negative effects of debt is dealt with, at the very end, by the European central bank. It’s a closed path were debt does not propagate. Banks lending money to governments, and then governments lending money to banks, and again and again until the bubble explodes is an scenario that is impossible within the constrains laid out in this section.

Antifragile

So far we have argued a system in which risk is mitigated. That is, a system in which adverse change can be resisted. But we initially intended to create a system that is not just resistant, but antifragile. An antifragile system, as Nassim Nicholas Taleb defined in The Antifragile, is a system that gains, grows stronger, when change happens. So in that sense:

Does a government that has a deficit and loans money from the central bank make the system stronger?

Yes.

When a government has a deficit it means that the productivity of said country is not high enough to pay for the services the government is providing. There are only two ways to fix this problem. Either the country increases tax collection, or reduces costs. There is no other way, as a permanent deficit will, sooner or later, bankrupt the country.

Let’s suppose that the government has a fair tax system and no endemic corruption. The effect of the EU central bank lending money to that government is that the government can keep paying for the services it provides to their citizens and also it increases the flow of money in that local economy. So the government will have time to modify their cost structure. Also, when there is an increase in the amount of money in a country it has a positive effect on that economy, thereby is helps in the long term to collect more taxes by increasing the demand services and goods and thus creation of new businesses.

If it were not the case that the government has a proper tax system and no endemic corruption, it would be a country that shouldn’t be in the Eurozone in the first place. It is required that countries willing to join the Eurozone meet certain rules, such as deficit limits. The system is already set, this just need to be enforced – it was not enforced in the case of Greece.

It also has an impact on the currency: it devaluates it. This is not inherently good or bad. It’s good for exports, and it is bad for imports. On principle, the value of a currency is a reflection of the productivity of a country relative to others. In the case of the Eurozone, it is a reflection of the overall productivity of the countries that compose the Eurozone. When businesses in a given country are making a benefit, investors invest in said business. When those investors are foreign, they first need to exchange whatever their currency is for Euros. That increases the demand for Euros, and thus increases its value relative to the other currency. The value of the Euro as a currency is simply a reflection of how well the businesses of a country are doing.

The objective of the Eurozone should not be to maintain the Euro in a particular value, that’s a red herring. The objective of the Eurozone should be to develop an economy that is efficient and productive. The value of the Euro as a currency is simply a reflection of how well we are doing just that. We should not try to maintain the Euro at a particular value by artificial means.

Does a bank that loans money from the central bank make the system stronger?

Yes

Under this system, banks can only ask for a loan to the central bank. When a bank needs money, it is because it needs liquidity or because it has loses.

If it has loses, it may be fair to let that bank go bankrupt. It is a private business after all.

Banks have a lot of their money invested. They may have a healthy account, but they may not really have the actual bills available. They lent that money to businesses. But if a bank suddenly need liquidity – actual coins – it should be able to do it because citizens should be able to withdraw their money at any time. Under this model, the European central bank guarantees that citizens will be able to withdraw their money.

Does a business that has a deficit and loans money from a regular bank make the system stronger?

Yes.

Businesses are the drivers of the productivity of a country. But they fail. A lot.

Under this model, the failure of a business will only impact the lending banks. No domino effect. This is a system that investors can feel a lot more confident in, because risk is mitigated.

To conclude: Building an economic and political system in which the two latest crisis couldn’t had happened is possible. It simply requires that we adopt a system that provides a solid wall between the different actors in this economy, so that the failure of one, does not cause the failure of the other.