Responding To The Euro Crisis: A Better Way

Gerald Holtham

Gerald Holtham

Europe needs a single currency that works. Many believe that a successful Euro means ‘more Europe’, a common fiscal policy and more powerful common institutions. That will take time and negotiation.  Meanwhile the crisis rumbles on and enthusiasm for the Euro and the European Union itself is visibly waning in a number of countries.  Endless recession weakens the European faith among the deficit countries while apparently endless demands for bail-outs weakens support in Germany and other countries which are net contributors to Union budgets.  A reform now that introduced an element of flexibility and ameliorated the present crisis is not, therefore, a distraction from the path of European unity but a necessary adjustment to it.  It may indeed be a precondition for further progress.

This note therefore proposes a solution that makes possible a sustainable single currency in the current Europe of nations.

The great 19th century economist Stanley Jevons wrote:

It is in the highest degree important that the reader should discriminate carefully and constantly between the four functions that money fulfils, at least in modern societies.  We are so accustomed to use the one same substance in all the four different ways that they tend to become confused together in thought.  We come to regard as almost necessary that union of functions which is, at the most, a matter of convenience, and may not always be desirable. We might certainly employ one substance as a medium of exchange, a second as a measure of value….

To preserve the Euro as the single currency of the entire current Euro-zone, we have to analyse what that means. What are the functions of money?  First it is legal tender, a means of facilitating transactions and settling accounts; second it is a store of value; third it is a unit of account, the way we keep score and compare the value of one thing to another.  When we consider the successes and failures of the Euro, we observe that these divide according to which of the functions of money most concern us.

Consider first the advantages of the Euro.

 • Transactions costs are reduced: currency exchange is eliminated within the EU;

 • Price transparency is enhanced in single market: everything is priced in Euros;

 • International seigniorage is obtained when other countries use the Euro as a reserve currency;

 • Branding for EU: many see the Euro as a signifier of European unity and a concrete symbol of the Union.

The first advantage relates to the Euro as legal tender; the second relates to it as a unit of account and the third to its role as a store of value.  The fourth is not a pure monetary function and is derivative of the other three.

The disadvantages are fewer but currently are causing problems:

 • Europe is not an optimal currency area, i.e. an area where a single monetary policy and external exchange rate is compatible with achieving stable inflation, full employment and a sustainable balance of payments in all parts of the area.

 • If prices and competitiveness get out of line among countries, there is no way to adjust except competitive deflation.

The trouble is that no exercise of thrift or structural reform will restore competitiveness to a country in a world of deficient demand as we have at present – at least not, without impossible strains on the social fabric.

Separating the functions of money

The solution is to distinguish two of the functions of money: legal tender and unit of account.  Note that the most important of the advantages claimed for a single currency stem from its function as legal tender, i.e. means of exchange and of settling debts.  With a single legal tender, the transactions costs of currency conversion are eliminated.  Europe at present can support having a single way to settle bills but having a single unit of account removes a means of adjusting relative price levels, which is currently necessary. We have arrived at the situation described by Jevons over one hundred years ago where having one “substance” fulfil all the functions of money has indeed become undesirable.

How can Europe preserve a single legal tender while restoring the capacity to adjust relative price levels that used to be conferred by realignments among national currencies?  Note that when a currency was realigned with others, what was changing was its relative value, its relative position as a unit of account – not its position as legal tender.  Each country can keep the Euro as its sole legal tender but should introduce a national unit of account (Nua).  It should legislate that all contracts between residents, all domestic price lists and all wage slips should be expressed in both Euros and Nuas. But sight or short-term bank deposits would remain denominated uniquely in Euro.

The government should fix the relationship between the Euro and the Nua subject to agreement with European partners.  It would specify that in all dual price arrangements, it is expected that the Nua price is preserved when the exchange rate changes.  It will adhere to this principle in its own transactions and rely on public and market pressure to enforce it more generally. It can thereby announce a devaluation without having a separate circulating currency.  No doubt, some people would seek to resist a decline in their receipts or earnings in Euro by attempting to peg their prices or wages to the Euro.  That risk existed with a national currency, of course, where inflation sometimes followed a depreciation.  Yet devaluations usually worked for a time.  The risk of inflation is lower, the more depressed the economy is and at present several are very depressed indeed.

If people stuck to Nua prices, producers would find their relative wage costs had fallen and margins on foreign sales, where prices were fixed in Euros, were better than margins on domestic sales. The desired competitivity consequences of devaluation would be achieved. In effect the Nua acts as a co-ordination device that facilitates a change of the general price level in Euros while reducing the need for inflation or recession as a means of bringing it about.

The Nua would apply to prices for current goods and services.  There would be no attempt to alter the value of existing bank deposits.   The sanctity of bank deposits is necessary to preserve a single medium of exchange and to prevent speculative bank runs and switching of deposits within the Euro-zone.  Cheques or drafts drawn on short-terms deposits are, like notes and coin, legal tender and it is essential that only Euros exist as legal tender.

All banks across Europe would pay the same for their reserves but would be forced to discriminate in their lending, which would be double-denominated so would effectively be in Nua.  That means yields on securities originating in a country thought to have an excessive price level would be higher owing to the perceived risk of devaluation.

Effects on the banking system

Banks in such a system would be changed institutions. Their liabilities in the form of deposits would be in Euros though they could also issue double-denominated bonds.  Many of their assets would be effectively in Nua, implying a currency risk in any country where devaluation was at all likely.  That would have two consequences.  Banks would have to hold sufficient capital to remain solvent in the event of devaluation and they would have to hold or have access to sufficient Euro reserves to meet liquidity requirements, i.e. demand for payments in Euros.  This would achieve two reforms that have been urged on banks and central banks since the last crisis.  A capital ratio of at least 20 per cent would be de rigueur in such a system and banks would have to hold enough reserves at the ECB or to have adequate Euro collateral to meet foreseeable Euro demands.  The banking system would become more like the reserve-constrained system described in economics text books – whereas in recent years banks made loans in the confidence that they could always borrow reserves from the central bank.  Moreover the latter always supplied, relying on interest rates to control demand and therefore regulate the volume of credit.

It is only banks who must carry exchange risk in the Nua system.  Of course other people can opt to carry exchange risk if they wish but they will not have to do so.  The banks will exact a price for that risk because they will charge more for Nua than for Euro loans.  This is likely to restrict the size of the banking system because it will lead to disintermediation whereby other institutions borrow and lend directly in Nuas.

Freedom of contract means people who wished to take out Euro loans could do so, just as some people today opt to borrow in foreign currency where there is a lower interest rate.  However, it must be supposed that most people and companies whose pay or revenue would follow the Nua in the event of realignment would opt to borrow in Nua.  That means bank shareholders would bear the brunt of devaluation or the gains from revaluation.  Devaluation would entail a positive real balance effect whereby bank deposits became more valuable in terms of what they would buy domestically while a revaluation would have the opposite effect.

At the same time the claimed advantages of a single currency would be preserved.  Prices would be quoted in the same numeraire in all countries, supporting the single market; there would be no need to change currencies to travel abroad, bank deposits, cash and coin would have the same significance everywhere, reducing many transactions costs.

Monetary policy

The ECB would of course retain responsibility for managing the Euro.  Since all prices in Europe would be quoted in Euro as well as Nua, European inflation in Euro would be well defined and the ECB could continue to target it by setting policy interest rates as it does now.  Doing so would set deposit rates across Europe so there was no tendency to move deposits between countries.  However, bank loans would be priced differentially according to the perceived risk of realignment.  The rates would be set by the banks and the market and the ECB would not intervene.

Those different interest rates would be appropriate in circumstances where devaluation was anticipated because of higher domestic inflation than in Europe generally.  The perverse effect of the current single currency, whereby higher inflation implies lower real interest rates providing a positive feedback and still higher inflation, would therefore be eliminated.  That was a problem in countries like Ireland and Spain before the crash.  At present, of course, it is not the case that countries requiring devaluation have relatively high inflation.  They are generally uncompetitive so the level of domestic prices is too high but they are also depressed so high interest rates is the last thing they need.  But in the proposed system, the remedy is at hand – a substantial devaluation of the Nua.  That would improve competitiveness and demand via net exports.  The positive real balance effect could also stimulate domestic demand.

The ECB would concentrate on managing the Europe-wide Euro inflation rate.  However, the EU would need to develop rules of the game covering Nua revaluations.  These would happen on the intiative of national governments but on the understanding that certain objective criteria were fulfilled as monitored by the Economic and Financial Committee of the EU.  The intention would be to eliminate devaluations to gain competitiveness gratuitously when a country’s circumstances in terms of unit labour costs or employment were no worse than its neighbours.

If the ECB followed a hard currency policy and delivered low European inflation, the Euro would be a good store of value.  Indeed the ECB would be relieved of the need to make unlimited loans against very poor collateral as it has to do at present to hold the Euro together.  Given a hard-currency policy for the Euro, devaluations of Nua would be much more common than revaluations within the EU.  As the sole store of value and medium of exchange for Europe, the Euro would be an attractive currency world-wide, earning seigniorage and fulfilling its symbolic function for the EU.

Of course, such a system would not resolve the immediate crisis entirely.  That may require some debt forgiveness and for some European banks to be restructured.  In a perfect world, surplus countries would also expand domestic demand with looser fiscal policies allowing heavily indebted deficit countries to grow without themselves having to resort to further debt finance.  Since that will not happen, the convalescence of the European and world economies will be long – even with banking reform and Nuas operating alongside the Euro. Yet with those innovations, the Euro can be preserved, the European Union can resist erosion and the slow march back to prosperity can begin.


  1. steve hall says

    Iwas thinking two two currencies but could not see how this would work. The key is to have bank deposits in Euros. This would work well done!!!

  2. Peter_Sarasota says

    This is a great proposal to keep the Euro as a transaction currency but let each country have its own banking and central currency. Hopefully people would be able to keep their bank accounts in the currency of the country where the bank is headquartered. So some of my money would-be in Deutsche Marks, some in the currency of my home country. Clearly the interest rates on savings would vary. But most consumer transactions would be done in Euros. Keep the convience of the Euro but return much power over the value to the individual member countries.