.

Prohibition of monetary financing of govern­ment spending under Article 123 TFEU.
Central banks between monetary sovereignty and bankmoney dominance

Photo IPG JOurnal

Photo IPG JOurnal

The strange prohibition of the sovereign from exercising its monetary sovereign rights

In the course of the euro sovereign debt crisis 2010–12, several structural defi­cien­cies of the Euro­pean mone­tary and finan­cial system became visible. With regard to govern­ment finan­cing, three facts in parti­cular should be mentio­ned here.
Firstly, the public has become aware that central banks have long ceased to be bank of the state, even though they were founded for this purpose 150–300 years ago. The central banks act as if they were only bank of the banks. If an EU government gets into payment difficulties today, it lacks a lender of last resort.

Secondly, at an advanced stage of the crisis, the European Central Bank (ECB) had no choice but to buy large amounts of govern­­ment bonds on the open market in order to stabi­lise the market and interest rates for govern­­ment bonds and to enable the govern­­­­ments con­­cerned to con­ti­nue borro­wing from banks and other investors. Through this and other measures the ECB flooded the banks with central-bank money (reserves) far beyond the banks' actual liquidity needs, with the declared inten­tion for the banks to use the money for extending more credit and buying govern­ment bonds even of weaker countries, thereby also coming to the rescue of the existing stock of govern­ment bonds, knowing that the lion's share of these bonds is held in the asset portfolio of banks, funds and insurance companies.

Thirdly, and not least, the European Stability Mechanism (ESM) was set up, as a kind of substitute lender of last resort for governments. This function was previously per­for­med by the Inter­natio­nal Monetary Fund (IMF). In the case of the Eurosystem, the IMF and ESM cooperate with each other, indirectly assisted by the ECB. This makes it easier to impose harsh and counter-productive austerity policies on debtor countries and to go easy on creditors as much as possible; even though the creditors as relentless lenders to sovereign tax-monopolists were as much to blame for that sovereign debt crisis as the governments concerned.

Article 123(1) of the Treaty on the Functioning of the European Union (TFEU), also known as the Lisbon Treaty or 'EU Constitution', plays an important role in this context. Paragraph 123(1) prohibits any type of direct central-bank credit to public bodies as well as the direct purchase of sovereign bonds by the ECB or national central banks of member states. Even the formerly customary ways-and-means advances (overdraft facilities for bridging temporary gaps between tax revenues and expenditures) were prohibited with the introduction of the euro.

Article 123 TFEU, paragraph 1
Overdraft facilities or any other type of credit facility with the European Central Bank or with the central banks of the Member States (hereinafter referred to as "national central banks") in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the European Central Bank or national central banks of debt instruments. 

In contrast, the secondary purchase of government bonds by central banks on the open market was and is widespread. According to a previous version of Art. 123 (2), the practice was explicitly permitted. Under Art. 123 (2) there was no limit on bond purchases, whereby these have in fact represented a rather small share of all govern­ment bonds. By purchasing government bonds from the holdings of banks and other financial institutions, central banks pay the banks with reserves that serve as a means of payment in interbank transactions. Non-monetary financial institutions, by contrast, are paid via the banks with liquid bankmoney (sight deposits at a bank). 

In the meantime, Art. 123 (2) has been amended, largely unnoticed by the public. The paragraph no longer says anything about open market purchases of government bonds, instead only that in terms of monetary policy public banks are to be treated the same as private banks.[1]

In short, immediate or direct monetary financing of public spending by the central bank past the banks is prohibited, while indirect subsequent re-financing of govern­ment spending by way of open market purchases of bonds from banks and other financial institu­tions is permitted. Honi soit qui mal y pense. With regard to the volume of govern­ment debt, an imme­diate direct purchase changes next to nothing com­pa­red to an indirect bank-mediated purchase. The difference is that for the privi­leged primary dealer banks this means a good stroke of business. Secondary bond buyers, too, profit from the fact that the state conti­nu­ously pays them interest on a high and constantly revolving mountain of debt. This is corres­pon­dingly expensive for the public purse – certainly less so in the current period of excep­tio­nally low interest rates, but other­wise to an ever greater extent.

It is remarkable that with the onset of the sovereign debt crisis in 2010, there was no hesitation for a weekend to disregard Article 125 TFEU (no bail-out). This article prohibits the EU and its member states from assuming responsibility for the national debt of other member states. In the need of the hour, however, it was said in order to prevent something worse, 'solidarity' had to be shown to the states that had been dropped by the bond market (and thus 'solidarity' to the respective bond holders, initially still banks to a large extent). Article 123 (1) TFEU, by contrast, has been steadfastly adhered to at every moment. When the ECB finally decided to do the right thing – which was to buy government bonds on the open market until the market calmed down – the ECB was not praised for doing so, but rather persistently criticised for undermining the ban on monetary financing according to Article 123 (1) TFEU.

Large-scale purchases of sovereign bonds certainly undermine the prohibition of monetary financing. However, this is not a cause for criticism, for the critics are missing the point. Secondary purchases of government bonds by central banks are legal. They make sense under various aspects. They are practised worldwide even without a crisis. So what is the point of the prescribed detour via the banking sector if it makes no difference in the amount of public debt, except that the primary and secondary bond dealers make a great deal that costs the public purse dearly? Well, exactly that.

What government and parliament have forbidden themselves to do, i.e. 'money printing', the banks are now doing for the government all the more unhesitatingly and to an even greater extent. Governments have the largest cash flow due to their tax monopoly and are therefore normally considered the best possible debtor – until some unforeseen crisis event leads to a sudden reassessment of the over-exposure of the banks and other financial institutions. They abruptly begin to sell off government bonds and no longer purchase new bonds or only at very high levels of interest. In doing so, they trigger a sovereign debt crisis, often in combination with a currency crisis and banking crisis.

Monetary sovereignty – single currency, money issuance, seigniorage  

Art. 123 (1) TFEU is a legal pile-driver for consolidating the privatisation of money creation and seigniorage, two of the three components of monetary sovereignty; the third, or rather first, is to define the national currency unit, such as the US dollar, euro etc. Privatisation of money creation is already well advanced in today's bank­money regime. So Art. 123 (1) TFEU appears, as it were, as an act of state-approval of the Banking School, whereas a chartalist standpoint in the tradition of the Currency School is much closer to the public interest.[2]

The terms currency and money are usually not kept apart, neither technically nor colloquially. However, a distinction is necessary in the sense that the 'currency' com­po­nent of mone­tary sove­reignty refers to the national monetary unit of account, while the money com­po­nent of mone­tary sovereignty entails the creation and circu­la­tion of money as legal tender deno­mi­na­ted in the respective national currency. This enables effective control of the stock of money and comes with the gain asso­cia­ted with money creation (seig­nio­rage) to the benefit of the public purse.  

This applies to all types of legal tender, today cash and central-bank reserves, and soon also central-bank digital currency. It would also have to apply to what is bankmoney today, that is, credit balances on customer bank accounts, liquid in the form of sight deposits, aka demand or overnight deposits, and deactivated in the form of savings and time deposits. However, neoclassical economists and many post-Keynesians do not see it that way. Unlike their classical liberal predecessors, they now consider private money creation at the expense of the state's monetary sovereignty to be just as normal and natural as the fact that private bankmoney has assumed a privileged para-state status due to its dominance and state guarantees.

Central bank money is base money, i.e. base-level or first-tier money. Bankmoney is second-tier money. In the meantime, there are several types of third-tier private money, among these money market fund shares (MMFs) in the amount of one third (EU) to over twice (USA) of cash and liquid bankmoney combined. MMFs are now often used as a means of payment in financial transactions. E-money, on the other hand, has not yet gained any importance. Stablecoins, on the other hand, are currently establishing themselves on a growing scale. Uncovered cryptocurrencies like Bitcoin, however, are immediate base-level challengers of national currencies. The fact that this is watched like a sensation rather than with concern is one of the oddities of today's monetary system politics.

If these trends continue, the new means of payment will soon become systemically relevant, like bankmoney in its earlier stages. In the event of a major crisis, govern­ments and central banks would then not be able to avoid granting the same monetary privileges to new third-tier types of money. These circumstances must be seen as a funda­men­tal aberration. Monetary sovereignty is one of the fundamental prerogatives of a sove­reign state or community of states. Allowing the privatisation of money creation to take place and all the same acting as guarantor and ultimate bearer of much of the liabilities arising from the private money issue is not a particularly clever combination.

Predominance of the banking sector and bankmoney               

Bankmoney is not central-bank issued legal tender, but is generally used as if it were. Today, the lion's share of money consists of bankmoney, 90–97 percent, de­pen­­­ding on the country and monetary aggregate. Accordingly, also the lion's share of the gain from money creation (seigniorage-like extra profits) is realised by the banks in the form of fi­nan­­cing costs avoided – be it as an extra interest margin on credit to non-banks (since the banks need to refinance overall only a fraction rather than the full amount of the bank­­money they create), or be it through the pur­chase of secu­­ri­­ties or real estate from non-banks, for which the banks also pay with just frac­tio­nally refinan­ced bank­­money. For the central bank and thus for the public purse, only a small part of seig­nio­rage remains, mainly from interest on central-bank loans to banks, and from the pro­ceeds of creditary foreign exchange management.

With Art. 123 (1) TFEU, the monetary sovereignty of euro member states has been formally suspended in favour of the banks' quasi-sovereignty in creating bankmoney. In any case, the EU member states have agreed to the article and thus practically to the surrender of their monetary sovereignty and their one-sided depen­dence on banks and the bond market when they need to borrow. The system-defining leading role of the banking sector in money creation pro-actively determines everything else in monetary terms, in particular the re-active and residual provision of cash and reserves by the ECB as well as, not least, the whole range of crisis measures to save the bankmoney, or systemically relevant banks, respectively.

Money creation has largely slipped from the central banks to the banking sector as a result of the develop­ment of non-cash payment transactions and the emergence of the bank­money regime. A bank 'controls' its bank­money creation with regard to its  indivi­dual business activities. There is no control of the resulting money supply and its effects. Nor can it, since banks cannot conduct monetary policy and should not be expected to do so.

Contrary to what is still written in textbooks, central banks do not control the banks' pro-active creation of credit and thus bankmoney, neither through reserve positions nor through central-bank interest rates. On the contrary, the banks' preceding balance sheet expansion leaves the central banks little choice but to accommodate the banks' demand for central-bank money.[3] Not only the volume of bankmoney, but also the volume of required reserves and cash to be withdrawn from the bankmoney, are thus completely determined by prior bankmoney credit.

On 100 units of bankmoney, the banks in the Eurosystem need central-bank money only to the fraction of about 3% – of which 1% are minimum reserves on customer deposits as well as 1.5% vault cash for the ATMs and 0.1-0.5% payment reserves (so-called excess reserves).[4] If the central bank does not want to disrupt current ope­ra­tions, it has to provide the necessary refinan­cing promptly. It can charge a higher interest rate for this, which narrows the interest margin of the banks somewhat, also because interest rates on the interbank market are rising as a result. However, the volume demand for reserves, as a fait accompli, is quite inelastic to central-bank interest rates. Even if there is a medium-term feedback loop, higher base rates will not stop banks from creating bankmoney for extending credit as long as expected returns on bankmoney lending and investment remain high enough.

As a consequence, the privatisation of money creation and seigniorage is well advanced. The central banks have not only become lenders of last resort for the banks, but in fact general anytime refinancers of the banks. Within the framework of the current bankmoney regime, the central bank is not the money issuer of first instance. It issues central-bank money re-actively and fractionally according to the monetary facts the banks create pro-actively.

Market failure versus state failure –
an intricate controversy especially concerning the monetary system

The prohibition of any monetary financing according to Art. 123(1) TFEU is historically rooted in Banking School doctrine and subsequently also in neoliberal normativity – or rather ultraliberal, unthinkingly anti-state attitudes. Bank credit to non-banks is in fact also monetary financing, but through bank credit, which is provided in the form of bankmoney. (Bank credit to treasuries is indeed paid in central-bank reserves into treasury transaction accounts with the central bank. However, since the government immediately re-spends what it takes in, the reserves immediately flow back to the banking sector).  

The stereotypical view is that state control of money leads to mismanagement and inflation, while bankmoney creation is led by market demand, oriented towards real investment needs and thus serves real non-inflationary growth. Both parts of this stereotype do not stand up to practical experience and empirical facts.

In recent decades, bankmoney creation has mainly fed non-GDP finance and real-estate transactions. Beyond that, demand for credit from the real economy, especially from smaller companies, is only inadequately served by the banks, while large industrial corporations have their own banks, or tap financial markets on their own. The relationship banks that used to be common they need correspondingly less.

Government spending, on the other hand, flows first and foremost into the real economy, through consumptive demand as well as through government investment and supply-side stimulus measures. This is not to give 'the state' economic precedence to 'the market' in the overall economy, which would indeed be mischief. The point here is to expose the mischief of monetary and financial ultraliberalism.    

In fact, episodes of state or state-controlled money creation show a mixed per­for­mance, sometimes respectable, sometimes poor. However, this is equally true, and in some cases more so in the bad, for periods of bank-determined money creation. These almost regularly lead to inflation, asset inflation (bubble formation), upward and downward overshooting of economic and financial cycles, and a resulting proneness to crises, as explained further below.[5]

Of course, it would conversely be wrong to portray parliaments and governments as the better guardians of the currency. The cases of excessive 'money printing' by govern­­­ments or at their instigation are quite numerous. When strong government influence on money creation is combined with clientelistic policies, this will almost certainly lead to monetary and fiscal policy failure. If there is any reasonably satis­fac­tory answer to the problem of fiat money creation, it lies in the dual indepen­dence of the national monetary authorities (central banks) from both government and the parti­cular interests of banks and finance at large.     

Inflations in the context of war and post-war conversion crises are a special chapter in themselves. Almost every major war event is accompanied by government over-indebtedness, while productive capacities are geared towards war production. After the war, this results in an overhang of money and uncovered peace-time demand, which triggers of inflation. This already happens during the war period, unless prices are centrally administered.

Other inflationary events are inadequately portrayed, for example the decline of the Con­ti­nen­tal Dollar, the treasury-issued paper money at the time of the American War of Inde­pen­dence, or the German hyper­inflation of 1920–23. In such cases, it is usually assumed that inflation and currency decline are due to irresponsible 'money printing' by the government. More often, however, other reasons prevail. In the case of the Continental Dollar, the reason was massive counterfeiting as a means of British warfare. British counterfeiting also played a role in the decline of the assignats of the French Revolution, although the tumultuous revolutionary events themselves were certainly the more decisive factor, especially in terms of large-scale expro­pria­tions and disrupted production and trade.

In the case of the German hyperinflation in the aftermath of the First World War, it was the enforcement of excessive war repa­rations in gold, industrial goods, US dollars and British pounds, accompanied by eco­nomic weakness and the decline of the Reichs­mark. The latter, in turn, was accom­pa­nied, and fuelled, by massive currency spe­cu­la­tion against the Reichs­mark, which the Allied super­­visory bodies forced the Reichs­bank to tolerate and finance the outflow of specu­­la­tive profits in foreign exchange.[6] This, too, amounted to a con­ti­nua­tion of the war by finan­cial means. Together with the rigid monetary tightening of the central banks in the economic depres­sion that began in 1929, the con­stel­lation proved to be an un­in­ten­­ded but effective support for the Nazis' rise to power.

Monetary and financial market failure in the bankmoney regime

For almost 350 years, money creation by the banking sector always tended to be pro-cyclically overshooting, that is, far beyond the real growth potential and the financial carrying capacity of the economy, while in the periods in-between credit exten­sion is stub­­born­ly diffi­dent. In a recession or crisis, the excess turns into a contrac­tio­nary under­­supply of money, which exacer­bates the downturn. Today, such slumps are counter­­­acted by government deficit spending and central-bank Quan­ti­tative Easing – still another aspect of questionable compensatory state interventions in favour of the mal­func­tioning bankmoney regime.

Regarding monetary overshoot, in Germany, for example, real economic growth in the period from 1992 to the onset of the crisis in 2008 was 23%, but nominal growth (in­clu­ding inflation) was 51%, and the increase in the money supply M1 (mostly bank­money) even 189%. The overall picture was similar in other countries. In the USA, the increase in bankmoney was significantly lower, instead, money market funds as a new payment instrument on financial markets rose to 2.5 times M1.

This means, roughly speaking, that only about one eighth of the expansion of the money supply went into real growth, but just as much into inflation. The large remainder, about three quarters, directly or indirectly fuelled financial market bubbles (asset inflation).

Monetary banking regimes are unstable, and bankmoney is unsafe due to its minimal coverage in central-bank money. As a result of GDP-disproportionate generation of bankmoney, inflation as well as asset inflation arise. The associated disproportionate creation of financial assets and debt causes the share of financial income to rise at the expense of earned income. Ultimately, the bankmoney regime is repeatedly plagued by banking and financial crises. According to a much-cited study by the IMF, between 1970 and the onset of the 2007/08 crisis, 425 financial crises occurred worldwide, including 145 banking sector crises, 208 currency crises and 72 sovereign debt crises.[7]

Against this background, it is far from reality to claim that bank credit is optimally limi­ted by the markets and serves to finance real-econo­mic invest­ment and expen­­di­­ture. The share of banks in financing companies as well as private and public budgets is declining, because large and increasingly also medium-sized companies are financing themselves on the non-bank capital market. In turn, bank credit has been increasingly channelled into real-estate credit (mainly as a non-GDP financial investment, less as a real construction investment) as well as investment banking and other non-GDP finance.[8]

Perhaps the most fundamental pro Banking School argument, according to Hayek, is that central-bank control of the stock of money represents bureaucratic pretence of knowledge. No one can know the right money supply, only the market knows. It is certainly true that no one can know the adequate money supply in advance. But that 'the market knows' the right measure is the same kind of mischief as medieval judgments of God, or the infalli­bility of the Pope. The market knows nothing at all. Markets are about interactive dynamics among suppliers and demanders who have partial knowledge and try to assert their interests and goals according to the means at their disposal. Whether what emerges is optimal or represents a market equilibrium is never really known, but rather when there is a blatant excess of demand or supply, or when there are cases of market dominance by a single actor or group of actors.    

The reason why the belief in the market cannot be fulfilled with regard to the free creation of money is that modern money lacks a self-limiting market mechanism. Modern money is pure fiat money which can be freely created 'out of nothing'. And if there is 'instant money' on demand, markets cannot produce something like balanced prices or interest rates. Rather borrowing money will be on the cheap, and financial capital prices will soar. The demand for money is just as self-enhancing as the money supply of the banks and now also of the shadow banks. Instead of market self-limi­ta­tion resulting from negative feedback, there is a positive-feedback upward spiral of money creation, credit expansion, price increases and indebtedness. Since around 1980, that overshooting expansion has decreasingly fed the real economy and infla­tion, and increasingly asset inflation of non-GDP finances.

New gold standard and fixed money growth: improper disimprovements

The neo-Austrian school concludes from the recurrent oversupply and interim undersupply of credit and money that there must be a return to the gold standard. For similar reasons, M. Friedman's monetarism wanted a fixed, mechanically applicable growth of the quantity of money by, for example, 3 per cent annually.

A gold-linked money supply or its mechanical growth (which is not even feasible in the bank­money regime) are not suitable solutions to the problem, but rather its aggra­va­tion. The money supply must be flexibly re-adjustable according to the economic situa­tion. In a context of growth and moder­ni­sation processes, a fixed money supply would in principle have a stagnant or even deflationary and depressive effect. This is one of the reasons why gold or silver standards have never lasted in real economic life. Depen­ding on the economic and political situation, the degree of precious metal cove­rage was modified from time to time, or its non-fulfilment was 'flexibly' tolerated, or the gold standard was at times even suspended. Wherever there was a doctrinaire refusal to do so, disaster follo­wed – see the mone­tary tighte­ning from 1929 onwards and the Great Depres­sion thereafter. Only large-scale deficit spending and mone­tary finan­cing of govern­ment stimulus pro­gram­mes put an end to that crisis in the mid-1930s.

It is all right that modern money is token fiat money. Modern money must be 'printed' by someone, or entered into an account, or put into circu­la­tion as a digital token, other­wise it would not exist. The question is: who has the right to create money and benefit from the seigniorage? Who has control over this? Accor­ding to which objec­tives? Who is liable and in what way if something goes wrong?

Monetary Imperative: Dual independence of central banks

For monetary policy the situation in today's bankmoney regime means navigating between Scylla and Charybdis, that is, on the one hand, the threat of monetary-financial market failure due to over-expansionary dynamics (particularly in non-GDP finance) and, on the other hand, the threat of monetary-fiscal state failure as a result of clientelistic policies. Under prevailing conditions, the central banks can ulti­mately prevent neither the one nor the other, even though one has recognised the basically appropriate institutional arran­ge­ment, that is, the inde­pen­dence of the central banks as monetary state authorities, as an additional element of the separation of state powers, in a way comparable to the independence of the judiciary.  

To the political left, the independence of the central banks is but the concealment of the rule of independent financial capitalism seeking to escape political influ­ence in order to implement politics of its own. Given the current circumstances, that view has a point. Nevertheless, such a view fails to recognise the real mutual dependence of market and state, also inclu­ding a high degree of interdependence between private and public finances. For example, the past decade of monetary Quantitative Easing (QE) was not only about QE for finance, but it also brought QE for people, i.e. QE for the real economy, inclu­­ding indirect monetary financing of crisis-related government spending.

What is central-bank independence supposed to mean anyway? First of all, it means the independence of monetary policy decisions, including the independence from government instructions. In liberal democracies, central banks today have been granted a high degree of independence in monetary policy decisions. They are bound by their legal mandate (if there is one in a serviceable manner), but not by instructions from the government. The ECB's independence from instructions on monetary policy is laid down in Art. 130 TFEU.

Often, parliament, government, tax office, central bank, financial supervisory bodies and other authorities are lumped together as if all state organs were a monolithic entity called 'state' or 'public sector', or also 'government' in American.  This then includes almost everything that is subject to public law. But a central bank as a state's monetary authority that is independent of presidential or ministerial instructions can no more be lumped together with parliament, governing Cabinet and public administration than can the judiciary, certainly not in monetary terms, and just as little in fiscal terms.

Central banks should indeed once again be bank of the state, but this does not mean that monetary policy in accordance with politically opportune fiscal policy should be the guiding principle for a central bank. Central-bank independence from government instructions entails the exclusion of interventions on the part of the ministry of finance or other government bodies, in analogy to the independence of the courts.

Likewise, a central bank can remain bank of the banks, possibly also bank of other financial institutions, but the interests of the banking sector and its demand for central-bank money must not remain the sole guiding principle of monetary action, as is the case today. In the existing bankmoney regime, the central bank and the banks are intimately entangled with each other, the central bank as an auxiliary organ of the banks. To be sure, for the central bank there is no obligation to follow the banks' needs and wishes, but func­tio­nally, its monetary policy options are to a large extent pre­deter­mined or con­­strained by the mone­tary facts which banks, shadow banks and the financial markets create in advance.

Due to this and a widespread bias towards Banking School thinking, central banks almost automatically comply with any refinancing demand by the banks, in times of crisis even more so than under normal conditions. The reactive involvement of the central banks in the banking business undermines the decisional independence of the central banks. This has recently been exacerbated by the fact that euro central banks have been entrusted with a number of tasks of banking super­vision – a case of insti­tu­tio­­na­lised collision of interests.

A central bank's independence in making monetary policy decisions is thus twofold: independence from government directives, but also functional independence from constraints imposed by the bankmoney regime. The reactive functional dependence of central banks on problematic monetary facts created by the banking sector and shadow banks urgently needs to be resolved. This will only be possible, however, to the degree that the money supply consists predominantly of central-bank money again, of unrestricted legal tender, i.e. sovereign money, instead of bankmoney, MMFs and stablecoins. As long as bankmoney dominates the monetary system, the problem remains unsolvable.

About monetary policy

The role of central banks as independent monetary authorities in the service of the general public should not be misunderstood to mean that a central bank should plan and prescribe the money supply. No. Prescriptive control of the money supply was a mistake of the gold standard as well as of monetarism. In any case, control of the money supply cannot be implemented in the existing bankmoney regime. This also applies to a considerable extent to conventional interest-rate and quantity policies.

As long as the share of central-bank money in the total stock of money continues to dwindle and threatens to disappear altogether with cash in circulation, central-bank interest-rate policy lacks the quantity lever it would need for effective transmission. In contrast, if such a lever were to be created again – through the re-proliferation of central-bank money, predictably as central bank digital currency in general use (digital euro) – interest-rate and quantity policy would become more effective again.

The extent to which central banks vary their base rate and accommodate or resist the market demand for money should then depend on a set of indicators. At present, the ECB focuses on price stability, targeted as 'below but close to 2%' consumer price infla­tion.  Even if the central banks were able to control inflation effectively, this would remain a too narrow horizon. Instead, a broader spectrum of relevant variables must be con­sidered in the decision-making process (which is in fact done in many cases, but neither systematically nor officially, not to mention notorious implementation deficits):
- consumer price inflation
- the external value of the currency
- eco­no­mic develop­ment, employ­ment and the business cycle (marginally provided for in Art. 127 (1) TFEU)
- asset inflation and the formation of bubbles
- the development of non-GDP finances in relation to GDP finances and the real economy  
- other aspects that may result from a special event or state of emergency.

By assessing and weighing these partly conflicting indicators and other relevant aspects, the monetary policy pursued will be tightened or loosened. The quantity of money is the resultant. It cannot be 'calculated'. Monetary policy, too, is politics and as such an art of the possible.

In the earlier ordo-liberal approach of capacity-oriented monetary policy, such ideas were to some extent in place. But it did not work because the bank­money regime under­­mines any monetary policy that does not suit its interests. None­theless, the central bank is held generally res­pon­sible, while the banks are only liable in individual cases. When there is a general banking and financial crisis, the central bank, govern­ment and tax­payers are inevi­tably liable for the banks. But if it is ulti­ma­tely always the state that guarantees the money, then an independent mone­tary authority must also exercise effective control over money creation. In other words, from a regulatory point of view it is obvious to move from bankmoney to sovereign central-bank money, if not overnight, then gradually over time.

Rendering monetary financing possible. Amendment or repeal of Art. 123 TFEU

Put simply, it follows from the above that the central bank must be less of a banker to the banks and more of a banker to the state. This means, on the one hand, to extricate the central banks from the constraints of the bankmoney regime by changing the com­posi­tion of the money supply (less bank­money, more central-bank money) and, on the other hand, removing the central banks' restrictions vis-à-vis the state as a financial actor.

Indirect monetary financing is legally possible anyway and should be continued as a standard measure. One point of con­tention here is the question of how large a share of outstanding sovereign bonds a central bank should be able to purchase, or whether there should be a fig leaf period between the issue of the bonds and their buy-up.

As to the prohibition of direct monetary financing of govern­ment expenditure, it follows from the above that Art. 123 TFEU should be amended or even entirely repealed.[9] A simple amendment could read as follows:

Article 123 TFEU, paragraph 1
Overdraft facilities or any other type of credit facility with the European Central Bank or with the central banks of the Member States (hereinafter referred to as "national central banks") in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States are just as permissible as is the purchase directly from them by the European Central Bank or national central banks of debt instruments.

Such an amendment Art. 123 TFEU means three things:
-    firstly, the continued permissibility of indirect monetary financing of government spending through sovereign bond open-market purchases by the central bank,
-    second, the possibility of direct absorption of government bonds by the central bank, thus bypassing the banking sector and bond markets, and
-    third, the reintroduction of a central-bank overdraft facility for the treasury to bridge temporary gaps between government spending and tax revenues.

One Western country that has much and good experience with direct monetary financing from 1935–1971 is Canada.[10] Also more recently, the Bank of Canada has continued to directly absorb up to one-fifth of each new bond issue by the govern­ment.[11] In this way, one has responded to the fact that modern money consists of freely created token money, or fiat money respectively, and that under this assumption it is hard to see why state borrowing would have to offer a lucrative and at the same time low-risk investment exclusively to privileged banking corporations and other financial investors at the expense of the public purse.   

A central-bank overdraft facility for the government existed in quite a few EU countries before the Lisbon Treaty took effect, even at the otherwise so monetarily restrained Bundesbank. Only the British had reserved the right to keep their traditional ways and means advances.[12] In the wake of the 2008 financial crisis and the 2020/21 covid crisis, this overdraft facility was expanded from an original £0.370 billion to £45 billion.[13]

Such monetary policy options do not mean what some like to read into them knee-jerk, namely a general financing of government budgets by the central bank, possibly to any extent. In view of today's government expenditure at 35-55% GDP, monetary financing of government spending on a large scale is out of the question, if only for reasons of price stability, except for rare situations of emergency rule. Normally, the central bank can only make partial contributions to the financing of government expenditure.[14] Nevertheless, the question at issue here is, in the interest of a state's monetary sovereignty, to lift the general ban on monetary financing of government spending, thereby correcting the one-sided dependence of public borrowing on the banking sector and bond markets.

Central Bank Digital Currency (CBDC), the possibility of its being debt-free, and inconsistent accounting in money creation

Another aspect of regaining monetary sovereignty is the change in the composition of the money supply directed towards a growing share of central-bank money, with the consequence of a lesser share of bankmoney and other private money surrogates. Over the coming years, a growing number of central banks will issue Central Bank Digital Currency (CBDC), that is, digital sovereign money in coexistence, but also competition, with bankmoney, such as a digital yuan, a Swedish e-krona or a digital euro. As soon as and to the extent this is the case, the ECB can then pay out its money also in digital euros instead of tra­di­tional solid cash for the public and non-cash reserves exclusively for the banks. Digi­tal euros can be put into circulation via the banks in exchange for bankmoney, according to market demand, or by paying bond sellers in digital euros, or by transferring the central-bank profit to the government.

An even more far-reaching step is the transfer of newly created CBDC as debt-free genuine seignio­rage to the treasury. Today, only the transfer of annual central bank profits is debt-free. All other central-bank transfers to the government continue to involve the government as debtor and the central bank as creditor. Within the frame­work of gene­rally accepted accounting rules (GAAP, IFRS) nothing else is possible.

According to these rules, money must come from somewhere, by way of a business transaction. A bank or central bank cannot simply write new money into its books as a monetary asset. It can only enter credit (asset) and liability (liability) in pairs, the credit as a claim for interest and repayment, the liability as an obligation to pay out the credit to the customer. In disbursing a loan, they would actually have to pay out money already in their possession to the borrower, as a switch of that money for a credit claim on the assets side, and reduce their liability to pay out the respective amount to the bor­ro­wer on the liabilities side. Instead, the recording of the liability in the bank balance sheet and the simultaneous entry of the credit amount in the customer cur­rent account already counts as a non-cash 'disbursement' of the amount in question – and would thus no longer be a liability, although it continues to be listed as such...

Thus, with the development of bankmoney, the ambivalent constellation has come about that bank and customer are each other's debtor and creditor at the same time. For example, the bank loan to a customer is at the same time a customer loan to the bank, namely a claim of the customer to the disbursement of central-bank money, if desired. However, if realised to a greater extent than usual, the banking system collapses on the basis of fractional reserves because the banks do not have enough central-bank money.

With central banks, the situation used to be similar, in that central-bank balances were an entitlement of account holders to the payment of silver coin or gold, if they wished so. With the definitive end of any gold standard, the former cover promise of the central banks, just like that of the banks, has dissolved into 'nothing' in monetary terms. Disbursement of central-bank money in the form of cash has continuously been in decline, while non-cash central-bank money for general public use has not existed so far. So the non-cash bankmoney, current-account balances, were being used like money and have thus effectively become money.

However, what stands behind the money is the economic substance of real-economic output as well as, possibly, financial assets of uncertain value, and: the power of the state to stand up and bail for the existence of the currency and the money. With regard to the money of a state's central bank, this is obvious and natural. But why banks and other financial institutes should be entitled to the privilege of sailing under the same flag, and this in a systemically dominant position, is elusive.

One may ask now whether the accounting rules are inconsistent with regard to money creation, or whether the existing practice is inconsistent, in that it does not really comply with the rules, which however is not identified as a violation and in­con­sis­tent appli­cation of the rules.[15] Would that be seen, neither banks nor central banks could create money – and the imagi­nary identity of credit and money would vanish into the thin air where it was taken from.

A solution to the problem lies in separating the act of money creation from the operational business of a central bank as reflected in its balance sheet. Money creation would take place in a separate 'book', say, a currency register. That register is not a bank and no balance sheet either. It is just a registry, a 'book' that records how much money of which type the monetary authority has issued or received back. From the register, one part of the money can flow to the treasury as genuine seigniorage, free of interest and redemption, while the other part is left to the operational central-bank balance sheet as a callable loan. In terms of monetary policy, money creation of the currency register and the (re-)financing business and open market dealings of the central bank can be decided by the same governing body or policy committee. In the Eurosystem, this would be the ECB Governing Council.

It was Ricardo who developed the plan of separating money creation from banking for the Bank of England 200 years ago. He conceived of the separation of a note issue department from the banking department as it still exists today. However, that sepa­ration is no longer relevant and never really was, because the note monopoly was only partially and slowly implemented and bankmoney began to outstrip central-bank money as early as in the 1880/90s.

Extensive neutralisation of sovereign debt

Even if Art. 123 TFEU were to be overcome and the central bank were to become more of a bank of the state again, and if it will introduce digital sovereign money into gene­ral circulation, and if it were to do this even debt-free, open questions remain, not least how the high levels of debt built up so far can be reduced without ruining oneself in the course of self-damaging austerity policies. Austerity, which involves counter-produc­tive public budget surpluses, no longer has to be an option anymore.

Nevertheless, if public debt levels remain as they are, and continue to grow, the risk of a long-term rise in interest rates hangs like a sword of Damocles over public finances.  Historically, comparable situations of over-indebtedness have often enough led to the collapse of state finances and a so-called currency reform with harsh capital and debt cuts. The alternative was a combination of inflation and nominal economic growth that was higher than the rise in interest rates and debt growth. Possibly, however, there might only be stagflation.

When historically a compatible reduction of large mountains of debt succeeded, the approach generally was to spread the debt over a period of decades or even a century, coupled with the fulfilled hope of a certain degree of inflation and growth, as happen­ed, for example, in the 19th century with the reduction of the British national debt from the Napoleonic Wars, or after the Second World War with the London Debt Agreement of 1953 to settle Germany's foreign debts.

Of late there have been frequent calls for sovereign debt cancellation.[16] One idea is for the central bank to buy up the government debt and then cancel it, given today's freely creatable fiat money and the resulting fact that a central bank need never be illiquid in its own currency. That would be too good to be true. It is only possible for a central bank to write off government bonds in its possession to a limited extent, determined by its equity capital and current profits, but not otherwise. For a central bank can write off its claims against the government on the asset side of its balance sheet, but not an equal amount of liabilities, i.e. reserves, on the liability side, because these are the non-cash central-bank money in the possession of banks and treasuries.

The option which currently remains is the tried and tested perspective of putting the debt on the back burner. Today, this can indeed be done more easily than under the former conditions of some sort of precious metal peg, or its doctrinaire echo of a necessary scarcity of money, while such scarcity no longer exists in reality, or at least does not need to exist.

The most consistent way of stretching government debt over time is for the central bank to buy large amounts of government debt and not to 'write it off' upon maturity (which is not possible), but to convert it into so-called zero-coupon perpetual consols, or 'perpetuals' for short. This consolidates and thus neutralises the sovereign bonds in the central-bank balance sheet for a long time. Through such long-term debt neutralisation room for manoeuvre is gained, and the not unfounded hope for better times is preserved, or just the hope for downsizing the problem through a certain degree of inflation and nominal economic growth.

If part of the annual central bank profit is used by the central bank for debt can­cel­la­tions, or used by the government for debt repayments, this actually means a regular long-term debt reduction, albeit at the expense of the central bank's profit remaining available. Both A. Turner and J. Stiglitz recommended debt neutralisation combined with can­cel­la­tion or repayment in smaller tranches to the Japanese government and central bank years ago.

This would also be facilitated by the fact that the introduction and dissemination of CBDC generates increased seigniorage, which in turn should greatly benefit the government budget and also debt management.

*                      *                      *

The possibilities of contributing to government spending and optimal sovereign debt management by way of monetary financing and seigniorage from sove­reign money creation do not exclude the placement of government bonds by primary dealer banks in the previous manner. However, the central bank will again be able to be bank of the state, not just bank of the banks. It will again be able to be issuer of first instance, and where it still has to be lender of last resort, it will also be able to do this not only for the banks but also for the government. Especially in times of crisis and emergency situations, this is indispensable.

Only a state that is strong and sovereign can warrant the rule of law based on civil rights and liberties. This also applies to the rights and liberties of an open entre­pre­neu­rial market economy. A state, however, that loses itself fiscally in an excess of debt dependency and leaves its monetary sovereignty to the particular interests of banks and other financial institu­tions is doomed to weakness and failure.

References

Benes, Jaromir / Kumhof, Michael 2012: The Chicago Plan Revisited, IMF Working Paper, WP/12/202.

Becklumb, Penny / Frigon, Mathieu. 2015. How the Bank of Canada Creates Money for the Federal Government. Ottawa: Library of Parliament, Publ.No. 2015-51-E, 10 Aug 2015.

Bindseil, Ulrich 2004: The Operational Target of Monetary Policy and the Rise and Fall of Reserve Position Doctrine, ECB Working Paper Series, No. 372, June 2004.

Deutsche Bank Markets Research 2017: Long-Term Asset Return Study, London, Sep 2017. 

Ferguson, Niall 2008: The Ascent of Money. A Financial History of the World, London: Allen Lane/Penguin Books.

Goodhart, Charles A.E. / Hudson, Michael. 2018. Could/Should Jubilee Debt Cancellations Be Reintroduced Today? CEPR Discussion Paper, No. DP12605, Jan 2018.

Häring, Norbert 2013: The veil of deception over money, real-world economics review, no. 63, 2013.

Huber, Joseph. 2017. Sovereign Money. Beyond reserve banking, London: Palgrave.

 Huber, Joseph 2014: Modern Money Theory and New Currency Theory. A Comparative Discussion, real-world economics review, no.66, January 2014, 38–57.

Hudson, Michael. 2018. And forgive them their debts. Lending, Foreclosure and Redemption from Bronze Age Finance to the Jubilee Year, Dresden: ISLET.

Keen, Steve 2011: Debunking Economics. The Naked Emperor Dethroned? London/New York: Zed Books.

Kindleberger, Charles P. 2000 [1978]: Manias, Panics, and Crashes. A History of Financial Crises, New York: Basic Books.

Laeven, Luc/Valencia, Fabian 2008: Systemic Banking Crises. A New Database, IMF Working Paper, WP 08/224, Washington.

Minsky, Hyman P. 1982: The Financial Instability Hypothesis, in: Kindleberger, C.P./Laffargue, J.-P. (Eds.), Financial Crises. Theory, History, and Policy, Cambridge University Press, 13–39.

Papadopoullos, Chris. 2020. Ways and Means is not monetary financing, OMFIF, 9 April 2020.

Reinhart, Carmen M. / Rogoff, Kenneth 2009: This Time is Different. Eight Centuries of Financial Folly, Princeton Uiversity Press.

Ryan-Collins, Josh 2015: Is Monetary Financing Inflationary? A Case Study of the Canadian Economy, 1935–75, Levy Economics Institute of Bard College, Working Paper No. 848, October 2015.

Schemmann, Michael 2015: Putting a Stop to Fictitious Bank Accounting, IICPA Publications, www.iicpa.com.

Schularick, Moritz / Taylor, Alan M. 2009: Credit Booms Gone Bust: Monetary Policy, Leverage Cycles, and Financial Crises 1780–2008, American Economic Review, 102 (2) 1029–1061.

Werner, Richard 2005: New Paradigm in Macroeconomics, New York: Palgrave.

Zarlenga, Stephen A. 2002. The Lost Science of Money. The Mythology of Money – the Story of Power, Valatie, NY: American Monetary Institute.

Endnotes

[1] Article 123 TFEU, paragraph 2: 'Paragraph 1 shall not apply to publicly owned credit institutions which, in the context of the supply of reserves by central banks, shall be given the same treatment by national central banks and the European Central Bank as private credit institutions.'

[2] On Currency School versus Banking School cf. sovereignmoney.site/more-money-system-theory#currencybanking.

[3] Bindseil 2004, Werner 2005 pp.155, Keen 2011, Häring 2013, Huber 2017 57–74.

[4] As a result of the crisis-induced monetary policy of Quantitative Easing (loose money), the banks now have much more reserves than they need opera­tio­nally. Most of these funds have flowed to them unso­li­ci­ted through central-bank purchases of govern­ment bonds – and have become a problem for the banks rather than a balance sheet support, because of the negative interest the ECB unwisely charges on the banks' reserves.

[5] Cf. Benes/Kumhof 2012, Schularick/Taylor 2009, Minsky 1982, Kindleberger 2000, Ferguson 2008, Reinhart/Rogoff 2009.

[6] Zarlenga 2002, chs. 14–21.

[7] Laeven/Valencia 2008, Reinhart/Rogoff 2009. Also see Deutsche Bank Markets Research 2017.

[8] European Central Bank, Monthly Bulletins, Tables 2.3.3–4.  

[9] On the topic of monetary state financing, also see https://sovereignmoney.site/monetary-financing-quantitative-easing-helicopter-money.

[10] Ryan-Collins 2015.                                                         

[11] Becklumb/Frigon 2015.

[12] Papadopoullos 2020.

[13] Financial Times 9 April 2020: Bank of England to directly finance UK government's extra spending. Move allows ministers to spend more in short term to combat coronavirus without tapping gilts market.

[14] One thesis of modern money theory has it that the government creates the money through its bond issue, the money then flowing back to the government through tax payments, which is supposed to take that money out of circulation so that it doesn't have any inflationary effect. This is a rare piece of surreal economics. Today, the government does not create any money at all (except for the irrelevant stock of coins). It is still the central bank and the banks that create the money used by the government, de­pen­ding on whether public bodies use central-bank transaction accounts or current bank accounts. In the US, the Treasury, or the Congress respectively, could issue government money under the Consti­tu­tion, but they haven't for a long time. So it is only banks, the central bank and certain shadow banks that create money. Tax payments to the treasury do not extinguish money, but keep that money in circu­la­tion pay-as-you-go, thus also with an effect on demand and prices. The lion's share of today's govern­ment budgets is financed, as it always has been, by taxes, levies and fees, the rest by borrowing from banks and other institutional investors. Government bonds held by central banks still represent a rela­ti­vely small share of total government debt.  

[15] Also see Schemmann 2015. 

[16] Cf. Hudson 2018, Goodhart/Hudson 2018.