As you may have heard, a 110 billion euro rescue package for Greece was announced in an effort to prevent a Greek default and inject confidence in the euro zone. This package will have dramatically higher chances of success at both goals if Greece is allowed to use the funds to pay taxes. Greece has a chance to fund itself at low interest rates. It also has a chance to serve as an example for the rest of the euro zone and thereby ease funding pressures on the entire region. But it must do the following: Insert a proviso that in the event of default, the newly issued securities can be used to pay tax. The trick? Make the provision state that in the event of default, the bearer on demand can use those defaulted securities to pay Greek government taxes. This makes it immediately obvious to investors that those new securities are “money good” and will ultimately redeem for face value for as long as the Greek government levies and enforces taxes.
Let’s take a step back and consider the purpose of taxation. Contrary to the commonly held perception, our tax dollars do not “fund” government spending, which is created at the push of the stroke of an electronic keyboard. So why, then, do we tax?
One is a more obvious reason which jibes with our own personal experience. The government taxes to regulate aggregate demand. In essence, that means if the economy is “too hot” raising taxes will cool it down, and if it’s “too cold” cutting taxes will warm it up. Taxes aren’t about getting money to spend but rather are about regulating our spending.
And that appears obvious. Clearly, if a government taxes 40% of your income, as opposed to 5%, that leaves you with less disposable income and therefore cuts down your discretionary spending power.
But tax serves another function which is less intuitive, particularly in a post gold standard world in which we have “fiat” currencies – that which the government designates by fiat to be the monetary unit of account to be deployed in our day to day transactions.
How does the government confer value on these seemingly worthless pieces of paper with pictures of dead presidents on them? These “greenbacks” are neither backed by gold, nor are they, strictly speaking, backed by the “full faith and credit” of the US government. Rather, their value comes because the government guarantees that we can use this unit of account – the dollar – to extinguish your liabilities to the state, which we otherwise call taxes.
The public would not give up goods and services to the government in return for otherwise worthless coins or paper notes unless there were good reasons to do so. The primary reason the public accepts what we call “fiat money” is because it has tax liabilities to the government. If the tax system were removed, the government would eventually find that its fiat money would lose its ability to purchase goods and services on the market. In the words of the economist Abba Lerner: “The modern state can make anything it chooses generally acceptable as money…It is true that a simple declaration that such and such is money will not do, even if backed by the most convincing constitutional evidence of the state’s absolute sovereignty. But if the state is willing to accept the proposed money in payment of taxes and other obligations to itself the trick is done.” Taxes, then, are what give value to government created currency.
What does this have to do with Greece? It is our contention that this is precisely what Greece should attempt to do, given the new funding arrangements agreed with the EU and IMF over the past weekend.
We recognize, of course, that this proposal it would also introduce a new “moral hazard” issue, as this newly found funding freedom, if abused, could be highly inflationary and further weaken the euro. If you don’t have a consolidated fiscal entity (i.e., a “United States of Europe”) which can enforce common fiscal rules for all of the nation states, then buying up national government debt constitutes a form of moral hazard as represents a race to the bottom. The country that deficit spends the most, wins. The end result is probably too much inflation. It is comparable to a situation where a nation like the US, for example, did not have national insurance regulation. In this kind of circumstance, the individual states got into a race to the bottom, where the state with the laxest standards stood to attract the most insurance companies, forcing each State to either lower standards or see its tax base flee. And it tends to end badly with AIG-style collapses.
What Europe’s policy makers would like to do is find a way to isolate Greece and mitigate the contagion effect; hence, the huge “shock and awe” proposal, the rumors of which did engender an 8% jump in the Greek stock market last Thursday.
On the face of it, it would appear that the package announced – a 110 billion euro rescue package for Greece to prevent a default – does mitigate the risk of the contagion from spreading through the rest of the bloc. But these proposals don’t really get to the nub of the problem. Any major package weakens the others who have to fund it in the market place because none of the others have the means to do fiscal properly (as they don’t create currency). A massive (say, 2 trillion euro) per capita distribution might be the only short-term answer, but nobody in the ECB is thinking along these lines because they think it would be “inflationary”.
And the size is almost too big. The size of the package to which the EU and IMF have agreed, though necessary, seems to make it clear that there is a much broader problem afoot. If 110 billion is required to “solve” the Greek problem, how much more for the next country? Instead of successfully engendering “shock and awe” in a manner which impresses the markets, the package could simply highlight the EU’s underlying financial weaknesses.
Nor does the ECB or the Economic Council of Finance Ministers (ECOFIN) have the means to enforce their austerity demands and keep them from being reversed once it’s known they’ve taken the position that it’s too risky to let any one nation fail.
The euro zone nations are all still in a bind, and their austerity measures mean they won’t keep up with a world recovery. Additionally, a Greek restructuring that reduces outstanding debt is a force that strengthens the euro as it reduces outstanding euro financial assets, but they need a weaker euro to get growth via exports.
It does not appear that the markets have truly thought through what a Greek default actually means. If one uses a Chapter 11 bankruptcy analogy, consider that large parts of the country could well be shut down as part of this restructuring exercise in order to allow the “company” (i.e. “Greece Inc”) to function at a smaller size, in theory giving the Greeks time to grow again and restructure their debts. But where do they get the euros from? They don’t create them and so it seems to us that if they default, they have to go back on the drachma. Otherwise, do you try to stop all euros from leaving Greece? Do you shut down the military or police department, so that the government is not spending as much? Eliminate the state pension scheme? Already, we are seeing signs of massive political disaffection.
The ability of Greece to use the funds from the rescue package as a means to extinguish Greek state liabilities would improve their financial ratios and stave off financial collapse, at least on a short-term basis, with the side effect of a downward spiral in output and employment, while the sovereign risk concerns are concurrently transmitted to Spain, Portugal, Ireland, Italy, and beyond. Those sovereign difficulties also morph into a full-scale private banking crisis, which can quickly extend to bank runs at the branch level.
Our suggestion will rescue Greece and the entire euro zone from the dangers of national government insolvencies. It will also turn the euro zone policy maker’s attention 180 degrees, back to their traditional role of containing the potential moral hazard issue of excessive deficit spending by the national governments through the Stability and Growth Pact. If the member states ultimately decide that the Stability and Growth Pact ratios need to be changed, that’s their decision. But the SGP represents the euro zone’s “national budget,” precisely designed to prevent the hyperinflationary outcome that the “race to the bottom” could potentially create. At the very least, our proposal will mitigate the deflationary impact of markets disciplining credit sensitive national governments and halting the potential spread of global financial contagion, without being inflationary.
Roosevelt Institute Senior Fellow Marshall Auerback is a market analyst and commentator and Warren Mosler is President of Valance Co.