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What happens to currencies when they die?

We pursue it, discuss it, count it and obsess over it… but do we ever really think about what ‘money’ is?

Senator Sean Barrett

MONEY IS A strange thing. We pursue it with fox-like cunning, discuss it, count it, fixate our lives upon its acquisition and expenditure but we very rarely think about it. Part of that is due to its ubiquity. We rarely think about the air we breathe or ground we walk on. The Greek referendum result has placed the future of the euro as a currency in question. So for the Greeks, for us, and the rest of the eurozone, does it matter if it is a euro, drachma, Deutschemark or punt?

Money is accorded its role by its actions: a store of value, a medium of exchange and a unit of account. Modern fiat money, as opposed to gold and silver coins of old, is money because it is declared as such by the State. It has no intrinsic value. The value of money comes from the legal declaration that it is medium and unit of account that reconciles all debts public and private. Once the revenue commissioners of a government declares a currency to be sufficient for the payment of taxes it is that country’s money.

How is money created?

Money is created in two ways, by the central bank and by banks. Central banks issue money. As part of this they acquire some revenue for the process of creating the money that is issued as notes and coin (seigniorage as it is called) and use a series of market and ledger exercises to create money ex nihilo. Banks also create money through their process of using deposits to generate loans. Overall money in terms of notes and coins in circulation is a tiny fraction of what economists and financiers understand money to be.

Why is this important? Once we demystify money we can start talking about what it really is – a series of ledger entries built around law, custom and transactions clearing systems. It is a tool for commercial action. As with any tool, once its usefulness has failed, it can be refashioned or discarded.

Creating an effective monetary system 

Europe has had a history of problems with creating an effective monetary systems. In the days of gold and silver coins you might think it was easier but inflation and economic collapse was just as common. Nobel Prize winner Thomas Sargent with Francois Velde wrote an excellent book The Big Problem of Small Change that highlighted that the world of precious metal currencies was fraught with difficulties with local communities creating token currencies to buy day-to-day items.

Much of the history of commerce links to how physical money and things written on account necessitated the need to create new techniques and methods. As Jacob Soll’s The Reckoning: Financial Accountability and the Making and Breaking of Nations highlights, our modern world of commerce is all based on a small mathematical treatise by Fra Luca Pacioli published in 1494. Those principles of accounting gave birth to much of my discipline, to the “science of the state” first practiced at the court of Louis XIV and the precipitated the downfall of his successor Louis XVI and has been the making and undoing of nations all the way down to Greece.

While accountants made and destroyed nations with their ledgers, money was equally problematic. Charles Kindleberger wrote about the destructive forces of the 1630s kipper-und-wipperzeit that destroyed the currency of central Europe causing a long lasting aversion to inflationary practices that pre-date the infamous Weimar Republic inflation of the 1920s.

Spain famously acquired literal “rivers of gold” pillaged from the aboriginal civilizations of Central and South America and destroyed their economy.

Britain’s currency and the Bank of England were almost destroyed in 1690s, and would have been were it not for the skill and determination of Isaac Newton.

France’s monetary system was destroyed by a card-sharpener Scotsman named John Law in the 1720s. (A wily Kerryman, Richard Cantillon, made a fortune in the process.)

All the way through the 18th century up to and through to the end of the Napoleonic Wars all the major nations of Europe systematically destroyed their currencies over and over again. As Carmen Reinhart and Kenneth Rogoff highlighted in their This Time is Different: 800 Years of Financially Folly countries, princes, kings, archdukes and emperors left a trail of defaulted debts in the wake of such currency disasters, wars, economic downturns and general moments of capriciousness. By the mid-19th century Europe made their first attempts at a single currency since the time of Charlemagne, then as now, it wasn’t a good idea.

Monetary unions in Europe are political animals

Europe’s attempts at monetary harmony have always ended in discord. Centuries of monetary turbulence had given rise to the idea that unified, rational and coordinated currency systems should be embraced. The late 19th century monetary arrangements Latin Monetary Union, Scandinavian Monetary Union, the German-Austrian Vereins Thaler Union and the Austro-Hungarian Monetary Union and ultimately the loose geopolitical arrangement of the UK, Germany and the United States of the classical gold standard from 1873 onwards.

All these were initially political responses to perceived threats from a rapidly changing economic landscape as the post 1848 political “balance of powers” landscape solidified and the full force of the industrial revolution disorientated traditional trade and power relationships. The economics of these systems was always tenuous and only the Scandinavian Monetary Union could be termed a success and even that could not withstand the pressures of the First World War.

The classical gold standard, in many ways the closest model we have to the “hard currency” inflation hawk eurozone, was sustained with many actions which prevented the perfect operation of its automatic mechanisms for politically expedient purposes. In the end, the political costs of the gold standard were so high they gave rise to destabilising politics. Modern universal suffrage democracy and the gold standard were fundamental incompatible systems.

In the case of Britain the need to embrace fiscal austerity in the name of “good economic governance” and maintain the gold standard gave rise to the infamous Invergordon Mutiny, the closest the UK has ever come to the Aurora firing its canon in St. Petersburg. Monetary unions in Europe are political animals, they survive only as long as the economic conditions are favourable and the political costs are near nil.

Parallel currency systems

What does that mean for GREXIT and the Eurozone? For the Greeks, a series of options are available. Producing a fully functional currency from scratch will rightly take up to six months as Bloomberg has highlighted but there are quick solutions.

The dissolution of the former Yugoslavia would offer the most appropriate example of how to quickly dissolve a currency union. Similar experiences existed in the former Austro-Hungarian Empire. In many countries, including Croatia, parallel currency systems officially and unofficially exist. You pay for your morning coffee and newspaper in local currency but buy your house or car in US dollars or euros.

The primary challenge will be keeping the Greek banks alive as capital flight and the painful severing of Greece from the Target II transactions clearing house system take place. Losses will be felt by all members of the eurozone at that point. It will be unavoidable. The legal mechanics will be the primary challenge. The ECB wrote a legal working paper on how to do it in 2009 – Withdrawal and Expulsion from the EU and EMU: Some Reflections” ECB Legal Working Paper No. 10 by Phoebus Athanassiou – is required reading this week. Contracts, cross-border transactions, all these things will need to be reconciled with an open and never-ending legal debate about how, when and by which means to pay these bills.

What does it mean for the currency union?

Greek sovereign debt will (most of it has collective action clauses making things “easier”) need to be restructured. Few people have the skill to do that. Lee Buchheit, an eminent lawyer based in New York described by the Guardian as the “fairy godmother to finance ministers in distress” will fashion a deal that will ensure unhappiness on all sides but will survive more than the duration of the flight between JFK and Athens (an achievement over EU negotiations so far).

Ultimately, for Greece there will be a period of time with acute declines in welfare and economic difficulty if the EU does not act to support and assist Greece in its transition out of EMU.

What does it mean for the currency union? As I stated at the outset, demystification is a powerful tool. Once the curtain has been drawn on the eurozone’s various shibboleths what will keep Portugal, Spain, Italy, France or Germany in the club? Italy and France traditionally relied on a healthy dose of devaluation to wind-up the dynamo of their economies. Spain has suffered greatly since the Global Financial Crisis. Portugal looks like a slightly more functional version of Greece, now overburdened with official sector debt. When will Germany finally lose political patience with the ECB, being the only large EU economy desiring a hard currency policy?

The common statement is that politics is the art of the possible. The monetary and political history of Europe since the first attempt at single polity on Christmas Day in the year 800 has been that it cannot hold. Politics, economics, conflict, fortune and banality of “events” have conspired against the continental political statement.

Money is a tool. It is a tool of the State, it is created and sustained by the State. The State takes its power from the political milieu that sustains it. When these fail monarchs, governments and the people, they abandon them as broken and obsolete tools. The journey to discover or create new tools may be fraught but the history of Europe illustrates that it is possible and it is the norm, not the exception.

Sean Barrett is an independent senator in Seanad Éireann, Member of Oireachtas Banking Inquiry and Associate Professor of Economics and Fellow of Trinity College Dublin.

‘My country was used as an austerity laboratory. The experiment failed.’

Hold onto your hats: there’s to be ANOTHER European summit this coming Sunday to discuss Greece

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Senator Sean Barrett

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