Should the European Central Bank give money to states at 0% interest?

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There is this long-standing belief in political thought that society can get rid of interest. That interest is a parasitical cost that we as benevolent human beings can abolish if we intend to. The road to a perfect society or at least to a much better world inevitably passes through a stage of eliminating all interest payments. Such a view has made itself manifest over the centuries in various ideologies, movements and philosophical doctrines. Not surprisingly perhaps, it started with the ancient Greeks and one of their greatest philosophers, Aristotle. In his proto-economic discussions, which included some correct insights, he made the unfortunate mistake of adding a moralistic dimension to an otherwise real world phenomenon, suggesting that interest was unnatural. Had he escaped from the ancient Greek philosophical moralism, he a genius as he undoubtedly was could have instead attempted to answer why interest existed in the first place.

The most recent incarnation of this ancient-old tradition can be found in the calls of several politicians or groups on the European Central Bank to supply credit directly to governments, ideally at 0% interest. They argue that the ECB should help countries combat the crisis, instead of speculating against them. They assess that the independence of the ECB from the plans of member-states is purely wrong, since it deprives governments from essential monetary policy tools that could help in ameliorating the chilling effects of the economic crisis. These views purport to show that the ECB, with the interest it adds on the money it creates, is an institution that only supports the machinations of speculators, greedy bankers and other sinister forces that operate to the detriment of the people.

Plausible as these arguments might sound, they really cannot stand serious analysis. This view of politics in general and economics in particular contains a tangle of fallacies ranging from the utopia of the perfect society that has been plaguing humanity ever since Plato; to the fundamental flaws in economic thinking. There is however a core fallacy. The vein, chimerical belief that there can be a world without interest.

Let us first deconstruct this fundamental error, before proceeding into the discussion on the real world case of the ECB and its role in the eurozone. Those who want to create a world without interest simply fail to understand the single most important lesson of economics: we live in a world of scarcity. We cannot enjoy infinite amounts of everything at the same time. There are natural limitations that always deprive us from the absolute exploitation of everything that can be found in this world, either tangible or non-tangible. This holds true regardless of the institution of society. That is, regardless of whether we live in a capitalist or communist or any other form of society. No matter what we do we cannot overcome scarcity.

Interest in a world of scarcity

Understanding scarcity is essential to realize why interest exists and to comprehend what it actually is. Interest is the value assigned to goods in the present time against the value of the same goods in future time.

Instead of technical theory, let me offer a more illustrative example. Assume we have a farmer who has a 100 in terms of available resources. He only makes a living out of his farm and he cannot afford to waste any of his scarce resources. Before he puts everything to work, he will have to make a plan over how to best use whatever he has at his disposal in order to make sure that the farm will yield him sufficient food to survive over the year. Moreover he will have to consider setting aside a portion of his resources for future use, while he will also need to deploy some of them to produce beer or wine or some other beverage.

The farmer cannot therefore use his limited resources to produce at the same time maximum food and drink while also saving for the next year. He will eventually have to economize. He will have to make a choice over how to allocate his limited resources in order to satisfy his present and future needs, otherwise risk facing starvation. Suppose now that he decides to use 90 out of the 100 to produce food and drink, while the rest is kept aside for future use.

The fact that he did not use all his resources, since he would have eventually denied himself of any future uses, means that he actually paid an interest of 10 for the utilization in present time of the other 90. In other words he made an arrangement between his present satisfaction and his future satisfaction. The amount he is willing to put aside for his present or future satisfaction is actually the interest he pays for it.

Allow me another example along these lines to forward my argument on the nature of interest. Assume you have in your pocket a 100 euro and you will receive your next salary seven days from now. You thus need to make sure that from today up until next week, you will satisfy all your needs with these limited funds. You will have to arrange the satisfaction of your daily desires in such a way, so that the money is enough to pass the whole week. If you choose to spend all your money on the first day then the interest you are actually paying is the lack of money you will suffer from, for the next 6 days. Though economists would rather call this a “trade-off”, in fact it can be understood as an originary interest payment.

The exact same mechanics exist in the real complex world. The interest rate on a loan reflects the relation between present and future valuations of that loan. In the modern economy, the market interest is of course determined by many other parameters such as the forces of supply and demand, the availability of substitutes, the preferences of individuals, the quantity of available resources, the expectations of investors, the conditions in the economy, the political environment, the prevailing theories etc.

Those anxious to defend their uneconomic theories by obfuscating and concealing this reality, will suggest that all of the above are self-serving arguments of “capitalism”. However such an argument would fail to recognize that interest per se always exists, even in the most primitive of societies, or the most ordinary of daily activities. Originary interest has existed in all hitherto societies. It is neither a byproduct of capitalism nor the invention of some people who engage in unbridled speculation and other “parasitic activities”.

Interest always exists in a world of scarcity. It would only cease to exist if we could eliminate scarcity; if we could somehow manage to create a “valhalla”, a “paradise” on earth. For as long as we have not reached such a high level of conscience nor are we ever going to, all talk of eliminating interest is nothing more than a bunch of nonsense, litanies to the opposite notwithstanding.

The costs of infinite money creation by the ECB

The mention to the uninformed view of the world that asserts the elimination of interest is essential to comprehend modern day political discourse concerning the role of the ECB in the eurozone. The agendas of certain populist politicians are replete with such views. I need not refer to particular individuals or parties, since this view is, surprisingly perhaps, found all over the eurozone and beyond. After all focusing on individuals would be misleading, since the problem is far deeper than the occasional beliefs of any single person, which can after all change at any given moment. Stripping away the particularities of each case, the claim that the ECB should give money directly to states at 0% interest has not be clearly thought out. It is based upon a tissue of unexamined principles and deep misunderstandings.

Apart from the egregious fallacy on the nature of interest, such views largely underestimate the implications of such an action, or they completely dismiss them with slight contempt and smugness. In truth a central bank that directly finances governments at 0% creates inflationary pressures, produces perverse incentives and facilitates or encourages the massive misallocation of scarce resources. Let alone the fact that in a monetary union of 17 nation-states such as the eurozone, we will also have to take into account the balance of power and the potential discriminations that can take place, eventually exacerbating all the other economic side-effects.

1. The constraints of inflation

There is this inherently flawed hypothesis that a central bank can create money at no cost. This is reinforced by the fact that modern economies operate under a fiat monetary system. That is a system where “money” is whatever a state edict determines. Thus legal money can only be the euro, and monopoly over the creation of this money is by law conferred to the European Central Bank (and the Eurosystem, but let’s avoid such technicalities). Since “we are the state” under a fiat monetary system, we can just turn on the printing press and create infinite amounts of such money to finally satisfy our needs. In other words, since the ECB is the monopoly for the supply of euro, and since the existing legal corpus enforces the use of euro as the only legal type of money, no one can really limit its operations. In a nutshell, this view fallaciously assumes that a central bank does not face the obstacle of scarcity.

A central bank, the ECB in this case, does face constraints despite the fact that it is the only one who has the power to supply money, euro. The constraint is again the originary interest. The present value of the supplied euros, over their future value, just like in the examples mentioned earlier. The reason for that is that if the ECB creates much more than it should, it will inevitably erode the value of all euros circulating in the economy. This phenomenon is called inflation. To better understand this let us resort to the observation of a little bit of history.

In older epochs, when economies operated under a gold standard or some other form of metallic currency system, the only way for the government to increase the supply of money without importing any additional precious metals, was to debase the currency. Though there have been several methods of carrying out this practice, the idea was to reduce the actual amount of the precious metal found in each coin. Thus make more coins with less valuable metal. For example an easy way was to cut the coins into smaller pieces that would still have the same face value. To better grasp this, it is the same as cutting a one euro coin in half to create two one euro coins — absurd. Wherever that happened, either be the Roman Empire or the mercantilist states of the 16th century onwards, it led to an erosion of the value of the available money (inflation), eventually causing much more harm than the intentioned good. In fact the debasement of currency has in most occasions been inseparably attached to the decline of empires.

A relatively recent, though indeed extreme, historical demonstration of the mechanics of this “debasement of currency”, now under a fiat monetary system, took place in the Weimar Republic, the German state that was found after the end of WWI. That state was (foolishly) burdened by the Allied forces, the victors, with extravagant war costs, as the Germans were considered the only ones responsible for the cause of the war. In the early 1920’s to pay back their mountains of debt they thought it reasonable to print the corresponding amount of Deutschmarks, naively assuming that there was no cost involved to a central bank printing money to finance government operations and to pay back national debts.

Because of the large-scale “debasement of currency”, the result was a phenomenon called “hyper-inflation”, i.e. extremely high rates of inflation in the domestic economy. At its peak, it caused prices to double every few hours or days. You could sit at a restaurant and by the time you had your meal, the price you would have to pay was twice as much. As soon as you received your salary, you would have to rush to the grocery store to buy whatever you could, before the money in your hand lost its purchasing power. Paper money was soon rendered completely worthless. Instead of being used for payments it only served the purposes of ordinary paper. The very notion of “saving money” became immaterial, since after a few hours it would have no real purchasing power. In an economy without real savings, where inflation runs rampant eating in to everything people produce, only poverty can befall upon society. Indeed this hyper-inflation completely obliterated the savings and the businesses of the middle class, while it literally impoverished most of the German population.

Though the case of the Weimar Republic is indubitably a special case, since it is the most extreme type of inflation, the fundamentals are identical nonetheless. There was a cost to printing money, even though the German central bank had a monopoly over the supply of Deutschmarks and despite the fact that government legislation determined that money as legal – the fiat money. Despite the force of the state, people would not use Deutschmarks since they realized that they had lost their value.

The moral is that a central bank, the ECB in our modern day eurozone, has limits over how much money to create. Of course under a fiat monetary system, a central bank certainly enjoys some discretion to slightly manipulate these constraints, but it definitely cannot defy them. In practical terms though, because “discretion” is often the first step on the road to disaster, the only means of ensuring that these constraints are not violated, is to provide institutional independence to the central bank. This is after all the well-established practice in a democratic state, characterized by the separation of powers.

A failure to set in place the checks and balances found in a democratic system, can indeed lead the whole edifice into jeopardy. If the executive, the government, can control the monetary function, then discretion becomes or can become abusive. Which brings us to the issue of perverse incentives as will be discussed on the section below.

2. The perverse incentives of money creation

A government that can at any time find money out of nowhere to finance its operations has a strong incentive to avoid making tough choices, in favor of carrying out its agenda, even though that will ultimately be detrimental for the economy. In more practical terms a politician will promise everything to his electorate and will pursue all these promises by means of resorting to the printing press of the central bank. All these demands will sound easy to meet once the presumed infinite source of wealth, the “cornucopia”, of the central bank’s printing press can be exploited.

Such power to resort to the central bank, instead of making realistic, though perhaps unpopular, promises and of carrying out pragmatic political plans; provides perverse incentives. Whoever has the honesty to tell people that printing money has a cost and denies making unrealistic promises will simply lose the elections. Once cheap money is offered unconditionally to governments, there is no guarantee whatsoever that it will not happen again. It will eventually be abused. In economic jargon this is also known as a “moral hazard”.

No real reform would ever take place if governments had access to infinite and cheap money. Doing things the easy way to satisfy short-term political opportunism would have been the norm, with whatever implications this would have in avoiding structural reforms, creating inflation, perpetuating corruption, strengthening cronyism etc. After all, one of the reasons the Greek economy and state have proven to be completely unorganized and in many ways counterproductive, has much to do with the cheap money (and foolish voter support) governments enjoyed over the previous decades, first due to the symbiosis between government and national central bank and second due to the cheap credit flowing into Greece after its accession to the eurozone.

For a better perspective, how strong would the deterring effect of a law against corruption be, if the judicial system was controlled exclusively by the government? Is there anyone out there doubting that ministers, officials and public servants would feel less threatened and would therefore be more prone to corruption? And if they could avoid punishment wouldn’t they eventually become involved in corruptive activity? That is why a democratic state needs to separate and diversify powers as much as possible, so that the shrewd can never exploit the loopholes in the system.

The gist is that if perverse incentives are in place, then there are no effective checks and balances in the system, for the sake of avoiding abuses of power. To prevent the ultimate of moral hazards, that of governments exploiting the money printing press with impunity; a central bank must always be institutionally independent, just as all powers are separated in a democratic state (judicial, executive, legislative). A central bank that is dependent on the dictates of any particular government, will eventually be a tool for manipulation and corruption, in the same way that justice would not really exist if judges were forced to interpret the law according to the agenda of the government.

3. The unseen costs

All of the above are enough to kill off any idea of allowing the ECB to provide money directly to states and at a 0% interest. But this is not the end of argument, since one can also speak of the unseen costs involved.

A central bank providing cheap money is offering the incentive to all parties involved to engage in frivolous spending. Governments, banks and businesses will underestimate the potential risks in every venture, while they will plan with less care and precision, since at the back of their mind they will know that they have a money press supporting them with infinite cash. When such a process is set in motion, it can only lead to a gradual but steady misallocation of resources.

The crisis we are now experiencing is a crisis of large-scale malinvestments, resulting from the cheap credit that fled into and sprung from Wall Street eventually giving rise to the bubbles around the world (see also “Money illusion as a solution to the eurocrisis?”). Cheap money facilitates and encourages malinvestments, as was the case with the property bubble in the US or with the purchases of Greek bonds prior to 2008-2009 among many, many others.

Concluding remarks on the money printing delusions

All the aforementioned arguments, when taken together constitute a solid defense against the uneconomic populism of certain politicians and/or economically illiterate groups who preach an interest-free utopia.

Fallacious assumption and belief are pilled on each other to create the multi-illegitimate claim that the ECB should directly finance governments, ideally at 0% interest rate.

Those who are inclined to endorse such ideas, think that they will avoid the suffering of real readjustments. That they will somehow have gain without any pain. They assume that the crisis can ultimately be addressed with the practically cost-free intervention of a central bank, the ECB in this case, without the people having to suffer any losses.

Even if we were to ignore all the above and accept this perverse mode of thinking as correct, we would still find it problematic. If money creation is free of any costs, then why not have a printing press positioned at the central offices of every ministry? Why bother with giving money to the central government which will then have to go through the laborious task of distributing it further? Moreover, why not allow local authorities to create money out of thin air? Wouldn’t that make their efforts easier and improve the daily life of citizens? Ultimately why not supply a money-creating machine to every household so that we can finally enjoy life without the slavery of interest?

Understandably such a rationale is purely wrong from beginning to end. The tragedy is that in times of economic crisis as our own, unrealistic promises of that sort become widely acceptable as they find fervent supporters in the masses of desperate voters.

Uneconomic arguments such as the interest-free financing of the ECB to governments, are fashionable enough, often embellished with triumphant rhetoric, noble values and far-reaching ambitions; yet they are too absurd to stand up to anything like critical thinking and mere reality.