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Putting the Capital Markets Union on sustainable foundations

Last week, the European Commission launched its Action Plan for a European Capital Markets Union (CMU). By European standards, this ‘most significant EU proposal for the last 10 years’ has proceeded at rapid pace under the leadership of the British Commissioner Lord Hill. For those attuned to the complexities of European politics, the CMU is a peace offering from Brussels (Berlin/Frankfurt) designed to showcase the strategic benefits that UK (and its City) enjoys from EU membership. Its (referendum) politics aside, the CMU’s ambitions are great: SME financing and job creation, growth via capital markets. Yet, we argue, if the CMU is to make a substantial and lasting contribution to investment and job creation in Europe, it must be accompanied by reforms that address systemic risk in securities-based financial systems and enhance pan-European supervision of securitization and repo markets.

The crisis of European banking after the collapse of Lehman was a crisis of market-based banking. European banks engaged in structured finance and other off-balance sheet activities were threatened by insolvency in 2008, leading to significant bail-out costs for European sovereigns. According to IMF research, 18 out of the 25 TBTF European banks vulnerable due to their trading activities required bailouts after 2008.  Since, as the IMF put it, ‘the vast majority of global finance is intermediated by a handful of large, complex financial institutions’,  initial regulatory efforts focused on reforming banks that had migrated to leveraged, interconnected, market-based activities. This also involved – through the FSB – global initiatives to curtail banks’ involvement in shadow banking, particularly in securitization and repo markets.

In this context, it is remarkable to see the growing consensus that growth in Europe requires more market-based finance. The European Commission makes the following case:  banks are still repairing balance sheets, new regulatory regimes increase their costs, making lending – to SMEs and other businesses – expensive. Allowing banks to engage more in capital market lending via securitisation, and to fund it in short-term money markets, would improve lending conditions in Europe, restarting growth. Those familiar with Perry Mehrling and Zoltan Pozsar’s work will recognise this ‘money market funding of capital market lending‘ as shadow banking.

Ironically, all evidence suggests that a Capital Markets Union is unlikely to improve SME financing. It’s unclear how much European SMEs are constrained not by limited access to finance, but by shortage of customers (i.e, demand). Stefanie Schulte, from RWGV, a German cooperative banks association, argues that even in the United States, the country upheld by the Commission as the model country in terms of capital markets, SME loan securitization is small and supported by public guarantees.  Here in Europe, when Germany recently tried to help SMEs issue bonds, the result was a wave of defaults and insolvencies. That experience suggests that the policy goal should not be to to reduce SME’s reliance on bank lending, but to nurture competitive and viable relationship banking. The argument of an over banked Europe compared to US is also bogus, Schulte argues:

   U.S. Federal Deposit Insurance Corporation (FDIC) counts more than 6400 credit institutions, among them thousands of small, privately owned, regionally active community banks. Community banks provide almost half of all small business loans in the U.S. In addition to this, there are more than 6000 credit unions. Per 1 million citizens, there are more than 40 banks and credit unions in the U.S. Now compare this to Europe: Here, Germany is one of the few countries with a relatively high density of banks. There are nearly 23 banks, credit cooperatives and savings banks per 1 million [German] citizens.

Four issues are essential to address for a sustainable CMU:

First, it is of paramount importance that key principles of “good securitisation” are not watered-down through pressure from large, international banks. Insisting that banks have a “skin in the game” is meant to avoid the perverse incentives that led to the global financial crisis. At the levels discussed now, however, risk retention requirements are too small to matter. Similarly, ongoing industry pressure to include synthetic forms of securitization in the CMU framework completely undermines the key notion of “simple” securitisation. The current ambiguity on whether to allow tranching in the forms of securitisation that are to be deemed ‘high quality’ also severely undermines the notion of simple and transparent securitization – since tranching by its very nature renders securitized products complex and opaque. A sustainable CMU must stand firm on the core principles – allowing only truly simple securitization in the framework, and insisting on substantial risk retention on the part of issuers. If it does not, it risks undermining rather than enhancing prosperity and growth in Europe.

Second, the CMU is likely to further increase the systemic importance of large banks in capital markets. Until recently, regulators in Europe were contemplating banking separation reforms to address the problem of too-big-to-fail banks. With the CMU, TBTF banks are likely to become larger still, as they will play key roles in reviving securitisation as issuers and market-makers. For their market-making activities, banks rely on collateralized funding markets, where borrowing against collateral makes leverage cheapest. So when the CMU speaks of the importance of “collateral fluidity”, it is essentially saying that we should ensure that collateral based funding for large banks remains unregulated although there is compelling evidence since the global financial crisis that banks run on each other in wholesale funding markets. Two implications result from this: (1) the sustainable CMU must abandon the notion of “freely flowing” collateral, instead adopting the (already watered down) minimum haircut requirements framework developed by the FSB and (2) serious banking separation reform must be pursued in parallel.

Third, regulators should take note that national supervisory regimes for capital markets are neither converging nor consistent. A pan-European agency that regulates European capital markets directly will be necessary to mitigate the cross-border nature of systemic risk in integrated capital markets, just as the Banking Union proved indispensable to adequately supervise large, cross-border European banks. Integrated capital markets are still vulnerable to sudden shifts in market liquidity, as the global financial crisis demonstrated that even very large markets can see liquidity evaporating rapidly. Without a pan-European regulator that can take countercyclical measures, it is difficult to see how systemic risks arising from European capital markets could be effectively addressed. An institutions-based regulatory regime – the one we have been building since 2008 – is ill suited to address (capital) market fragilities. A sustainable CMU must recognize that integrated capital markets cannot have segmented regulation.

Fourth, the action plan unveiled last week promotes a private Capital Markets Union. While the Commission has been reluctant to spell out the implications for government bond markets, it is important to recognize that the cornerstone of financial systems, government bond markets, have been (further) segmented by first the banking and then the sovereign debt crisis. Recent improvements are mainly due to the ECB’s quantitative easing (QE) and OMT commitments. Yet such unconventional monetary policies are designed to be temporary, while Europe has seen growing pressures for revisiting the preferential regulatory treatment of government bonds. Alberto Giovannini, one of the early architects of the European financial architecture, reminds us that ‘a very large proportion of the securities-based financial system requires means of transactions, and riskless government securities are best candidates’. How can capital markets function without risk-free sovereigns? Credit ratings and market liquidity will matter even more, thus sharpening the existing asymmetries between ‘periphery’ and ‘core’ (read Germany) governments.  Since the latter are more inclined to run budget surpluses, the second answer is exactly what brought us the 2008 crisis of shadow banking: private sector takes over the provision of ‘safe assets’.  A sustainable CMU should aim to eradicate existing asymmetries in market liquidity so that integrated government bond markets support the convergence in the costs of market funding for businesses across Europe.

Daniela Gabor and Jakob Vestergaard

The essay is based on ongoing joint work. We are grateful for comments from Vincenzo Bavoso and Frédéric Hache.

Alcimos vs ECB, financial stability edition

I listened in to the first hour of a very interesting conversation on the Modern Money Network about the Alcimos vs. ECB case where Alcimos contests the legality of the ECB’s refusal to fulfil its LOLR function for Greek banks. A lot of that conversation revolved around the ECB’s (lack of) mandate for financial stability. Two observations:

  1. The “ECB has no mandate for financial stability’ argument needs to be confronted with the fact that the ECB’s policies have financial stability implications. In a paper Cornel Ban and I have written, soon to be published in the Journal of Common Market Studies, we argue that the ECB’s collateral framework is pro-cyclical – that is, the risk management practices that it adopted from private repo market participants can and have sharpened liquidity spirals in Europe, with damaging consequences for periphery sovereigns. The ECB marks to market daily, makes margin calls daily, and has repeatedly hiked haircuts, just like  private shadow banks have done in crisis (and let’s not forget, the reason why the FSB has made reform of repo markets a priority for global financial stability).  This is why the various rounds of LTROs failed to stabilise European financial markets (LTROs are basically long-term repos, with the pro-cyclical risk management framework inbuilt) and why OMTs should be viewed as a commitment to preserve market liquidity in the markets where the very large European repo market sources collateral  – government bond markets.
  2. The ‘mandate’ argument is spurious: the ECB has repeatedly interfered in the fiscal affairs of Member States, most recently opposing publicly the FTT plans. More importantly, it has invoked financial stability arguments to oppose the FTT, particularly on the repo market. As the Financial Times reported, Benoît Cœuré, ECB executive board member, said in 2013:

 “We’re willing to engage constructively with governments and the European Commission to ensure that the tax has no   negative impact on financial stability”

The ECB cannot cherry-pick when and how it cares about financial stability. Given its independence, it should most certainly not interfere in tax decisions of elected governments by invoking financial stability while simultaneously threatening to let the Greek banking system go because it has no financial stability mandate! It’s like someone putting their house on fire and deciding not to worry about it because they are not the officially-designated firemen.

7 years after Lehman and little to show for it on the repo front

Lehman

The collapse of Lehman Brothers brought out of its obscurity the repo market, where financial institutions borrow against collateral (and temporarily transfer title of that collateral to lender). As its bankruptcy examiner reported, ‘six weeks before it went bankrupt, Lehman Brothers Holdings Inc. was effectively out of securities that could be used as collateral to back the short-term loans it needed to survive’. Gorton and Metrick famously termed Lehman’s collapse a run on the repo market.

Lehman’s collapse put the repo market on the regulatory map. Long gone were the days where central bankers thought repo were risk free funding instruments. In early 2008, discussing tensions in US financial markets, then chairman of US Fed Ben Bernanke mused:

  ‘remarkably, some financial institutions have even experienced pressures in rolling over maturing repurchase agreements     (repos). I say “remarkably” because, until recently, short-term repos had always been regarded as virtually risk-free instruments and thus largely immune to the type of rollover or withdrawal risks associated with short-term unsecured obligations’

By 2012, under a G20 mandate, the Financial Stability Board had identified repo markets as markets systemic to shadow banking, and created a separate work stream to design a regulatory regime that would address systemic repo fragilities. Reform would combine two sets of measures: improved transparency and structural measures that would curtail – or at least dampen – links between leverage, asset prices and cyclical liquidity – or, in Mark Carney’s words – ‘the cycle of excessive borrowing in economic booms that cannot be sustained when liquidity dissipates in core fixed-income markets’.

On both fronts, there is little, or uneven, progress.

Consider first transparency. The EU – with a repo market estimated to be similar in size to the US – leads the way. In the US, the Office for Financial Research (that once housed Zoltan Pozsar), recently deplored the voluntary reporting standards, warning that a ‘lack of a common data standard for identifying counterparties presents a substantial challenge in monitoring cross-market and cross-border exposures’. Indeed, the New York Fed identified six data points necessary for policy makers to get a systemic view of repo markets: ‘principal amount, interest rate (or lending rate for securities lending transactions), collateral type, haircut, tenor, and counterparty’. The voluntary reporting standards cover few of these.  In contrast, EU institutions have recently (June 2015)  reached a political compromise on Reporting and Transparency of Securities Financing Transactions (another name for repos). Expected to pass the last hurdle in October 2015 in the European Parliament, the Reporting requirements go beyond the six data points to include specific information about reuse and substitutability.

in comparison to the US, the European transparency rules appear nothing short of impressive. If and when put in practice (ESMA still needs to design the reporting template), the new rules will provide regulators (unfortunately not yet academics) with unprecedented granular detail of systemic repo connections. Yet behind this achievement lies a critical political compromise.  The European Parliament agreed to drop from its March 2015 draft Regulation the structural measures envisaged by the FSB (minimum haircuts).

This compromise illustrates well the little progress in designing structural measures to regulate repo markets. Initially, the FSB envisaged minimum haircuts to be applied to repo contracts regardless of counterparty and collateral. By Oct. 2014, it restricted its recommendations to a small subset of the repo universe (particularly for Europe, where banks dominate) where non-banks engage in repos with non-government collateral. The bulk of repo transactions – 80% against government collateral – will at best be monitored (in Europe), but not directly regulated. And the future looks even bleaker. The European Commission’s Capital Market Union plans highlight the importance of ‘collateral fluidity’, a clever way of saying repo markets should continue to be self-regulating.

What explains this growing reluctance to regulate repos? Political economists studying the regulation of finance typically look for ‘regulatory capture’ or ‘the power of finance’. This makes the repo industry lobby – the ICMA European Repo Council – sound rather powerful in European and global politics. While this may play a role, I argue in a paper just out in Journal of European Public Policy,  something more interesting, and more structural, is at play.

The paper asks how come that the repo market was the first to go off the table at the European FTT negotiations. It traces the history of the self-regulating repo market back to the Financial Collateral Directive of 2002, and to Alberto Giovannini, a very important figure in the recent history of European finance. During the early years of the Euro, the European repo market was a project designed by large European and US banks and supported by the Commission and the ECB, the two latter convinced that the specific mechanics of the repo would make its integration an engine for broader financial integration in Europe. This pre-crisis ‘repo bargain’ came under questioning at the height of the European crisis, when Germany and France suddenly linked repos to short-selling and systemic risk. With support from the two large member states, the Commission (controversially) included the repo market in the FTT, and defended it throughout the negotiations for enhanced cooperation. Yet by 2013 the Commission remained the lonely voice against a growing consensus – quietly supported by the ECB – that taxing the repo market would harm liquidity in government bond markets and hamper the transmission of monetary policy. Besides legitimate questions of the ECB’s interference in the fiscal affairs of member states, the debates on taxing the repo market demonstrate vividly the ambiguities that regulators face in reforming little understood markets – the conceptual confusions around ‘liquidity’ a case in point.

Rather than simply invoking an ‘all-powerful’ repo lobby, what matters in understanding the regulatory politics around repo markets is to trace clearly, and settle conceptually, the stakes that both governments and central banks have in the repo market.

 Daniela Gabor

Confessions of a deficit denier

Guest Post

The phrase ‘deficit denier’ is thrown around as an insult almost on a par with the denial of major historic disasters. As an event I clearly cannot deny the existence of a budget deficit at the present time, nor deny that there have been budget deficits for the vast majority of my lifetime.

I am though a ‘deficit denier’ in two important respects. The first is that I (and many others) deny the proposition that the budget deficit is the ‘most important economic problem’ facing the UK. Think of the economic problems facing us – poverty, unemployment, need for a greener economy and tackling climate change, low productivity growth, current account deficit, lack of housing etc.— against which any budget deficit problem fades into near insignificance. Even if the budget deficit is regarded as an issue, it should be seen as a sign of imbalances in the rest of the economy, and it is those imbalances which need to be addressed. When the deficit rose sharply in late 2008 and into 2009 it reflected the imbalances, at that time particularly the collapse of investment and of consumer demand. At present a growing imbalance is the current account deficit, and it is that deficit which needs to be addressed.

The second denial concerns the need to eliminate the budget deficit as the end point of fiscal policy. The austerity brigade promote the view that government budgets have to be balanced or in surplus (as now proposed by Osborne). And some anti-austerity campaigners still adhere to some need to eliminate the budget deficit, even if it is the sense of St Augustine ‘Lord, grant me chastity and continence; but not yet.’ Let us first recognise that to some degree growth would reduce the budget deficit, notably as tax revenues rise, and that allowing recovery to continue would allow the deficit to fall. The usual rule of thumb is that a 1 per cent increase in output would reduce budget deficit by the order of 0.5 per cent of GDP. Hence it would appear that 8 per cent higher output would be sufficient to clear the present budget deficit. However, growth which continued (and did not just represent a recovery from recession) and which involved growth of productivity and real wages would lead to public expenditure being higher as public sector wages linked with private sector wages and pensions and other transfer payments indexed to wages. In that setting the deficit would only be significantly reduced with growth if public sector wages and pensions were reduced relative to private sector wages.

The appropriate target for the budget position (whether deficit or surplus) is to ensure that fiscal policy is consistent with the achievement of high and sustainable levels of employment which we could recognize as full employment. How big or small such a deficit (or surplus) would be clearly depends on what is happening elsewhere in the private sector – what is the levels of investment and savings, what is the scale of exports, imports and the current account position. The calculation of the necessary budget position is not an easy one to make, and the budget position so required shifts over time. It is also not an easy view point to put across. But, to coin a phrase, there is no alternative if high levels of employment are to be achieved.

Malcolm Sawyer

(m.c.sawyer@lubs.leeds.ac.uk)

Repo confusions

Yesterday’s Google Alert on repo markets showed a confusing picture:

Screen Shot 2015-06-26 at 09.55.34

The Reuters piece looks at the US repo market. Dealers and banks there are anxious about the spillovers of the potential Greek default (remembering Lehman triggered a run in repo) and this anxiety shows in higher repo rates.

The Bloomberg article talks about the impact that the shrinking Danish repo market has on the covered bond market. Declining use of repos by banks harms liquidity in the secondary covered bond market, and threatens Danish banks’ liquidity buffers. Bloomberg cites the Danish central bank and local banks common view that regulation is discouraging\ banks’ use of repos, with unexpected consequences for the rest of the financial sector. As banks return to being more like banks (relationship based) and less like (repo) market players, financial stability suffers.

The FT piece paints a very different picture. In contrast to the US, European banks and money market funds do not seem to be concerned about the financial stability implications of the Greek negotiations. The problem in European repo markets is how to get rid of your cash – as with negative bond yields, money market funds now have others to lend cash to them. The culprit, in this story, is the ECB, who charges banks on their reserve accounts, and thus distorts short-term money markets ‘driving our traders absolutely mad’.

There are several interesting questions arising from this comparative picture:

1. How come Greek tensions manifest in US, but not European repo markets? Is it about the exposure of US to European markets, about the time horizon for tightening, or some form of inexplicable European optimism for a Greek solution ?

2. How can we account for, and separate, the impact of unconventional monetary policy  and regulation on the repo markets? Bloomberg portrays the Danish central bank as unwilling to accept its contribution to repo contraction, whereas the FT piece has traders complaining about the ECB.

This last question is fundamental given that repo markets are systemic to shadow banking. The FSB has recognised this since 2009, but its attempts to reform repos – to transform a market governed by private rules into a market governed by public rules (on haircuts) – have been watered down considerably. The European Commission and the ECB are also going down the same route, now content with simply imposing Transparency and Reporting Requirements (although some exceptions will also apply there) without trying to change margining practices that are inherently fragile. The Capital Markets Union (CMU) project also stresses that there is a trade-off between regulation and a well functioning repo market.

Thus, the argument that regulation shrinks the repo market and constrains’ banks ability to act as market makers is very useful for delaying and defeating measures to regulate the market and bring it out of the shadows. When central banks start tightening, it may come to haunt them.

3. What are the broader consequences of increasingly organising the financial system around markets and market liquidity, as the CMU aims, in turn reliant on repo markets that not even the repo lobby knows much about?

The Capital Markets Union: faith in finance restored, contract with finance rewritten?

source: Finance Watch

source: Finance Watch

Things are changing in European finance. Recent proposals by the European Commission turn post-crisis thinking on the regulation of shadow banking on its head. After Lehman regulators around the world agreed to curtail banks’ involvement in shadow banking, but recent policy initiatives frame shadow banking not as a source of systemic risk but as a crucial prerequisite for restoring sustainable growth in Europe. The Capital Markets Union (CMU) proposals aim to transform shadow banking into stable market-based finance, linking investors and savers with growth and employment. As the consultation phase has come to an end, it is clear that the CMU agenda will revive the two markets systemic to shadow banking – securitization markets and repo markets (where banks borrow short term against collateral). Two concerns arise. First, in its current form, the CMU is unlikely to advance its stated objectives. Second, the CMU risk undermining other efforts to regulate (shadow) banking.

The CMU vision is securitisation-led growth, where tradable debt connects institutional investors with entrepreneurs in SMEs and elsewhere. Since European banks need to reverse the excessive pre-crisis expansion, market-based financing alone can meet the capital needs of companies throughout Europe. Revived securitisation markets are expected to free up bank balance sheets, create liquid mediums for institutional investors to hold; and spur SME lending and infrastructure investment.

However, the CMU is unlikely to achieve much vis-a-vis these objectives if it creates new and sharpens existing sources of financial instability. If “simple, transparent securitisation” is the panacea, why haven’t markets embraced it already? Could it be the opaque legal engineering and tranching that makes securitised products attractive to investors? In this perspective, recent suggestions that public bodies -such as the European Investment Bank –  could guarantee junior and mezzanine tranches of synthetic securitisation suggests that the concept of ‘simple, transparent’ securitisation may be loose its original intent, and socialise private risks (again).

Furthermore, where securitised products are funded through repo markets, systemic risk increases. If collateral is allowed to flow freely, as envisaged by the CMU, well-known effects of procyclicality and interconnectedness will increase considerably.

The CMU’s rethinking of shadow banking encourages us to think of market liquidity as a key prerequisite of financial market efficiency and economic growth. But recent crisis experience shows that market liquidity easily evaporates in times of crisis. This is why regulators have recognised that the complex, volatile market liquidity and excessive leverage funded in repo markets are two sides of the same coin. Freely flowing collateral would make liquidity more not less fragile. This is why the Financial Stability Board (FSB) has proposed a framework for reducing the systemic vulnerabilities of the repo-liquidity nexus.

Although the CMU ostensibly aims to reduce banks’ dominance in European finance, it risks achieving the opposite. Bank separation proposals are currently at risk because the banking industry is gently persuading policymakers that such measures would undermine its role as market makers and providers of market liquidity. Since the CMU increasingly organise European finance around market liquidity, it may inadvertently increase the systemic importance of banks.

Assuming that the CMU is irreversible, we urge careful thinking on three issues. First, how can new securitisation be organised so as to best promote transparency and contain systemic risks? A pan-European regulatory agency tasked with standard-setting and prudential oversight could prove essential. Direct supervision of European capital markets should not be considered an ”unhelpful distraction” that adds little to well-functioning national supervision, when national supervisory approaches are far from either convergent or consistent. On the contrary, it is worrying that European member states dismiss the cross-border nature of systemic risk only six years after the crisis of global finance. It is worth remembering that the same arguments about national supervision of large European banks left member states woefully unprepared for the crisis of European banking after Lehman.

Second, the CMU should be accompanied by fundamental reforms of European repo markets, adopting the original FSB proposals (universal minimum haircuts) that targeted the sources of procyclicality and excessive leverage across all types of securities financing transactions. Otherwise, the reporting and transparency framework proposed by European regulators will have limited structural impact. Last but not least, European regulators would be well-advised to consider the desirability of less liquid markets that create incentives for buy-to-hold investors.

Daniela Gabor and Jakob Vestergaard

Monbiot’s misguided monetary reforms

Joseph Schumpeter observed that “a sharply-defined type of social reform monomaniac sees money, its reform or abolition, as a social panacea”. These words came to mind while reading George Monbiot’s suggestion that alternative monetary arrangements hold the potential to transform Greece and release it from its current state of purgatory. Monbiot attributes ultimate responsibility for the unfolding Greek tragedy not to the Northern European states that have forced self-defeating austerity upon Greece, but to the “private banks” that have used European state institutions as their “intermediaries”.

While true that policy has been characterised by bailouts for the banks and austerity for the public it is plainly wrong to suggest that private banks are the ultimate puppet-masters driving European policy. Nonetheless, Monbiot suggests that the usurious grip of the bankers can be broken by introducing alternative monetary arrangements.

He highlights debates around the recently resurrected Chicago Plan which, in the 1930s, proposed that banks be forced to back all customer deposits with government-issued money. In so doing, banks would be deprived of their power to create money “out of thin air” and control of the money supply would be returned to its rightful owner – the state. Monbiot wrongly attributes the proposal to Martin Wolf of the Financial Times who is a recent convert to the plan following the lobbying of the campaign group Positive Money.

Monbiot goes on to claim that introduction of the plan would generate billions of pounds in government revenues. This mistakenly implies that the capability of private banks to create money somehow rules out the possibility of governments financing spending directly by paying for it with newly printed money. In fact, nothing about the current system prevents central banks from directly financing government spending. The obstacles that exist are legal barriers, erected to prevent government abuse of the power. Legal barriers are not irrevocable. Adair Turner has recently argued that such constraints should be relaxed in the UK, allowing a portion of the post-crisis quantitative easing to become permanent. What this amounts to is free money for the government produced at the printing press. Nothing about such public money printing requires that private banks be stripped of the capacity to also produce money.

Monbiot asserts that bank money creation somehow lies behind problems of environmental degradation. This is a dangerously confused point – albeit one which is made with increasing regularity. This view appears to rely on the false assertion that lending at interest by banks imposes an inescapable need for exponential growth in order to service the resulting debts.

Monbiot then presents his proposal for the salvation of Greece. Local currencies should be issued in combination with the “thrilling, transformative system that almost saved Europe from fascism … called stamp scrip”. In support of local currencies Monbiot uses the example of the Bristol Pound. His support of stamp scrip is based on the experience of towns in Austria and Germany in the aftermath of the hyperinflation of the 1920s.

Stamp scrip works by requiring currency to be stamped monthly at a price equal to a proportion of the face value of the note. This causes the value of the currency to degrade with time. Much the same effect could be engineered by imposing negative interest rates on bank deposits – or by raising inflation to a high enough level.

The point of such an approach is to prevent people from hoarding cash – to force them to spend their incomes. The problem in Greece is not that people are receiving income they do not spend. It is that their incomes have shrunk so much that they can no longer afford basic necessities. The poorest in Greece are accumulating debts, not hoarding. While there is a problem of hoarding, this excess saving is taking place in Germany, not Greece.

What about local currencies? Greece is currently locked in a showdown with the Troika which has two possible outcomes – either significant compromises are made by one or both sides or Greece leaves the euro. While the reinstated drachma might count as a new “local currency” it is not, I suspect, what Monbiot has in mind.

So what does he have in mind? The example he uses, the Bristol Pound, is trusted – and therefore stable in value – because it is 100% backed by sterling deposits. For every Bristol Pound in circulation a Bank of England pound is held on deposit at the Bristol Credit Union – a similar arrangement allows Scottish banks to issues their own notes. It is only the explicit backing of the British state which gives the Bristol Pound its value.

Such parallel currencies are feasible precisely because they do not threaten to undermine state-issued national currency: Bristol Council cannot fund itself by issuing Bristol Pounds. The same would not be true of Greece. The introduction of any parallel currency which wasn’t fully backed by euro balances with the ECB would amount to de facto suspension of the euro. This would almost certainly be a one-way ticket: if the currency was a success, why go back to the euro? If a failure, what are the chances of Greece being invited back?

This type of scrip currency arrangement is proposed by Flassbeck and Lapavitsas in their blueprint for Greek euro exit – they advocate the temporary introduction of state IOUs to augment the euros that would remain within the country if Greek exit become a reality. But such issuance would require both capital controls to prevent outflow of the remaining euros and a credible state guarantee that such IOUs would be redeemed. The proposal is intended only as a short-run stopgap while a new currency is prepared. Any attempt to impose such a system permanently without writing off debts to official creditors – it is these official creditors, rather than private banks, that the bailout aims to protect – would rapidly lead to a foreign exchange crisis as euros were used to service debts denominated in what would be essentially a foreign currency.

Monbiot is wrong about this being a showdown between the public and the banks. The current situation in Europe is a confrontation between states – and one in which there exists a massive imbalance of power between the protagonists. Whichever side prevails, the state – either the Greek state or the German state – will remain the dominant force in shaping society for the foreseeable future. No amount of monetary tinkering will change this.

[Edited: A shorter version appeared as a letter in the Guardian]

Jo Michell