Note to Greece: Mixing Currency and Politics Doesn’t Work

This article appeared in Forbes on July 27, 2015.

Greece's monetary troubles have dominated the headlines now for weeks, releasing a torrent of analysis assigning blame or proposing solutions. Yet that torrent overlooks the bigger tragedy in which the recent Greek drama is but the latest act:  governments' misuse of currency as a tool of politics.

What currency is meant to do—and how the euro betrays that purpose

Ask any competent economist what currency is and he or she will tell you that it's a generally accepted medium of exchange meant to overcome the difficulties of barter. A specialist might go on to explain how certain currency systems do a better job of facilitating exchange and of avoiding financial crises than others. Few would think of currency as a tool of politics.

The euro's creators, in contrast, meant it to serve not just as a medium of exchange but as a symbol of European solidarity. By treating currency as a political tool, they unwittingly put politics at loggerheads with economics. Economic considerations demanded that the European Central Bank resist bailing out fiscally irresponsible eurozone members. Politics, on the other hand, insisted that that the eurozone be held together by hook or by crook. So far politics has prevailed. But precisely because it has, the euro's fate hangs in the balance.

The current situation is not without precedent

The euro’s predicament is nothing new. Governments have long considered currency a tool of politics, and currency has long been the worse for it. Until modern times, governments routinely looked upon currency not as a medium of exchange but as a source of easy revenue. They made the minting of currency a royal “prerogative” and illicit minting a capital crime, so they could, in a pinch, pay their bills in adulterated coin. As a result, ancient and medieval history are chock-full of currency debasements and accompanying turmoil, from the Roman emperors’ gradual conversion of the denarius from a silver to a copper coin to the “Great Debasements” of Henry VIII and Edward VI.

Although paper money was originally developed as a substitute for governments’ crummy coins, that didn’t keep medieval governments from perceiving its fiscal advantages: Printing paper was, after all, even easier than minting metal discs. Early central banks, including the Swedish Riksbank, the Bank of England and the Bank of France (not to mention the last-named bank’s ill-fated predecessor, John Law’s Banque Royale), were all meant to be government piggy-banks. Their creators couldn’t care less whether their monopoly privileges might detract from monetary efficiency and stability.

And detract they did. Despite its later reputation as a paragon of monetary stability, the Bank of England was the main cause of periodic English financial crises throughout the 18th and 19th centuries. Its privileged status caused other banks to employ its IOUs, rather than gold, as cash reserves and to ride side-saddle with it on its lending sprees until its own gold losses caused it to dump them, triggering a credit crunch. When he famously argued that the Bank should instead act as a “lender of last resort,” Walter Bagehot wasn’t endorsing its monopoly, as modern central-bank apologists would have it. On the contrary: Bagehot blamed England’s crises on the Bank of England’s monopoly status. Bagehot’s ideal system was one in which banks shared equal privileges. Scotland, which had long had such a system, was famously crisis-free.

During the American Civil War, the Union also chose to treat currency as a fiscal tool by issuing its own “Greenbacks” and by requiring newly-authorized national banks to back their notes with its bonds. That second scheme may have been a clever way to help finance the war. But later, as the requisite bonds became hard to come by, and national banks found that they couldn’t always afford to meet the public’s currency needs, it became the main cause of American financial instability.

Banking systems that remain free of politics are more stable

The ensuing “currency panics” ought to have led to the repeal of the troublesome and no longer needed bond-backing requirement. Canada’s banks, after all, faced no such requirement, and Canada, like Scotland, experienced no crises. Instead—politics again—the panics led to the creation of the Federal Reserve System and, within a generation, to the United States’ worst crisis of all, though hardly its last.

Some governments still treat their currency systems as cash cows—look at Venezuela and, before it quit printing its own currency, Zimbabwe. But revenue is only one reason why governments tamper with currency. Geopolitics is another. When, in 1925, Winston Churchill chose to restore the pound’s prewar gold value—though that meant plunging Great Britain into a deflationary depression—he was, according to some, concerned about sterling’s international prestige, not macroeconomics. And when, after World War II, newly decolonized countries rushed to establish their own currencies, they were thinking of currency not as a means for facilitating trade but as a symbol of sovereignty. Sadly, many of those new currencies would end up symbolizing something else again, namely, government profligacy and corruption.

It would be nice if currency schemes designed to serve political ends also happened to be economically sound, or at least sustainable. But they usually aren’t. If the Greek crisis doesn’t at least convince the public to distrust such schemes, it will be worse than a tragedy: it will be a farce.