Parallel Currencies: More Poison than Panacea

This post was written more than six years ago, just before the French Presidential elections of 2017, but it was never published. Still, this remains my personal view on the subject and I thought it might be worth posting just in case the parallel currency fantasy ever returns (which I sincerely hope will not happen). I think a lot of this logic would also apply to parallel currencies elsewhere. I’m just posting it right now because I see in the FT that someone is Baaack. https://www.ft.com/content/f3f12866-8476-4367-a74f-e5039f39c16c. I’m not actually sure on the details of his proposal (and it’s probably not a real parallel currency anyway), but this might still be useful.

The tl;dr version is that any successful parallel currency expedient in the Euro-area would require the cooperation of the ECB to maintain valuation at or close to par and that the political capital (domestic and within the EZ) expended on any such expedient would be better spent on getting the cooperation of fiscal watchdogs (Commission) and the monetary authority (ECB) to accept and backstop increased fiscal space rather than taking the credibility risk of overt monetary heterodoxy. Major disclaimer — I am not a lawyer anywhere, nor am I an economist, and unlike the latter, I’ve never played the former on TV.

They have mostly disappeared (mercifully) but every once in a while, one hears proposals for countries to retain the Euro, but alongside it, circulate a parallel national currency that circulates alongside it only within the borders of the Eurozone member attempting a dual currency system. The politics of such an approach stem from an attempt to square the political preferences of those who prefer more expansionary fiscal and monetary policy with the preferences of those who worry about the value of their assets, whether lodged in banks or in government bonds. Talk of a parallel currency is an attempt to promise creditors of the national government or depositors in the country’s banks that the value of Euro denominated assets will not fall, and at the same time to convince those hurt by the crisis that governments will have additional monetary or quasi-fiscal resources to stoke an expansion.

I examine here whether such an expedient will work, and conclude that it will not, for a variety of legal, economic and political reasons. Despite claims that a parallel currency would not violate EU treaties, a closer scrutiny of the treaties does suggest protagonists of these plans could be on thin ice from a legal point of view. The economic and financial aspects of parallel currency usage are even more daunting, with there being only a handful of examples of such systems in the modern era, none of which were actually successful. Finally, the level of pan-EU cooperation (and the role of the ECB in particular) required to allow a parallel currency to circulate alongside the Euro is extraordinarily high, bringing into play exactly the same political fissures within the Eurozone already evident in the unfolding of the EZ crisis.

It is also important to note that many of the plans for the introduction of a parallel currency were made at a time when not only was the Eurozone economy was more fragile, but also when ECB policy itself was less creative in responding to the situation of the peripheral economies. This raises a question of costs and benefits, and the issue of whether a parallel currency expedient would in fact be superior to the current set of ECB policies. Since Mario Draghi’s “whatever it takes” speech in July 2012, the ECB has begun to replicate the actions of the Federal Reserve and the Bank of Japan. It has taken action to unblock the credit channel via its TLTROs, it has offered troubled peripheral economies a concessional (albeit conditional) monetary backstop that prevents destabilizing rises in bond yields via its OMT program, and straightforward unconventional monetary policy via its Quantitative Easing program.

Conversely, the proponents of parallel currency circulation keep referring to short-lived experiments in single countries that were ultimately unsuccessful. California’s experience with IOUs during a budget crisis in 2009 lasted all of two months before the financial market backlash against IOUs led to a state-level agreement to slash spending. In Argentina, multiple national and provincial IOUs circulated in mid-late 2001, just as the currency board regime approached its end in December that year. These parallel currencies included national government LECOPs, and the Province of Buenos Aires’ Patacons (which became famous when a fast food company introduced the cut rate Patacombo meal). As explored in more detail below, the very use of parallel currencies even as a temporary expedient can lead to a crisis of confidence that brings about heightened financial market pressures that exacerbate rather than alleviate a country’s problems. But before exploring the financial implications of parallel currencies, it is worth exploring the claim that parallel currency issuance is by itself consistent with the EU treaties, though I will preface this with a disclaimer on having any actual legal expertise in EU law other than reading through key parts of the Treaties.

It is also important to note that Eurozone members have formally given up certain essential attributes of sovereignty to the EU. Monetary policy freedom is constrained by several articles of the Treaties on the Functioning of the European Union. Article 2 (1) and Article 3.1 © together state that only the Union may legislate and adopt legally binding acts and specifically arrogates to the Union an exclusive competence in monetary policy for the Member States whose currency is the euro. Article 123 (the famous no-bailout clause that prohibits overdraft facilities or the direct purchase of debt instruments) applies to national central banks. Article 128 limits the exclusive right to issue euro banknotes within the Union to the ECB and the national central banks and states that banknotes issued by the ECB and the NCB shall by the only such notes to have the status of legal tender within the union. Article 130 protects the independence of NCBs from national governments. Article 140 governs the irrevocable rate at the euro shall be substituted for the currency of the member state ….. as the single currency in the member state concerned. (emphasis mine).

The above list suggests there is little to no legal room for any Eurozone member to make its own monetary policy, to leave the Euro, to force its central bank into purchases of government debt, or even to introduce a parallel currency alongside the Euro. It can do any or all of those things outside the EU, but not inside it. These provisions have led to ideas of a quasi-fiscal variant of currency that is not generated by a central bank but rather by the fiscal authorities and can be used as payment for taxes. It is unclear whether this would in fact run afoul of the “legal tender” provision of Art. 128 and the “single currency” provision of Article 140, but more to the point, the practical and political aspects of such a quasi- currency seem quite daunting.

First of all, France and Italy have Euro denominated liabilities, of which 60% are held outside the country in the case of France, and roughly 37% in the case of Italy. Any parallel currency will likely trade below parity against the Euro, which might help alleviate loss of international competitiveness if wages are paid in the parallel currency, but at the same time a parallel currency that trades at less than par will raise concerns about mismatches between government revenues denominated in the parallel currency and government debts denominated in Euros. Even under the best of circumstances, there will be serious contradictions in calibrating the amount of parallel currency creation. Large infusions of quasi-fiscal parallel currency will heighten investor concerns about policy heterodoxy and government asset-liability matching, leading to heightened credit risk premia that destabilize sovereign debt dynamics, thus creating a vicious circle. Conversely, small infusions of the same genus of parallel currency might not alarm investors to the same degree, but will have less of a positive cyclical impact via either fiscal stimulus or competitiveness gains via a fiscal devaluation.

This dilemma applies even more strongly in the case of banks (a sector that is large and troubled in Italy and large and very complex in France). Legacy assets and liabilities would be denominated in €, even as a large infusion of quasi-fiscal currency will change the behavior of both debtors and creditors of the banking system. This would likely lead to political attempts by debtors to convert their contracts into the new parallel currency in which some portions of their own receipts are now denominated. Conversely, despite any assurances that might be made by authorities, it is very likely that depositors and other creditors of the banking system will seek to withdraw their Euros from the country’s banking system and move them elsewhere. The expectation of asset-liability mismatches would very likely lead to a wholesale and retail bank run that feeds on itself. Capital controls are a logical next step, but the credit crunch that follows these disruptions would vastly outweigh any stimulative impact from the infusion of any parallel currency.

From a political point of view, the critical issue is that the cooperation of the ECB would still be required to keep the parallel currency to sinking too far and too fast against the Euro. Because the ECB’s ability to generate EUR is unconstrained, the ECB would need to intervene to minimize the divergence between the parallel currency and the Euro. In other words, even moving to a parallel currency would still require recourse to the ECB’s credibility and to the ECB’s balance sheet, necessitating a dialogue with the ECB and the core European group of creditor countries.

Any such dialogue would be fraught, because any obligation on the ECB to target an exchange rate band vis-a-vis newly introduced parallel currencies would contravene the treaty provisions the give the ECB a single-mandate — to fight inflation. It is also important to note that any such discussion on a parallel currency could jeopardize the way in which the peripheral countries have already gained recourse to the ECB’s balance sheet as a result of the massive shifts in that institution’s operations since the onset of the Eurozone crisis.

For all the accusations that the Eurozone replicates gold standard regimes, the evolution of the Eurozone since 2010 has made it much more flexible than its purported historical antecedents in either the gold standard or currency board type regimes. Since the beginning of the Euro, the Target 2 payment system has guaranteed practically unlimited absorption by a shared central bank of massive shifts in investors’ desire to hold peripheral assets (a feature completely lacking in the case of Argentina in 2001, for example). More recently, peripherals have gained the benefits of aggressive central bank actions to unblock credit channels via the ECB’s TLTRO program and the benefit of a quantitative easing program orchestrated by a central bank that provides the world’s second reserve currency. Country specific tensions are designed to be countered by the OMT — a program to counter “unwarranted” rises in risk premia in exchange for reform conditionality, even as the ECB has also accepted its status as a pari-passu creditor in cases of future sovereign default.

The point is that in many respects, the ECB already acts in a number of ways as a lender of last resort to governments, but one whose willingness to act as such depends on conditionality. A peripheral seeking an unconditional lender of last resort in its own central bank could seek a leap into the unknown via Euro-exit, but my point here is that for a dual currency regime to have any chance at all of surviving (and historical precedent suggests the odds may be against this), an ECB backstop is still essential. The ECB would still be needed to preserve the value of the newly introduced parallel currency from plummeting against the Euro, and any such support would most likely involve policy conditionality. Whether the purported solution to the discontents of the Eurozone takes the form of parallel currencies or of a full-on return to an Exchange Rate Mechanism in which the return to national currencies is accompanied by protocols and methods to limit exchange rate volatility, neither is possible without the cooperation of the anchor central bank at the hub of the system (ECB in the former case, and Bundesbank on the latter), which in turn will involve conditions and limits. For all the talk of EU populists about regaining national sovereignty, markets (and the need for protection from markets) will impose natural constraints on sovereignty.

A final conceptual point is that a currency is essentially a liability of the consolidated public sector including the central bank. Efforts at issuing a parallel currency would increase the emission of public sector liabilities at the legal edges of EU treaty frameworks, and in a way that muddies the distinction between fiscal and monetary liabilities. Any such effort would likely devastate the credibility of all public sector liabilities creating massive spillovers into government bond markets and into financial system stability, very likely necessitating negotiations on the conditions for supranational or ECB assistance. Rather than take a leap into a parallel currency system (something that has no successful precedents and has not even been attempted in economies of the size and financial complexity of France or Italy), the obvious political pathway in Europe is to negotiate more “normal” increases in fiscal liabilities and the structural conditions under which they will be permitted. What remains to be seen is if and when any economic populist party that wins power in Europe actually realizes these constraints.