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Should the Fed Add FX Swaps to its Asset Purchasing Programs?

By Elham Saeidinezhad and Jack Krupinski

“As Stigum reminded us, the market for Eurodollar deposits follows the sun around the globe. Therefore, no one, including and especially the Fed, can hide from its rays.”

The COVID-19 crisis renewed the heated debate on whether the US dollar could lose its status as the world’s dominant currency. Still, in present conditions, without loss of generality, the world reserve currency is the dollar. The exorbitant privilege implies that the deficit agents globally need to acquire dollars. These players probably have a small reserve holding, usually in the form of US Treasury securities. Still, more generally, they will need to purchase dollars in a global foreign exchange (FX) markets to finance their dollar-denominated assets. One of the significant determinants of the dollar funding costs that these investors face is the cost of hedging foreign exchange risk. Traditionally, the market for the Eurodollar deposits has been the final destination for these non-US investors. However, after the great financial crisis, investors have turned to a particular, and important segment of the FX market, called the FX swap market, to raise dollar funding. This shift in the behavior of foreign investors might have repercussions for the rates in the US money market.

The point to emphasize is that the price of Eurodollar funding, used to discipline the behavior of the foreign deficit agents, can affect the US domestic money market. This usage of FX swap markets by foreign investors to overcome US dollar funding shortages could move short-term domestic rates from the Fed’s target range. Higher rates could impair liquidity in US money markets by increasing the financing cost for US investors. To maintain the FX swap rate at a desirable level, and keep the Fed Funds rate at a target range, the Fed might have to include FX derivatives in its asset purchasing programs.

The use of the FX swap market to raise dollar funding depends on the relative costs in the FX swap and the Eurodollar market. This relative cost is represented in the spread between the FX swap rate and LIBOR. The “FX swap-implied rate” or “FX swap rate” is the cost of raising foreign currency via the FX derivatives market. While the “FX swap rate” is the primary indicator that measures the cost of borrowing in the FX swap market, the “FX-hedged yield curve” represents that. The “FX-hedged yield curve” adjusts the yield curve to reflect the cost of financing for hedged international investors and represents the hedged return. On the other hand, LIBOR, or probably SOFR in the post-LIBOR era, is the cost of raising dollar directly from the market for Eurodollar deposits.

In tranquil times, arbitrage, and the corresponding Covered Interest Parity condition, implies that investors are indifferent in tapping either market to raise funding. On the contrary, during periods when the bank balance sheet capacity is scarce, the demand of investors shifts strongly toward a particular market as the spread between LIBOR and FX swap rate increases sharply. More specifically, when the FX swap rate for a given currency is less than the cost of raising dollar directly from the market for Eurodollar deposits, institutions will tend to borrow from the FX swap market rather than using the money market. Likewise, a higher FX swap rate would discourage the use of FX swaps in financing.

By focusing on the dollar funding, it is evident that the FX swap market is fundamentally a money market, not a capital market, for at least two reasons. First, the overwhelming majority of the market is short-term. Second, it determines the cost of Eurodollar funding, both directly and indirectly, by providing an alternative route of funding. It is no accident that since the beginning of the COVID-19 outbreak, indicators of dollar funding costs in foreign exchange markets, including “FX swap-implied rate”, have risen sharply, approaching levels last seen during the great financial crisis. During crises, non-US banks usually finance their US dollar assets by tapping the FX swap market, where someone borrows dollars using FX derivatives by pledging another currency as collateral. In this period, heightened uncertainty leads US banks that face liquidity shortage to hoard liquid assets rather than lend to foreigners. Such coordinated decisions by the US banks put upward pressure on FX swap rates.

The FX swap market also affects the cost of Eurodollar funding indirectly through the FX dealers. In essence, most deficit agents might acquire dollars by relying entirely on the private FX dealing system. Two different types of dealers in the FX market are typical FX dealers and speculative dealers. The FX dealer system expedites settlement by expanding credit. In the current international order, the FX dealer usually has to provide dollar funding. The dealer creates a dollar liability that the deficit agent buys at the spot exchange rate using local currency, to pay the surplus country. The result is the expansion of the dealer’s balance sheet and its exposure to FX risk. The FX risk, or exchange risk, is a risk that the dollar price of the dealer’s new FX asset might fall. The bid-ask spread that the FX dealer earns reflects this price risk and the resulting cost of hedging.

As a hedge against this price risk, the dealer enters an FX swap market to purchase an offsetting forward exchange contract from a speculative dealer. As Stigum shows, and Mehrling emphasizes, the FX dealer borrows term FX currencies and lends term dollars. As a result of entering into a forward contract, the FX dealer has a “matched book”—if the dollar price of its new FX spot asset falls, then so also will the dollar value of its new FX term liability. It does, however, still face liquidity risk since maintaining the hedge requires rolling over its spot dollar liability position until the maturity of its term dollar asset position. A “speculative” dealer provides the forward hedge to the FX dealer. This dealer faces exposure to exchange risk and might use a futures position, or an FX options position to hedge. The point to emphasize here is that the hedging cost of the speculative dealer affects the price that the normal FX dealer faces when entering a forward contract and ultimately determines the price of Eurodollar funding.

The critical question is, what connects the domestic US markets with the Euromarkets as mentioned earlier? In different maturity ranges, US and Eurodollar rates track each other extraordinarily closely over time. In other words, even though spreads widen and narrow, and sometimes rates cross, the main trends up and down are always the same in both markets. Stigum (2007) suggests that there is no doubt that this consistency in rates is the work of arbitrage.

Two sorts of arbitrages are used to link US and Eurodollar rates, technical and transitory. Opportunities for technical arbitrage vanished with the movement of CHIPS to same-day settlement and payment finality. Transitory arbitrages, in contrast, are money flows that occur in response to temporary discrepancies that arise between US and Eurodollar rates because rates in the two markets are being affected by differing supply and demand pressures. Much transitory arbitrage used to be carried on by banks that actively borrow and lend funds in both markets. The arbitrage that banks do between the domestic and Eurodollar markets is referred to as soft arbitrage. In making funding choices, domestic versus Eurodollars, US banks always compare relative costs on an all-in basis.

But that still leaves open the question of where the primary impetus for rate changes typically comes from. Put it differently, are changes in US rates pushing Eurodollar rates up and down, or vice versa? A British Eurobanker has a brief answer: “Rarely does the tail wag the dog. The US money market is the dog, the Eurodollar market, the tail.” The statement has been a truth for most parts before the great financial crisis. The fact of this statement has created a foreign contingent of Fed watchers. However, the direction of this effect might have reversed after the great financial crisis. In other words, some longer-term shifts have made the US money market respond to the developments in the Eurodollar funding.

This was one of the lessons from the US repo-market turmoil. On Monday, September 16, and Tuesday, September 17, Overnight Treasury general collateral (GC) repurchase-agreement (repo) rates surprisingly surged to almost 10%. Two factors made these developments extraordinary: First, the banks, who act as a dealer of near last resort in this market due to their direct access to the Fed’s balance sheets, did not inject liquidity. Second, this time around, the Secured Overnight Financing Rate (SOFR), which is replacing LIBOR to measure the cost of Eurodollar financing, also increased significantly, leading the Fed to intervene directly in the repo market.

Credit Suisse’ Zoltan Poszar points out that an increase in the supply of US Treasuries along with the inversion in the FX-hedged yield of Treasuries has created such anomalies in the US money market. Earlier last year, an increase in hedging costs caused the inversion of a curve that represents the FX-hedged yield of Treasuries at different maturities. Post- great financial crisis, the size of foreign demands for US assets, including the US Treasury bonds, increased significantly. For these investors, the cost of FX swaps is the primary factor that affects their demand for US assets since that hedge return, called FX-hedged yield, is an important component of total return on investment. This FX-hedged yield ultimately drives investment decisions as hedge introduces an extra cash flow that a domestic bond investment does not have. This additional hedge return affects liquidity considerations because hedging generates its own cash flows.

The yield-curve inversion disincentivizes foreign investors, mostly carry traders, trying to earn a margin from borrowing short term to buy Treasuries (i.e., lending longer-term). Demand for Eurodollars—which are required by deficit agents to settle payment obligations—is very high right now, which has caused the FX Swap rate-LIBOR spread to widen. The demand to directly raise dollars through FX swaps has driven the price increase, but this also affects investors who typically use FX swaps to hedge dollar investments. As the hedge return falls (it is negative for the Euro), it becomes less profitable for foreign investors to buy Treasury debt. More importantly, for foreign investors, the point at which this trade becomes unprofitable has been reached way before the yield curve inverted, as they had to pay for hedging costs (in yen or euro). This then forces Treasuries onto the balance sheets of primary dealers and have repercussions in the domestic money market as it creates balance sheet constraints for these large banks. This constraint led banks with ample reserves to be unwilling to lend money to each other for an interest rate of up to 10% when they would only receive 1.8% from the Fed.

This seems like some type of “crowding out,” in which demand for dollar funding via the FX swap has driven up the price of the derivative and crowded out those investors who would typically use the swap as a hedging tool. Because it is more costly to hedge dollar investments, there is a risk that demand for US Treasuries will decrease. This problem is driven by the “dual-purpose” of the FX swaps. By directly buying this derivative, the Fed can stabilize prices and encourage foreign investors to keep buying Treasuries by increasing hedge return. Beyond acting to stabilize the global financial market, the Fed has a direct domestic interest in intervening in the FX market because of the spillover into US money markets.

The yield curve that the Fed should start to influence is the FX-hedged yield of Treasuries, rather than the Treasury yield curve since it encompasses the costs of US dollar funding for foreigners. Because of the spillover of FX swap turbulences to the US money markets, the FX swap rate will influence the US domestic money market. If we’re right about funding stresses and the direction of effects, the Fed might have to start adding FX swaps to its asset purchasing program. This decision could bridge the imbalance in the FX swap market and offer foreign investors a better yield. The safe asset – US Treasuries – is significantly funded by foreign investors, and if the FX swap market pulls balance sheet and funding away from them, the safe asset will go on sale. Treasury yields can spike, and the Fed will have to shift from buying bills to buying what matters– FX derivatives. Such ideas might make some people- especially those who believe that keeping the dollar as the world’s reserve currency is a massive drag on the struggling US economy and label the dollar’s international status as an “an exorbitant burden,”- uncomfortable. However, as Stigum reminded us, the market for Eurodollar deposits follows the sun around the globe. Therefore, no one, including and especially the Fed, can hide from its rays.

Elham Saeidinezhad is lecturer in Economics at UCLA. Before joining the Economics Department at UCLA, she was a research economist in International Finance and Macroeconomics research group at Milken Institute, Santa Monica, where she investigated the post-crisis structural changes in the capital market as a result of macroprudential regulations. Before that, she was a postdoctoral fellow at INET, working closely with Prof. Perry Mehrling and studying his “Money View”. Elham obtained her Ph.D. from the University of Sheffield, UK, in empirical Macroeconomics in 2013. You may contact Elham via the Young Scholars Directory

Jack Krupinski is a student at UCLA, studying Mathematics and Economics. He is pursuing an actuarial associateship and is working to develop a statistical understanding of risk. Jack’s economic research interests involve using the “Money View” and empirical methods to analyze international finance and monetary policy.

Is our Monetary System as Systemic and International as Coronavirus?

By Elham Saeidinezhad | The coronavirus crisis has sparked different policy responses from different countries. The common thread among these reactions is that states are putting globalization on pause. Yet, re-establishment of central bank swap lines is making “money,” chiefly Eurodollars, the first element that has become more global in the wake of the Coronavirus outbreak. This is not an unexpected phenomenon for those of us who are armed with insights from the Perry Mehrling’s “Money View” framework. The fact that the monetary system is inherently international explains why the Fed reinstalled its standing U.S. dollar liquidity swap line arrangements with five other central banks just after it lowered its domestic federal fund’s target to zero percent. However, the crisis also forces us to see global dollar funding from a lens closer to home; the fact that the Eurodollar market, at its core, is a domestic macro-financial linkage. In other words, its breakdown is a source of systemic risk within communities as it disrupts the two-way connection between the real economy and the financial sector. This perspective clarifies the Fed’s reactions to the crisis in hand. It also helps us understand the recent debate in the economics profession about the future of central bank tools.

The Great Financial Crisis of 2008-09 confirmed the vital importance of advancing our understanding of macro-financial linkages. The Coronavirus crisis is testing this understanding on a global scale. Most of the literature highlights the impact of sharp fluctuations in long-term fundamentals such as asset prices and capital flows on the financial positions of firms and the economy. In doing so, economists underestimate the effects of disturbances in the Eurodollar market, which provides short-term dollar funding globally, on real economic activities such as trade. These miscalculations, which flow from economists’ natural approach to money as a veil over the real economy, could be costly. Foreign banks play a significant role in the wholesale Eurodollar market to raise US dollar financing for their clients. These clients, usually multinational corporations, are part of a global supply chain that covers different activities from receiving an order to producing the final goods and services. Depending on their financial positions, these firms either wish to hold large dollar balances or receive dollar–denominated loans. The deficit firms use the dollar funding to make payments for their purchases. The surplus firms, on the other hand, expect to receive payments in the dollar after selling their products. The interconnectedness between the payment system and global supply chains causes the Eurodollar market to act as a bridge between the real economy and the financial sector.

The Coronavirus outbreak is putting a strain on this link, both domestically and globally: it disrupts the supply chain and forces every firm along the chain to become a deficit agent in the process. The supply chain moves products or services from one supplier to another and is essentially the sum of all firms’ sales. These sales (revenues) are, in effect, a measure of payments, the majority of which occur in the Eurodollar market. A sharp shock to the sale, as a result of the outbreak, precipitates a lower ability to make payments. When an output is not being shipped, the producer of final goods in China does not have dollar funding to pay the suppliers of intermediate products. As a result, firms in other countries do not have a dollar either. The trauma that coronavirus crisis injects into manufacturing and other industries thus leads to missed payments internationally. Missed payments will make more firms become deficit agents. This includes banks, which are lower down in the hierarchy, and the central banks, which are responsible for relaxing the survival constraints for the banking system. By focusing on the payments system and Eurodollar market, we were able to see the “survival constraint” in action.

The question for monetary policy is how far the central bank decides to relax that survival constraint by lowering the bank rate. This is why central banks, including the Fed, are reducing interest rates to zero percent. However, the ability to relax the survival constraint for banks further down in the hierarchy depends also on the strength of foreign central banks to inject dollar funding into their financial system. The Fed has therefore re-established the dollar swap line with five other major central banks. The swap lines are available standing facilities and serve as a vital liquidity backstop to ease strains in global funding markets. The point to hold on to here is that the U.S. central bank is at a level in the hierarchy above other central banks

Central banks’ main concern is about missed payments of U.S. dollars, as they can deal with missed payments in local currency efficiently. In normal circumstances, the fact that non-U.S. central banks hold foreign exchange reserves enables them to intervene in the market seamlessly if private FX dealers are unable to do so. In these periods, customer-led demand causes some banks to have a natural surplus position (more dollar deposits than loans) and other banks to have an inherent deficit position (more dollar loans than deposits). FX dealers connect the deficit banks with the surplus banks by absorbing the imbalances into their balance sheets. Financial globalization has enabled each FX dealer to resolve the imbalance by doing business with some U.S. banks, but it seems more natural all around for them to do business with each other. During this crisis, however, even U.S. banks have started to feel the liquidity crunch due to the negative impacts of the outbreak on financial conditions. When U.S. banks pull back from market-making in the Eurodollar market, there will be a shortage of dollar funding globally. Traditionally, in these circumstances, foreign central banks assume the role of the lender of last resort to lend dollars to both banks and non-banks in their jurisdiction. However, the severity of the Coronavirus crisis is creating a growing risk that such intermediation will fracture. This is the case as speculators and investors alike have become uncertain of the size of foreign central banks’ dollar reserve holding.

To address these concerns, the Fed has re-established swap lines to lend dollars to other central banks, which then lend it to banks. The swap lines were originally designed to help the funding needs of banks during 2008. However, these swap lines might be inadequate to ease the tension in the market. The problem is that the geographic reach of the swap lines is too narrow. The Fed has swap lines only with the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank and the Swiss National Bank. The reason is that the 2008-09 financial crisis affected banks in these particular jurisdictions severely. But the breadth of the current crisis is more extensive as every country along the supply chain is struggling to get dollars. In other words, the Fed’s dollar swap lines should become more global, and the international hierarchy needs to flatten.

To ease the pressure of missed payments internationally, and prevent the systemic risk outbreak domestically, the Fed and its five major central bank partners have coordinated action to enhance the provision of liquidity via the standing U.S. dollar liquidity swap line arrangements. These tools help to mitigate the effects of strains on the supply chain, both domestically and abroad. Such temporary agreements have been part of central banks’ set of monetary policy instruments for decades. The main lessons from the Coronavirus outbreak for central bank watchers is that swap lines and central bank collaborations, are here to stay — indeed, they should become more expansive than before. These operations are becoming a permanent tool of monetary policy as financial stability becomes a more natural mandate of the central banks. As Zoltan Pozsar has recently shown, the supply chain of goods and services is the reverse of the dollar funding payment system. Central banks’ collaboration prevents this hybridity from becoming a source of systemic risk, both domestically and internationally.

This piece was originally part of “Special Edition Roundtable: Money in the Time of Coronavirus” by JustMoney.org platform.

Where Does Profit Come from in the Payments Industry?

“Don’t be seduced into thinking that that which does not make a profit is without value.”
Arthur Miller

The recent development in the payments industry, namely the rise of Fintech companies, has created an opportunity to revisit the economics of payment system and the puzzling nature of profit in this industry. Major banks, credit card companies, and financial institutions have long controlled payments, but their dominance looks increasingly shaky. The latest merger amongst Tech companies, for instance, came in the first week of February 2020, when Worldline agreed to buy Ingenico for $7.8bn, forming the largest European payments company in a sector dominated by US-based giants. While these events are shaping the future of money and the payment system, we still do not have a full understanding of a puzzle at the center of the payment system. The issue is that the source of profit is very limited in the payment system as the spread that the providers charge is literally equal to zero. This fixed price, called par, is the price of converting bank deposits to currency. The continuity of the payment system, nevertheless, fully depends on the ability of these firms to keep this parity condition. Demystifying this paradox is key to understanding the future of the payments system that is ruled by non-banks. The issue is that unlike banks, who earn profit by supplying liquidity and the payment system together, non-banks’ profitability from facilitating payments mostly depends on their size and market power. In other words, non-bank institutions can relish higher profits only if they can process lots of payments. The idea is that consolidations increase profitability by reducing high fixed costs- the required technology investments- and freeing-up financial resources. These funds can then be reinvested in better technology to extend their advantage over smaller rivals. This strategy might be unsustainable when the economy is slowing down and there are fewer transactions. In these circumstances, keeping the par fixed becomes an art rather than a technicality. Banks have been successful in providing payment systems during the financial crisis since they offer other profitable financial services that keep them in business. In addition, they explicitly receive central banks’ liquidity backstop.

Traditionally, the banking system provides payment services by being prepared to trade currency for deposits and vice versa, at a fixed price par. However, when we try to understand the economics of banks’ function as providers of payment systems, we quickly face a puzzle. The question is how banks manage to make markets in currency and deposits at a fixed price and a zero spread. In other words, what incentivizes banks to provide this crucial service. Typically, what enables the banks to offer payment systems, despite its negligible earnings, is their complementary and profitable role of being dealers in liquidity. Banks are in additional business, the business of bearing liquidity risk by issuing demand liabilities and investing the funds at term, and this business is highly profitable. They cannot change the price of deposits in terms of currency. Still, they can expand and contract the number of deposits because deposits are their own liability, and they can expand and contract the quantity of currency because of their access to the discount window at the Fed.

This two-tier monetary system, with the central bank serving as the banker to commercial banks, is the essence of the account-based payment system and creates flexibility for the banks. This flexibility enables banks to provide payment systems despite the fact the price is fixed, and their profit from this function is negligible. It also differentiates banks, who are dealers in the money market, from other kinds of dealers such as security dealers. Security dealers’ ability to establish very long positions in securities and cash is limited due to their restricted access to funding liquidity. The profit that these dealers earn comes from setting an asking price that is higher than the bid price. This profit is called inside spread. Banks, on the other hand, make an inside spread that is equal to zero when providing payment since currency and deposits trade at par. However, they are not constrained by the number of deposits or currency they can create. In other words, although they have less flexibility in price, they have more flexibility in quantity. This flexibility comes from banks’ direct access to the central banks’ liquidity facilities. Their exclusive access to the central banks’ liquidity facilities also ensures the finality of payments, where payment is deemed to be final and irrevocable so that individuals and businesses can make payments in full confidence.

The Fintech revolution that is changing the payment ecosystem is making it evident that the next generation payment methods are to bypass banks and credit cards. The most recent trend in the payment system that is generating a change in the market structure is the mergers and acquisitions of the non-bank companies with strengths in different parts of the payments value chain. Despite these developments, we still do not have a clear picture of how these non-banks tech companies who are shaping the future of money can deal with a mystery at the heart of the monetary system; The issue that the source of profit is very limited in the payment system as the spread that the providers charge is literally equal to zero. The continuity of the payment system, on the other hand, fully depends on the ability of these firms to keep this parity condition. This paradox reflects the hybrid nature of the payment system that is masked by a fixed price called par. This hybridity is between account-based money (bank deposits) and currency (central bank reserve).

Is Transiting to SOFR Affecting Firms’ Survival and Liquidity Constraints?

“Without reflection, we go blindly on our way, creating more unintended consequences, and failing to achieve anything useful.”
Margaret J. Wheatley

In 2017, after a manipulation scandal, the former FCA Chief Executive Andrew Bailey called for replacing LIBOR and had made clear that the publication of LIBOR is not guaranteed beyond 2021. A new rate created by the Fed—known as the secured overnight financing rate, or SOFR- seems to pull ahead in the race to replace LIBOR. However, finding a substitute has been a very challenging task for banks, regulators, and investors. The primary worries about the transition away from the LIBOR have been whether the replacement is going to reflect the risks from short-term lending and will be supported by a liquid market that behaves predictably. Most of these concerns are rooted in the future. However, a less examined yet more immediate result of this structural change might be the current instabilities in the market for short-term borrowing. In other words, this transition to SOFR creates daily fluctuations in market prices for derivatives such as futures that are mark-to-market and in the process affects firms’ funding and liquidity requirements. This side effect might be one of the underlying causes of a challenge that the Fed is currently facing, which is understanding the turbulences in the repo market.

This shift to the post-Libor financial market has important implications for the prices of the futures contracts and firms’ liquidity constraints. Futures are derivatives that take or hedge a position on the general level of interest rates. They are also “Mark-to-Market,” which means that, whenever the futures prices change, daily payments must be made. The collateral underlying the futures contract, as well as the futures contract itself, are both marked to market every day and requires daily cash payments. LIBOR, or London Interbank Offer Rate, is used as a reference for setting the interest rate on approximately $200 trillion of financial contracts ranging from home mortgages to corporate loans. However, about $190 trillion of the $200 trillion in financial deals linked to LIBOR are in the futures market. As a result, during this transition period, the price of these contracts swings daily, as the market perceives what the future value of alternative rate to be. In process, these fluctuations in prices generate cash flows that affect liquidity and funding positions of a variety of firms that use futures contracts, including hedge funds that use them to speculate on Federal Reserve policy changes and banks that use them to protect themselves against interest-rate hikes when they lend money.

To sum up, the shift from LIBOR to SOFR not only is changing market structure but also generating cash flow consequences that are putting extra pressure on money market rates. While banks and exchanges are expanding a market for secondary financial products tied to the SOFR, they are using futures to hedge investors from losing money or protecting borrowers from an unexpectedly rise on their payments. In doing so, they make futures prices swing. These fluctuations in prices generate cash flows that affect liquidity positions of firms that invest in futures contracts. Money markets, such as the repo, secure the short-term funding that is required by these firms to meet their cash flow commitments. In the process of easing worries, banks are consistently changing the market price of the futures, generating new payment requirements, and putting pressure on short-term funding market. To evaluate the effects of this transition better, we might have to switch our framework from the traditional “Finance View” to “Money View.” The reason is that the former view emphasizes the role of future cash flows on current asset prices while the latter framework studies the impact of today’s cash flow requirements on the firm’s survival constraints.

Central Banks and the Folk Tales of Money

By Pierre Ortlieb.

On June 10th, 2018, Swiss voters participated in a referendum on the very nature of money creation in their small alpine republic. The so-called “Vollgeld Initiative,” or “sovereign money initiative,” on their ballots would have required Swiss commercial banks to fully back their “demand deposits” in central bank money, effectively stripping private banks of their power to create money through loans in the current fractional reserve banking system.

In the build-up to this poll, the Swiss National Bank (SNB) tailored their statements on credit creation based on their audience: when speaking to the public, the SNB chose to promulgate an outdated “loanable funds” model of money creation, while it adopted an endogenous theory of credit creation when speaking to market participants. This served to mollify both audiences, reassuring them of the ability and sophistication of the SNB. Yet the contradicting stories offered by the SNB are part of a broader trend that has emerged as central banks have expended tremendous effort on trying to communicate their operations, with different banks offering different explanations for how money is
created. This risks damaging public trust in money far more than any referendum could.

***

At the SNB annual General Shareholders Meeting in April 2018, Governor Thomas Jordan was verbally confronted by two members of the audience who demanded Jordan explain how money is created – Jordan’s understanding of credit, they argued, was flawed and antiquated. Faced with this line of questioning, Jordan rebutted that banks use sight deposits from other customers to create loans and credit. The audience members pushed back in disagreement, but Jordan did not waver.

On the surface, Jordan’s claim on money creation is an explanation one would find in most economics textbooks. In this common story, banks act as mere intermediaries in a credit creation process that transforms savings into productive investment.

However, only months earlier, Governor Jordan told a different story in a speech delivered to the Zürich Macroeconomics Association. Facing an audience of economists and market professionals, Jordan had embraced a portrayal of money creation that is more modern but starkly opposed to the more folk-theoretical, or “textbook” view. Jordan described how “deposits at commercial banks” are created: In the present-day financial system, when a bank creates a loan, “an individual bank increases deposits in the banking system and hence also the overall money supply.” This is the antithesis of the folk theory offered to the public, presenting a glaring contradiction. Yet the SNB’s duplicity is part of a broader trend: central banks are unable to provide a unified message on credit creation, both internally and among themselves.

For instance, in 2014, the Bank of England published a short, plainly-written paper that described in detail how commercial banks create money essentially out of nothing, by issuing loans to their customers. The Bank author’s noted that “the reality of how money is created today differs from the description found in some economics textbooks,” and sought to correct what they perceived as a popular misinterpretation of the credit creation process. Norges Bank, Norway’s monetary authority, has made a similar push to clarify that credit creation is driven by commercial banks, rather than by printing presses in the basement of the central bank. Nonetheless, other central banks, such as the Bundesbank, have gone to great lengths to stress that monetary authorities have strict control the money supply. As economist Rüdiger Dornbusch notes, the German saving public “have been brought up to trust in the simple quantity theory” of money, “and they are not ready to believe in a new institution and new operating instructions.”

***

While this debate over the mechanics of money creation may seem arcane, it has crucial implication for central bank legitimacy. During normal times, trust in money is built through commonplace uses of money; money works best when it can be taken for granted. As the sociologist Benjamin Braun notes, a central bank’s legitimacy depends in part on it acting in line with a dominant, textbook theory of money that is familiar to its constituents.

Yet this is no longer the case. Since the financial crisis, this trust has been shaken, as exemplified by Switzerland’s referendum on sovereign money in June 2018. Faced with political pressures and uncertain macroeconomic environments, some central banks have had to be much more proactive about their communications, and much more frank about the murky nature of money. As quantitative easing has stoked public fears of price instability, monetary authorities including the Bank of England have sought to clarify who really produces money. In this sense, taking steps to inform the public on the real source of money – bank loans – is a worthwhile step, as it provides constraints on what a central bank can be reasonably expected to do, and reduces informational asymmetries between technical experts and lay citizens.

On the other hand, a number of central banks have taken the dangerous approach of simply tailoring their message based on their audience: when speaking to technical experts, say one thing, and when speaking to the public, say another. The janus-faced SNB is a case in point. This rhetorical duplicity is important as it allows central banks to both assuage popular concerns over the stability of money, by fostering the illusion that they maintain control over price stability and monetary conditions, while similarly soothing markets with the impression that they possess a nuanced and empirically accurate framework of how credit creation works. For both audiences, this produces a sense of institutional commitment which sustains both public and market trust in money under conditions of uncertainty.

Yet this newfound duplicity in central bank communications is perilous, and risks further undermining public trust in money should they not succeed in straddling this fine line. Continuing to play into folk theories of money as these drift further and further away from the reality of credit creation will inevitably have unsettling ramifications. For example, it might lead to the election of politicians keen to exploit and pressure central banks, or the production of crises in the form of bank runs.

Germany’s far-right Alternative für Deutschland, for instance, was founded and achieved its initial popularity as a party opposed to the allegedly inflationary policies of the European Central Bank, which failed to adequately communicate the purpose of its expansionary post-crisis monetary program. Once a central bank’s strategies and the public’s understanding of money become discordant, they lose the ability to assure their constituents of the continued functioning of money, placing their own standing at risk.

Central banks would be better off engaging in a clear, concise, and careful communications program to inform the public of how credit actually works, even if they might not really want to know how the sausage gets made. Otherwise, they risk further shaking public trust in critical monetary institutions.

About the Author: Pierre Ortlieb is a graduate student, writer, and researcher based in London. He is interested in political economy and central banks, and currently works at a public investment think tank (the views expressed herein do not represent those of his employer).

Victorian despite themselves: central banks in historical perspective

Central banks have not always been independent, inflation targeting bodies, and to treat them as such is to obscure their complex histories and alternative institutional constellations

Central banks have not always been independent, inflation targeting bodies, and to treat them as such is to obscure their complex histories and alternative institutional constellations. By Pierre Ortlieb.

Donald Trump’s most recent feud with the Federal Reserve reached a new peak late last week as the U.S. President lambasted the institution’s policy stance. “I don’t have an accommodating Fed,” he noted. Commentary on Trump’s outburst is perhaps even more alarming than his words themselves. For instance, The Week noted that Trump’s encroachment on Fed independence was “essentially unprecedented”; imperiling the central bank’s status as a guardian of price stability was reckless, foolish. This reading of the history of central banks is misguided, however. Our current paradigm of independent central banks deploying their tools to maintain low inflation is a deeply contingent historical phenomenon and obscures central banks’ frequent role as publicly-controlled institutions and fiscal buttresses throughout their centuries of existence.

The contemporary notion of independent, conservative central banks was enshrined gradually over the 1990s, a decade in which over thirty countries – developed and developing – guaranteed the legal and operational independence of their monetary authorities. This institutionalization of inflation-averse central banks has come hand-in-hand with an aversion to “inflationary” deficit financing and fiscal expansionism, which has been restrained by an exclusive focus on price stability. This has come to be treated as the best practice approach to central banking, a paradigm which, until recently, was rarely questioned among policymakers. Reaction to Donald Trump’s comments has been emblematic of this.

Yet the history of central banks shows them to be far more intertwined with states and treasuries than current commentary or policy would suggest. At their founding, central banks frequently served not as constraints on the state, but rather as fiscal agents of the state. The inception of the Bank of England (BoE) in 1694, for example, was the result of a compromise that granted the state loans to finance its war with France, while the BoE was granted the right to issue and manage banknotes. As a result of this bargain, the market for public debt in the United Kingdom exploded in the 18th century, and government debt peaked at 260 percent of GDP during the Napoleonic wars. This both facilitated the expansion of Britain’s hegemonic financial position and enabled the industrial revolution, as borrowing at low risk made vast industrial development possible.

Direct state financing was, however, not the only means through central banks fostered favorable monetary conditions and growth during this era. The use of various “gold devices” to manage credit conditions from within the straitjacket of the gold standard was commonplace. The Reichsbank, for example, granted interest-free loans to importers of gold and inhibited gold exports to establish de facto exchange controls and some degree of exchange rate flexibility.

Various central banks also pursued sectoral policies, lending government-subsidized credit at lower real interest rates to key developmental industries. The 1913 Federal Reserve Act, for instance, was designed such that it would improve the global competitiveness of New York financial institutions. It is important to note that at the time, these central banks were largely established as private institutions with government-backed monopolies; yet this did not alter the fact that, in practice, they served as crucial instruments for the expansion and development of Western economies. Beyond the US and the UK, central banks across Western Europe, such as the Banque de France (1800), the Bank of Spain (1874), and the Reichsbank (1876), served a similar initial function as developmental agents of their respective states.

Nevertheless, this was not a uniform or constant system. The existence of the gold standard itself constrained the use of monetary instruments to foster growth across developed economies during the late 19th century. Furthermore, Victorian-era British policy came to revolve around sound finance and fiscal discipline, as the use of a central bank to finance the national state was increasingly in tension with Britain’s central position in the international trading system. Inflationary fiscal deficits were seen as inhibiting growth and dampening international investment. This “Victorian model” focus on price stability produced a paradigm shift in the UK away from expansionary deficit financing towards more restrained policy.

Despite interludes, the use of central banks as macroeconomic instruments endured and emerged reinforced in the aftermath of the Great Depression and the Second World War. After 1945, governments across the Western world adopted full employment objectives as part of the consensus of “embedded liberalism,” a practice which often also involved nationalizing central banks, so they could serve as tools of macroeconomic policy. Credit allocation came to serve social goals, and central banks were given additional tasks such as managing capital flows to maintain low interest rates. In France, the Banque de France was brought under the umbrella of the National Credit Council, the institution charged with managing financial aspects of government industrial and modernization policies. While other countries employed different mechanisms in implementing this consensus, the overarching aim of monetary institutions serving social goals was broadly shared across developed countries in the postwar era, as it had been during the 19th century during the infancy of central banks.

This consensus of central banks undergirding fiscal policy fragmented and fell apart from the 1970s onwards. The experience of stagflation, the increasing influence of financial institutions in policymaking, as well as a growing academic consensus on the dangers of central bank collusion with governments, dismantled both the expansionary fiscal state and the subservient central bank. The “Volcker revolution” in the United States was a first step in the gradual, post-Nixon institutionalization of a price stability-focused, independent central bank. The Bank of England was granted operational independence in 1997 by Labour Chancellor Gordon Brown, while the ECB has been independent since its inception in 1998.

The current paradigm of independent, inflation targeting central banks thus obscures the messy history of central banks as public institutions. Since their inception, monetary authorities have performed various different roles; while they served as guardians of price stability in Victorian England, they have originally served as developmental and fiscal agents for expansionary states, and have frequently continued to do so in the centuries since. Treating central bank independence as an ahistorical best practice approach is misleading, and we should recall that there have been alternatives to the current framework. As some have heralded the end of the era of central bank independence, while others have underscored the benefits of re-politicizing monetary policy, it is worth bearing this history in mind.

The CFA Franc Zones: Neocolonialism and Dependency

French geopolitics in Africa is interested in natural resources. Initially, the franc zone was set as a colonial monetary system by issuing currency in the colonies because France wanted to avoid transporting cash. After these countries gained their independence, the monetary system continued its operation and went on to include two other countries that were not former French colonies. At present, the CFA franc zones are made up of 14 countries. The fact that even today the currency of these regions is pegged to the euro (formerly French franc) and that reserves are deposited in France shows the subtle neocolonialism France has been pursuing unchecked. It is a currency union where France is the center and has veto power. This is supported by African governing elites who rely on the economic, political, technical, and sometimes military support provided by France. It is no wonder then that these former colonies are not growing to their full potential because they have exchanged development through sovereignty for dependency on France. This article investigates the set up of the CFA franc zones, its ties to French neocolonialism and its ability to further breed dependency in the former colonies of West and Central Africa.

The CFA Franc Zones

The first franc zone was set up in 1939 as a monetary region with a the French franc as its main currency. In 1945, the Franc des Colonies Francaises d’Afrique (CFA franc) and the Franc des Colonies Francaises du Pacifique (CFP franc) were created. After independence, Morocco, Tunisia, Algeria, and Guinea left. The Central African Economic and Monetary Union (CEMAC) and the West African Economic and Monetary Community (WAEMU) are known as the two CFA franc zones. WAEMU has eight members: Benin, Burkina Faso, Cote D’Ivoire, Guinea-Bissau (a former Portuguese colony joined in 1997), Mali, Niger, Senegal, and Togo. Their common currency is the “franc de la Communaute Financiere de l”Afrique (CFA franc), which is issued by the Central Bank of the West African States (BCEAO) located in Dakar, Senegal. CEMAC has six members: Cameroon, the Central African Republic, Chad, the Republic of Congo, Equatorial Guinea (a former Spanish colony joined in 1985) and Gabon. Their common currency is “franc de la Cooperation Financiere Africaine”, which is issued by the Bank of the Central African States (BEAC) located in Yaounde, Cameroon. It is worth mentioning that the BCEAO and the BEAC were headquartered in Paris until the late 1970s.

Since 1948, the two CFA francs were pegged at the rate of 50 CFA francs per French franc. In 1994, the CFA francs went through devaluation, 50 percent to be exact. At present, the arrangement of France to the two unions are a fixed peg to the euro, a convertibility guarantee by the French Treasury and lastly, a set of legal, institutional and policy requirements. The CFA franc zone links three currencies: the two unions and the euro. The CFA franc is fixed at 655.957 per euro. WAEMU and CEMAC each have their own central banks that are independent of each other. The CFA francs can be converted to the euro, but cannot directly be converted into each other. The money is sent to France as an operations account in the French Treasury by the two central banks. Furthermore, “at least 20 percent of sight liabilities of each central bank must be covered by foreign exchange reserves, at least 50 percent of foreign exchange reserves must be held in the operations account and increasing interest rate penalties apply if there is an overdraft. France is also represented on the board of both institutions.” In “Colonial Hangover: the Case of the CFA”, Pierre Canac and Rogelio Garcia-Contreras explain,

“The functioning of the Operations Accounts is critical to maintaining the convertibility of the CFA francs at the official exchange rate while, at the same time, allowing the regional central banks to maintain some monetary autonomy. The Operations Accounts are credited with the foreign reserves of the BCEAO and the BEAC, but can be negative when the balance of payments of the CFA zone members is unfavorable. When this is the case, the French treasury lends foreign reserves to the two central banks. This special relationship with the French treasury allows the two African central banks to maintain the fixity of the exchange rate while allowing them to have some limited control over their monetary policy. The amount of borrowing allowed is unlimited although subject to several constraints in order to limit the size of the debt. First, the central banks receive interest on their credit in the Operations Account, while they must pay a progressively increasing interest rate on their debit in the account. Second, foreign reserves other than French francs or euros may have to be surrendered – a practice called ‘ratissage’, or additional reserves may have to be borrowed from the IMF. Third, the French treasury appoints members to the boards of the BCEAO and BEAC in order to influence their respective monetary policies and to ensure their consistency with the fixed parity. The autonomy of both African central banks is curbed by the French authorities, thereby prolonging the colonial relationship between France and its former colonies.”

Apparently, representatives from France fill important positions in the Presidency, Ministry of Defense, Central Bank, Treasury, Accounting and Budget Departments, and Ministry of Finance, which allows them to have oversight and influence policy decisions. One French scholar observed that ministries from Francophone African states make around 2000 visits to Paris in an average year. Adom shows the money kept at the French treasury earns no or very low interest for the franc zone nations. In 2007, the former Senegalese President, Abdoulaye Wade had stated that the funds can be used to boost investment, economic growth and alleviate poverty in the member countries instead of sitting in France.

After the 1994 devaluation, the two CFA francs were pegged at the new rate of 100 CFA francs per French franc. The reason for the devaluation was accounted to loss of competitiveness as the French franc appreciated against the currency of major trading partners. These zones competitiveness was in the French market, but not to world markets. In the 1980s, there was a fall in the price of raw materials and a depreciation of the dollar. As a result, the growth and export of these nations were impacted. The governments of these zones were facing budget deficits, which they financed by borrowing from abroad until the IMF refused to lend them any more money in 1993. As for trade between the unions, it is low due to an external tariff. Capital flows between these unions is highly restricted. The hope that a monetary union would increase trade among the CFA franc zones never materialized.

Neocolonialism and France

Kwame Nkrumah stated, “…imperialism… claims, that it is “giving” independence to its former subjects, to be followed by “aid” for their development. Under cover of such phrases, however, it devises innumerable ways to accomplish objectives formerly achieved by naked colonialism. It is this sum total of these modern attempts to perpetuate colonialism while at the same time talking about “freedom”, which has come to be known as neo-colonialism.”

In “Government accounting reform in an ex-French African colony: The political economy of neocolonialism”, P.J.C. Lassou and T. Hopper state, “colonialism does not cease with the declaration of political independence or the lowering of the last European flag. Decolonization is a formal facade if former colonies cannot acquire the socio-economic base and political institutions to manage themselves as sovereign independent countries. The modern manifestation of colonial and imperialist traits is commonly labeled neocolonialism, which is sometimes linked to ‘dependency’. Neocolonialism occurs when the former colonial power still controls the political and economic institutions of former colonies.”

France is carrying out neocolonialism by disguising this arrangement as a monetary union. These nations gave up their sovereign right to France. Neocolonialism is an impediment to development within African nations. France’s intervention was carried out through economic, political and militaristic ways. The ‘Accords de Cooperation’ was signed by African leaders who gained power with France’s help at independence. On the other hand, the ‘Accords speciaux de defence’ provided France power to intervene militarily to protect African leaders who protected France’s interests. Lastly, the economic accords require former colonies to export their raw materials such as oil, uranium, phosphate, cocoa, coffee, rubber, cotton … etc to France while importing industrial goods and services primary from France. Furthermore, these nations reduce or ban their raw material exports when French defense interest require.

Lassou and Hopper stress that accounting is a neglected part of development policies, especially in Francophone Africa. They share that “market-based reforms when applied in the South generally and Africa specifically…promote neocolonialism, enabling former colonial powers to retain control over political and economic institutions of former colonies to the advantage of multi-national corporations and trade whereby ‘Southern’ countries export cheap raw materials to ‘Northern’ countries and import high value-added goods and services in return.”

According to the Human Development Index, out of 187 countries, the last three and seven of the worst ten countries are from Francophone Africa. France’s neocolonialism approach is extremely subtle and paternalistic. The former French President, Jacques Chirac, said, “ We forget one thing: that is, a large part of the money that is in our [I.e., the French’s] wallet comes precisely from the exploitation of Africa [mostly Francophone Africa] over centuries.” In 2008, he went on to say, “without Africa France would slide down into the rank of a [third] world power.”

Dependency Theory and Francophone Africa

Africa, Asia, and Latin America have pursued sustainable development since gaining independence. However, a few countries succeeded in actually developing their economies. In the 1950s, Raul Prebisch and other economist came up with the dependency theory, which explains why “economic growth in the advanced industrialized countries did not necessarily lead to growth in poorer countries.” Prebisch suggested that poor countries (periphery nations) exported raw materials to the developed countries (center nations) and imported finished goods. Moreover, there is a dynamic relationship between dominant and dependent states. Andre Gunder Frank claimed that the capitalist world system was divided into two concentric spheres: center and periphery. The advanced center countries need cheap raw materials from the underdeveloped periphery as well as a market to send their finished products.

It has been decades since African countries gained independence. However, this independence was replaced by a dominance-dependence relationship known as post-colonialism. A dominance-dependence occurs “when one country is able to participate in a definitive or determining way in the decision-making process of another country while the second country is unable to have the same participation in the decision-making of the first country.” Furthermore, the foreign and domestic policies of the independent African nations continue to be influenced by outside powers, especially their former colonizers. The post-colonial relationship when it came to former French colonies is the dominant role held by France.

French colonialism was one of state colonialism. It was one of direct rule where native chiefs assisted French administrators, which led to the rise of local elites who were educated in the French system. The former colonies were indoctrinated with French culture, language, and law. In the time of independence, sub-Saharan colonies decolonized in a non-violent way while former British colonies gained their independence through war, a violent way that loosened the relationship towards Great Britain. Because freedom from France was carried out through non-violence, it came naturally for local elites to take power and continue their strong ties with France.

Through the CFA franc zone, France is able to control the money supply, monetary and financial regulations, banking activities, credit allocation, and budgetary and economic policies of these nations. In addition, it breeds corruption and illegal diversion of public aid between France and its former colonies. For instance, conditional French public aid has forced these African states to spend the ‘aid’ money on French equipment, goods or contracts with French firms, especially construction and public work firms.

S.K.B. Asante points out that regional integration approaches do not remove the neocolonialism and dependency the African continent faces. He states, “none of the regional schemes have adequate provisions for attacking the all-embracing issue of dependency reduction nor have the efforts made towards this objective had any significant impact…the problem of dependency poses difficulties for African countries attempting a strategy of regional integration. Dependency serves as an obstacle to de-development it not only limits the beneficial effects of integration in both national and regional economy.”

Economic Performance of the CFA Franc Zones

France is the main trading partner of the CFA franc zones. CFA franc zones, unlike other African nations, have avoided high inflations due to France. The two zones between 1989 and 1999 had 33 percent of imports and 40 percent of Foreign Direct Investment from France. These regions are highly dependent on France. Despite their ties to France, these CFA franc zones remain extremely poor. The two regions had a population of 132 million in 2008 where 70 percent are in WAEMU and 30 percent are in CAEMC. Their total GDP is equal to 4 percent of the French GDP. These regions are “producers and exporters of raw materials, including oil, minerals, wood and agricultural commodities, and agricultural commodities, they are highly sensitive to world price fluctuations and the trade policies of their trading partners, mainly the EU and the US. Their industrial sectors are rather underdeveloped.” Non-oil producing nations within the CFA franc zones have very low GDP per capita.

According to Assande Des’ Adom, even after the currency was devalued, the CFA franc zones still suffer from currency misalignments. Adom points out, “the current monetary arrangements between the former colonies and France were designed based essentially on the economic interest of the latter. A prominent Ivorian economist goes even further to explain how franc zone’s member countries indirectly finance the French economy through these peculiar monetary arrangements.”

The CFA franc zone is challenged by globalization, volatile oil and raw material prices in addition to regional security problems. It can be argued that the “dependency and neocolonial practices surrounding the relationship between France and former colonial possessions in Africa is the inability of CFA countries to build up monetary reserves.” In today’s world, control of a country is carried out through economic and monetary ways. Nkrumah had warned

“The neocolonial state may be obliged to take the manufactured products of the imperialist power to the exclusion of competing products elsewhere. Control over government policy in the neo-colonial state may be secured by payment towards the cost of running the State, by the provision of civil servants in positions where they can dictate policy, and by monetary control over foreign exchange through the imposition of a banking system controlled by the imperial power.”

In conclusion, the CFA franc zones continue to be dominated by the political will, economic interest, and geopolitical strategy pursued by the French republic. It seems some elite leaders do not wean away from France’s influence. President Omar Bongo of Gabor said, “France without Gabon is like a car without petrol, Gabon without France is analogous to a car without a driver.” The previous quote can be applied to almost all of the franc zone nations. The set up of the currency unions benefits France more than its members. French colonialism is preventing the development of these nations and causing them to be dependent.

Taxes and Turmoil in Lebanese Politics

A series of protests have begun to rock Lebanon as of mid-March 2017. Protesters are taking to the streets to denounce the Lebanese government’s plan to introduce or increase 22 new taxes on citizens, most notably increasing the VAT tax from 10-11%, as well as various other taxes on food, drink, public notary services, and other categories that stand to impact daily purchases in the country. These measures will further reduce spending power of average Lebanese citizens during a time period when poverty has already risen by 66%(!) in the past 6 years, when around 30% of the population lives below the poverty line, when 9% of the Lebanese population lives on less than $1 per day, and when Syrian refugees continue to pour into Lebanon by the millions, further exacerbating Lebanese economic woes. Furthermore, Lebanon is the 3rd most unequal country on this planet in terms of wealth inequality, and this inequality implies that these new tax measures will primarily impact those who are already struggling to survive, let alone maintain a decent standard of living. In fact, these newly proposed taxes will be what economists call a “regressive tax,” since they will consume a bigger portion of the poor’s income compared to the rich.

The biggest complaint, rightfully so, of the protesters is that Lebanese politicians, with their entrenched system of confessionalism and nepotism, have stolen from public funds to aggrandize their own wealth, and have left the average Lebanese citizen struggling to survive off of the crumbs tossed to them. This rampant corruption, culture of excess, and paralysis of state oversight has contributed to a debt-to-GDP ratio of 140%, one of the highest in the world. Despite such mounting debt, the Lebanese government has little show for it in terms of providing services to the public.

For example, the Lebanese government cuts off electricity for several hours a day throughout the country— sometimes as much as 40-50% of the day, and claims that there are simply no public funds available to provide electricity for a full 24 hours. This is where the new tax proposal comes in; the government maintains that their hands are simply tied, and that these painful measures are needed to make a dent in paying off the public debt. However, when we examine the issue of public debt from the perspective of Modern Money Theory (MMT), we find that this idea is based on ignorance of how taxes and spending work at the public level.

MMT asserts that any sovereign government is capable of printing its own money into existence to pay for anything that it wishes to, from public healthcare to defense to infrastructure, or any other government-funded project. Because the government can create money out of nothing by simply printing it, or electronically transferring it to bank accounts, this by definition removes the necessity to collect taxes as a form of revenue to pay for things. The Lebanese government, for example, could have enough money to pay for electricity 24 hours a day if it simply created money to pay for it by electronically transferring the sum to the bank accounts to pay electricity companies. All of this can be done without ensuring that there is an equal amount of taxes flowing into the government, because the government does not use these taxes to pay for things. It pays for things by creating money out of nothing.

With this understanding, we can then reverse the causal relationship between taxes and public spending: taxes do not fund public spending. Rather, public spending creates the money by which citizens can conduct economic activity, including paying taxes. This is not an example of the classic “chicken vs. egg” conundrum. In this case, we can definitely say which side came first, for logical reasons. Citizens would simply not be able to pay taxes unless they had the money to pay for them in the first place, which in turn must be created by the government and released into the economy through public spending.

This implies that the government’s debt and deficit, as a matter of principle, does not matter to the public sector in the same way that a debt would matter to a household or firm. Government can always print more money in order to pay for things, including interest on debts. If a household tried to create its own play money and offer it to the credit card company at the end of the month, it would be rightfully ridiculed. However, because the government’s currency is universally recognized as bestowing the holder with value, it is accepted anywhere, and for “all debts, public and private.” In effect, it is the sovereignty of the state, and the credibility of their power to meet contractual financial obligations, that gives the money its value.

So, what then is the purpose of taxes, if they are not used to fund government spending? Primarily, taxes are a way of the government asserting sovereignty over its citizens. By denominating the taxes levied on citizens in the currency that they print, the government ensures that there will always be a widespread demand for its currency that people need to obtain to pay taxes. This ability to create money out of nothing and to generate widespread demand for it is a powerful component of state sovereignty, and, as other articles attest, the modern state as we know it would not even exist today without this power.

Taxes also serve another important economic function: they limit how much money a person can spend (purchasing power). When the government is worried about inflation (rising prices throughout society) brought about by rapid economic growth, for example, increasing taxes would be one way of decreasing spending in the entire economy, thus counteracting the threat of inflation. However, what does this mean for a country like Lebanon with a sizable percentage of its population living under the poverty line, and where the problem is too little spending and economic growth, not too much?

If Lebanese citizens have to pay increasingly higher taxes on daily necessities, their purchasing power will shrink. As their purchasing power and consumption declines, businesses will suffer. Investment and employment rates would likely decline, and poverty would increase. This increase in poverty would translate into citizens having even less money to contribute to taxes, since they would be consuming less and would have a smaller income. In such a situation, instead of these new tax measures decreasing the government debt, it is conceivable that they would actually do the exact opposite by increasing it, due to a decline in consumption and income, which are two of the biggest sources of taxes for the Lebanese government.

To conclude, it is time to admit the problems facing Lebanon are much more complex and fundamental than any new tax proposals would ever fix. Taxes do not create revenue for government spending, and in fact, new taxes in the country would even threaten to propel the already unacceptably high poverty line in the country even higher, as incomes and purchasing power are eroded. There is no reason to believe that the government debt even needs to be paid off in the first place, since government can never run out of money to pay for things, including debt servicing payments. Rather, the most fundamental problem in Lebanon is a political system characterized by diversionary religious sectarianism, and a culture of corruption and disdain for the masses that have allowed the Lebanese politicians to usurp public funds for personal gain, all while keeping a stranglehold on the people’s aspirations for freedom and dignity for decades.

Written by Stephanie Attar
Stephanie is part of the third group of students studying at the Levy Institute. Prior to coming to the Levy, she completed a masters degree in political science, with a concentration in political philosophy. Her research always incorporates Marxian dialectical materialism in order to analyze the interconnected nature between the state and the economy. She is also interested in the Arab world, global inequalities engendered by capitalism-imperialism, and radical solutions to advance the interests of humanity.