What Central Banks Around the World Should Do to Avoid a Financial Crisis

Tl;dr: by cancelling a part of the national debt owned to central bank and keeping inflation low, it is possible to decrease the economic cost of the pandemic crisis.

In a recent article on the quarantine, I explained the economic and financial cost that the pandemic had brought upon us and how the lockdown had destroyed the economy.

The unfavorable economic situation the EU was already in before the pandemic did not help either.

So How Do We Get Out of That?

We need to understand where money comes from.

At the very beginning, money was mined out of the earth (copper, iron, gold).

Today, money is printed by the central bank.

However, nothing comes for free. When the central bank lends the state money (it cannot lend money to anyone else), the state can use it.

But if we can print money, why isn’t everyone rich?

Because money in the economy does not matter. What matters is what the economy produces. The total amount of money should at all time, reflects the value of the total of goods and services produced in the economy.

If the amount of money in the economy is 10 euros, and if the economy produces 10 cars, each car should cost 1 euro. If the economy produces 5 cars, each car will cost 2 euros.

Money does not matter. It’s simply a manner to estimate the price of a good. The price will change according to the ratio money/total value of goods that exist in society.

This is why printing money, such as Germany in the 1930s (we all know what happened afterward), Venezuela in 2018, Zimbabwe in the 2000s did does not fix any problems. The problem is always a production problem. It’s not about printing more, but about producing more.

As explained above, prices vary according to the volume of money compared to the value of goods and services produced in society. An increase in prices is called inflation. A decrease in prices is called deflation.

Inflation is not what we generally think and it can happen in several ways.

I’m not pretending to list all of the ways inflation can happen, I’ll just list two ways, the most interesting ones: inflation as a supply/demand effect and inflation as currency printing in a multi-currency economic area.

The Supply/Demand Effect

Let’s take a country that did not suffer from the 1929 US crash: the Soviet Union.

The Soviet Union in 1929 was completely closed off and circular.

The USSR imported very little from other countries and exported very little as well.

So when the shock hit the worldwide economy, it did not hit the Soviet Union since it wasn’t integrated into the worldwide economy.

Now let’s say that the Soviet Union, at some point, decides to print some cash and put it into the hands of the population. The citizens would have three choices: they could whether invest this cash, keep it, or spend it.

Should they decide to invest it, the value of companies would go up.

Should they decide to spend it, there would be inflation.

Should they decide to keep it under their mattress, the printing would have absolutely no effect on the economy.

And this is key!

It is not ultimately the printing of money that creates inflation in a closed-off economy. It is what you make of it.

Why?

Because of the supply and demand equilibrium.

If a commodity, let’s say oil, sees more demand (people that want to buy) than supply (people that sell), the seller will be able to raise its price and offer oil to the highest bidder.

In 2007 for example, the economy was running well and everyone thought the oil reserves were emptying off super fast. As a result, oil enjoyed high demand and became more expensive.

In April 2020 though, there was so much oil in the market that at some point, it went into negative prices.

Yes: you could have been paid to take physical delivery of oil.

So, printing is one way to create inflation.

If you increase the amount of money that is spent in the economy and if the supply of commodities remains the same, the increase in demand will stimulate an increase in prices.

If you do the opposite though, that is, decreasing the amount of money, the demand for goods will decrease and so the prices too. That is deflation.

Printing money therefore does not de facto provoke inflation in a closed-off economy. The money needs to be spent.

The Value of a Currency in a Multi-Currency Economic System

What we have just seen concerns the case of Russia in the 1930s.

For the rest of the countries, the value of their currency is quoted in comparison to the value of other currencies.

Broadly speaking, the value of one currency reflects the attractiveness of the currency. What does it mean?

A currency is attractive if it can get you the stuff you need.

Let’s say that Saudi Arabia is the only country in the world that produces oil. The world needs oil and needs Saudi Riyal to buy this oil.

The Riyal will therefore have a high value because a lot of people need Riyal to buy the oil.

They will go to the Saudi central bank and exchange their € or US$ against Riyal to buy some oil.

The oil producer will receive these Riyals, go back to the central bank and exchange them for € so she can go to Belgium for holidays.

That’s the world of currencies.

The more important an economy is, the more important the currency.

Today, the importance of an economy depends on its size, productivity, and product rarity (measured in the number of patterns and innovation, or sometimes, in terms of natural resources even though the reality is a bit more complicated).

The most innovative economies in the world rated in patterns are the US economy, the Japanese economy, the Chinese economy (China is a different story though), the Swiss economy, and the Euro economy.

So, we can reasonably assess that their currencies have a high value.

Now, what happens once Switzerland decides it needs to acquire a lot of products from a € country?

It will print some Swiss Francs, go to the European Central Bank, and exchange them against €.

In the beginning, the ECB will be happy to exchange Swiss Francs against € because many people need Francs to buy products in Switzerland.

The more Francs get exchanged though, the less enthusiastic the ECB gets because it already has some Francs, and so the Franc is slowly losing its value.

In the beginning, maybe a Franc could be exchanged for 1€. But as the ECB is getting Francs, it demands more and more Francs to exchange against 1€.

It is, therefore, more and more expensive for Swiss to exchange their Francs in €.

A medicine bought in France used to cost maybe 10 Francs to an importer that would sell it in Switzerland for 15 Francs. As the Franc is losing value due to printing, the medicine costs now the importer 15 Francs and he has, therefore, to sell it for 20 Francs in Switzerland to make a profit.

Everything that is imported is getting more expensive: it’s inflation, created by a loss of value due to an increase in exchange volume of a currency. Similarly, everything in Switzerland becomes cheaper. Europeans are therefore happy to go exchange their Euros against Francs to buy Swiss goods. As a result, the price of the currency finds an equilibrium.

Now, we understand how inflation happens. In most cases, high inflation is a consequence of high internal demand for foreign products, poor innovation at home, poor productivity at home, and excessive money printing.

Inflation can also be created by economic sanctions: if the US decides to punish everyone that will deal with the Iranians, no one will want to deal with the Iranians and the Iranian currency will lose value because no one will be buying Iranian currency to buy in Iran.

A combination of the three happened in Venezuela, which saw inflation of…10 000% in 2019.

How Can We Fix the Crisis Induced by the Pandemic?

In the US, the Fed has been printing unlimited money (March-April-May 2020) to bail out companies and avoid them bankruptcy.

Now, you might think that it will trigger inflation, but it will not.

First of all, US consumers have a lot of debt and when they don’t have debt, they don’t have much money due to social-economic inequality.

As such, a crisis will not get US citizens to spend more but less (because salaries have and will decrease), even though the Fed is printing money like degenerates.

Second of all, the US economy remains the biggest and most developed economy in the world.

The US$ represents 70% of the worldwide currency reserve.

A Chilean company buying products in Kazakhstan may very well buy in US$ because the Chilean company probably sells in the US (and therefore owns US$) while the Kazakh company probably wants to buy products in the US (and therefore needs US$).

The US economy is so big and important that everyone wants and likes US$, which prevents the US$ from losing its value.

There is another phenomenon. We said earlier that a currency is losing value when its volume exchanged increases regarding other currencies.

As the entire world entered quarantine, everyone has been printing money.

If everyone is creating more currency volume, the value of currencies in comparison to each other, will not change much.

And that brings us to the solution.

The Solution

The reason why a country needs to refund its own central bank is to avoid inflation, or stagflation (extreme inflation Venezuelan style).

This pandemic case is unique and different.

The lockdown has virtually immobilized huge parts of the worldwide economy.

People ran out of cash. It’s a liquidity problem, so everyone has been printing to put cash into the hands of these people.

In a time when people don’t spend (like now), the economy is at risk of deflation.

If people who got cash need to refund this cash, this will only exacerbate the deflation problem as they will spend less to refund their debts.

Refunding the central bank of the money that has been printed is, therefore, more harmful than good.

Economic agents (countries, companies, people) with too much debt eventually become strangled by their debts.

They can’t produce anymore, which means the country loses on tax and spends more on unemployment benefits, can’t refund its debt and the whole thing turns into a vicious circle that leads to authoritarianism and social crises.

The solution to the financial crisis is therefore quite simple: cancel the debt from the central banks.

This will enable countries that have difficulties like Italy (or France) to breathe a little and reform so that they can be more efficient and in the future, avoid such a borrowing problem.

To Conclude

John Adams, the second US President, said the following:

“There are two ways to conquer and enslave a nation. One is by the sword. The other is by debt.”

Athene, in -515, almost fell into anarchy because the rich had become too rich and the poor had contracted debts they could have never repaid.

To solve this, debts were canceled, slaves that had been enslaved because of debt were freed and democracy was installed to benefit the Athenian society overall.

The rich lost a bit, but it eventually saved the economic system and so everyone at the same time.

Systems are not perfect.

Sometimes, your hard drive is overheating, your motherboard goes crazy, or your graphic chipset bugs.

What do you do when it happens?

You reset.

It’s time to reset the world economy and start afresh.

Photo credits: Photo by Ehud Neuhaus on Unsplash