The tragedy of the Euro.

• Author: Bagus, Philipp
• Position: Essay

The Eurosystem, the monetary system in the European Monetary Union (EMU), has brought the euro to the verge of collapse. We can understand how this situation arose in terms of the theory of negative external effects and the tragedy of the commons. Poorly defined property fights in money can cause negative external effects to be neglected. In practice, the EMU has evolved into a tragedy of the commons because several independent national governments have made use of the European Central Bank (ECB) to finance their deficits indirectly.

The theory of the tragedy of the commons states that a publicly owned good will tend to be overexploited and disappear. The euro and its purchasing power are following this course. The euro is threatened by independent states' trying to finance their deficits via the ECB and to externalize part of their deficit costs in the form of higher prices in the EMU. This mechanism of a tragedy of the commons has contributed to the current sovereign-debt crisis in Europe. In this article, I explain how a tragedy of the commons exists in the EMU because of public property in money and how it is caused by the possibility of financing deficits through a single central bank.

External Costs and the Tragedy of the Commons

A tragedy of the commons, a term coined by Garrett Hardin (1968), is a special case of the external-costs problem. External costs generally occur when property rights are not well defined or defended and a single privileged actor can externalize costs on others (Mises 1998, 651). (1) If the actors are not fully responsible for the effects of their actions, they will not take into account all the consequences of these actions. This situation is exemplified by a factory owner who is allowed to dump waste in a lake.

External costs also occur when fiat money is issued. Fiat money is a medium of exchange that the issuer (the state) puts into circulation backed by no collateral except the paper on which the notes are printed. Residents are then forced to accept this kind of money as a means of payment (legal tender). Fiat money thus represents an encroachment on the principle of freedom of contract. People cannot do with their property what they want but are forced to accept fiat money in exchanges and to use it for tax payments. If no one had to accept public paper money, no external costs would be incurred. People could simply decide not to accept fiat money.

Given the absent private-property rights in money production and a monopolist producer of fiat money, the benefits of the production of money accrue to its producer, and external costs take the form of rising prices and, in most cases, a lower quality of money. (2) These external costs are imposed on all users of fiat money. The additional monetary units allow their holders to bid up prices.

The main beneficiary of the central bank's increase in money supply is the government, for two reasons. (3) First, increases in the money supply lead to profits called "seigniorage." Central-bank profits are remitted to the government at the end of the year. Second, central banks can finance government directly by buying government bonds or indirectly by accepting government bonds as collateral for loans to the banking system.

In a tragedy of the commons, a specific characteristic is added to the external-cost problem, and several actors exploiting one property can externalize costs onto others. Not only can one factory owner dump waste into the private lake, but two or more can do so also. Not only can one central bank produce base money, but several can.

The traditional example of a tragedy of the commons is common property such as public beaches or schools of fish in the ocean. They are exploited without regard to the disadvantages that can be partially externalized. The users obtain benefits, but the costs are externalized. By fishing the school, a fisher obtains the benefits; however, all fishers bear the cost of a reduced school size. If someone has private-property rights in the school, he will fully assume the costs of reducing the school's size and will have an incentive to care for its long-term preservation. When the school is public property, however, everyone has an incentive to overfish (that is, to overexploit) the resource because the benefits are internalized, and the costs are partially externalized. All benefits go to the first fisher, but the whole group shares the damage suffered through reduction of the school. In fact, each fisher has an incentive to catch fish as fast as possible, knowing the other fishers' incentive.

The concept of the tragedy of the commons can be applied successfully to other areas, such as the political system. In a brilliant article, Earl Brubaker applies it to the public budget: "[T]he budgetary process converts private property into common property 'up for grabs'" (1997, 356). The public treasury is open for exploitation by interest groups. The result is a push for a continuous increase in the public budget and a fight over its distribution.

Overexploitation of public property can be restricted in several ways. The simplest way is to privatize public property and to define and defend private-property rights. Another solution is to use moral persuasion and to educate the actors who exploit the commons. For example, fishers can be persuaded to voluntarily restrict their exploitation of the school. A further option is to regulate the commons to restrict its overexploitation. Garrett Hardin (1968) calls such regulated commons "managed commons": the government limits the exploitation. An example is the introduction of fishing quotas that provide every fisher a certain catch per year. Thus, each fisher receives a monopoly right that he will try to exploit fully. Because he is the only owner of this right, there are no external costs. Thus, overexploitation is prevented.

The Tragedy of the Commons and the Euro

Although the external effects of a monopolistic money producer are common in the Western world, the euro's establishment has created a unique layer of external effects and a tragedy of the commons. Within the EMU, all governments can use the ECB to finance their deficits indirectly. So there is a tragedy of the commons in base-money production. As already noted, a central bank can finance a single government's deficits by buying government bonds or by accepting them as collateral for new loans to the banking system. Within the EMU, several governments can finance themselves via a single central bank, the ECB.

When governments in the EMU run deficits and issue bonds, a large amount of these bonds are bought by the banking system. The banking system buys these bonds because they are accepted as collateral by the ECB in its lending operations. (4) The banks presenting the government bonds as collateral receive new base money from the ECB. The banks then create new money by credit expansion, exchanging the money against government bonds and using the government bonds to refinance with the ECB. The end result is that the government has financed its deficits with new money, and the banks have received new base money by pledging the bonds as collateral.

This scheme's incentives are clear. The first users of the new money benefit. Governments and banks have more money available; however, prices have not yet been bid up. When governments start spending the money, prices are bid up, and incomes increase, mainly in the deficit countries. As prices and incomes increase in the deficit country, the new money flows abroad, where the effect on prices has not yet been felt. In this way, the new money spreads through the whole monetary union.

The deficit countries that first use the new money win. They have a higher monetary income before prices start to rise. They benefit at the cost of the new money's last receivers, who are mainly in foreign member states that do not run (such high) deficits. The last receivers lose as their incomes start to rise only after prices have increased. The benefits of the increase in the money supply go to the first users, whereas all users of the currency share the damage to the monetary unit's purchasing power. The consequence is a tragedy of the commons. Any governments running deficits can profit and offer the gift of a more balanced budget to its voters at other governments' cost.

In fact, this setup can be compared to a situation in which several individuals possess a printing press for the same fiat currency. These...