How To Fix A Central Bank

A conversation with Economist John Cochrane on the Rasheed Griffith Show

Jul 15, 2025

Show notes

Rasheed and economist John Cochrane discuss the structural complexities of the Eurozone’s monetary system, focusing particularly on TARGET2 balances. Trade imbalances within the Eurozone are no longer offset through private financial claims, but have instead created a vast network of public-sector IOUs among national and central banks.

The transformation of the Euro into a fiscal conduit has introduced new risks, especially in the case a country exiting the Eurozone, leaving its massive debts unpaid. Cochrane emphasizes that monetary and fiscal policies are inseparable, particularly in a high-debt environment, and suggests that the architecture of the Eurozone should reflect this integrated reality.

Join us for this informative episode as we also tackle contemporary banking mechanics, including CBDCs and the Fed aversion to narrow banking, alongside growing pains like ballooning US debt and a regulation-encumbered banking system.

Follow John Cochrane on X

Follow Rasheed Griffith on X

Okay. So my first question is on TARGET2, especially on TARGET2 balances inside the Eurozone that look a lot like IOUs between central banks, which I think is a view you share, but some people would argue that no, it's just accounting data and therefore risk-free. So what are the hidden assumptions that those people are missing?

John: Risk-free or not risk-free is a- those are separate question. Let's unpack this. Suppose someone in Italy or Spain buys a Porsche from Germany. They gotta send money to Germany, right? And the way this normally works with trade is if you have a trade deficit, there's a corresponding capital account surplus.

What does that mean? That means that one, the money goes to Germany, but Germans don't wanna sit on money. They end up having to hold Spanish or Italian securities, loans, stocks, bonds, something like that. So you're gonna have imports of goods. You trade a claim, some financial claim, in the other direction.

That's how it's supposed to work, but that's not how it ended up working in the Eurozone. Through a combination of unintended effects of the ample reserves regime, the way it works now is that a large fraction of the trade deficit, the money simply goes and sits there, and it sits there on the central bank's books.

So what ends up happening is. The Spanish person buying a Porsche commands his bank to give the Central Bank of Spain some money. The Central Bank of Spain gives that money to the European Central Bank. The European Central Bank gives that money to the bank in Germany, and it just sits there so that rather than Germany accumulating claims on the Spanish economy, the German Central Bank ends up accumulating claims on the ECB, which accumulates debts from Spain.

So this is transferred through central banks rather than through private securities. Okay I hope you don't mind, when we were writing this book, it took me a long time to understand TARGET2. I hope I do understand it now. Now, what's weird about this is now we have trillions of euros.

The ECB owes the German Central Bank trillions of Euros. And the Spanish Central Bank owes the ECB trillions of Euros, all of it paying low, supposedly risk-free interest rates. Rather than this going through, Germany holding, say, bank debt in Spain that then finances Spanish investment.

Now, is that good, bad, or dangerous? There are trillions of overhangs. Were Spain to leave the Euro, Spain might well say, tough luck. We're not paying that. Where are we supposed to get a trillion Euros?" And I think that is the that's the sense of risk, and to the larger question, this is not money.

This is fiscal, these are assets, this is wealth. So the Euro system, which was supposed to just be the common currency for Europe, has ended up managing a trillion Euros. I forget, but that's the size of the numbers. A trillion euro promise of debt of Spain to the ECB and debt of the ECB to Germany to the German Central Bank.

And that was not the intention of the Euro system to channel these fiscal transfers and tri-fiscal promises and lending, and so forth. Sorry about the long answer, but the minute you say TARGET2, it's like a bowl of spaghetti.

Rasheed: There is a, even today, people even, I would say professional monetary economists, they always conflate or, probably don't conflict enough, fiscal and monetary when they're having their models or even their intuition pumps.

And every time I have a conversation with someone, they say, "Oh, but this particular bond portfolio, but okay, fine". But still, when you think about your totality of things, you can't do that clean separation.

John: Yes. Hallelujah! No, of course. I'm pedaling two books, "The Fiscal Theory of the Price Level" and "The Crisis Cycle" with Luis Garicano and Klaus Masuch, which are fundamentally dedicated-

Rasheed: I have that book here.

John: Ah, thank you. I gotta sell some books. They're dedicated to the proposition that fiscal and monetary policy are always integrated. They're always part of the same thing. Now, in some circumstances, the fiscal part is less important. As the Euro is set up and has evolved, and as our governments are more and more indebted, the fiscal and monetary linkages are stronger, so always and everywhere, inflation, especially, is a combination of fiscal and monetary policy.

Rasheed: Okay. And the next question. Euro skeptics often say that the Euro straitjackets a country that needs its exchange rate. It's a very common comment. If Finland, for example, could float tomorrow, how much would they buy?

Maybe 5% growth? Or would they just crash out?

John: I'm sorry, who could leave tomorrow?

Rasheed: Finland. If Finland were to leave the zone, for example.

John: Finland. Oh boy. It was hard enough to know about the economy of Spain. And now you want me to know the economy of Finland. Now, Finland, it strikes me, as an ignorant American, it strikes me a fairly well-run country.

Norway's doing fine with its currency and Denmark, and it is doing fine with its currency. The UK is doing okay. But should Greece and Spain have their own currency, I think it is a harder question. So this is a… I'll try to be honest, rather than just give my opinion.

There's this question of the "optimal currency area" in economics. Who should share a currency, and who should have their own currency? I think my lovely house in Palo Alto should have its currency, and anytime there's a negative shock, I should get to just print money and offset the negative shock to the Cochrane family balances.

Maybe not. That's too small. So clearly you want some scale. And in Europe, of course, having a common currency helps have a common market and economic integration. The counterargument is first for the smaller. So one, the argument for bigger is we shall be using the meter, sorry, fellow Americans, why should we?

In Europe, every town used to have different units of measurement. That's crazy. We should all use the same units of measurement. We should use the meter and the degree Celsius, and, sorry, America. Okay, we're down to two. America goes its way, and everyone else uses the meter, but the standard of value, why should we use a different standard of value?

So the argument goes. Prices do vary across countries. I just drove from New Mexico to California. The price of gas is like $2 and 50 cents in New Mexico and $6 in California. It's like living in a different country. It's not clear why we have the same currency.

But the big argument is that sometimes it's hard for prices to change. So, if you let the currency change instead, it's easier on the economy to have the currency change rather than the price change. If the economic fundamentals require wages to go down in Spain relative to Germany, it would be easier to simply bring back the peseta.

I hope I got that right. And I'm used to doing Italian examples. Bring back the peseta and devalue the peseta rather than let the wages go down.

So the argument is that Central Banks and their infinite wisdom can artfully devalue the currency just enough to offset various shocks.

Now, when you look at the history of that, I don't know Spain enough, but I certainly know Italy and Greece. How much did Italy and Greece grow because of their Central Bank's artful ability to just slightly devalue shocks? How well has Argentina done by its Central Bankers, artfully devaluing shocks? Or was having your currency in a small country simply a piggy bank for the government to inflate its way out of trouble periodically?

And as a result, nobody would lend money to the government, and it inhibited private markets, 'cause interest rates are always high. After all, we're waiting for the next devaluation or inflation to come along. So, having a joint currency is a fiscal pre-commitment. It says we will not, we may not inflate away the debt this time, and if we default on the debt, it's gonna cause big pain.

You're tying yourself to the mast. As it did to Greece and Spain, they made that pre-commitment. They joined the euro inflation ended. They were able to borrow at incredibly low rates. And they overused the capacity to borrow. So then those pre-commitments all came through, you tied yourself to the mast, and then the ships started sinking.

But tying yourself to the mast was a good thing and should have been exploited more wisely. So those are the thoughts that lead me to conclude that larger currency areas are better. Economic integration, easier trade, and the fiscal pre-commitment that especially countries with weak fiscal institutions, weak central banks will not inflate.

They put that whole decision off to somebody else. I think those benefits are greater than the supposed ability of a small country's central bankers to offset some shock somewhere. And if it's difficult to have prices fall, which is this, that, that is the standard economic thing, oh, prices falling or terrible.

Why then do we have so many laws making it hard to lower prices and wages, right? All of macroeconomics is right, now there is one problem. Recessions are costly because of one thing and one thing only that prices are somewhat sticky. Instead of having central bankers exploit this. Why don't we get rid of all the laws that force prices to be sticky, and then we get rid of the problem?

Now, maybe there's other, you, macro, we don't know what recessions are, but at least intellectual coherence demands that we think about what's called, structural problems, internal devaluation, rather than just counting on every time the Cochrane family finances are in trouble we'll just devalue the "Cochrane dollar" a little bit.

Rasheed: It sounds like, I'm not sure how familiar you are with the Charles Kindleberger key currency argument where he's very, I guess maybe not influential, known in some parts for a particular idea he had where he used currency or money as a metaphor language where it's good to have one world language.

It's good to have a very few sets of languages that people can communicate with. It's better for world peace, for world trade, and for world commerce. Why not have one world currency or at least go towards one in the trend? And it is always a bit confusing to me why the intuition is always the opposite direction because it's not like you're, like, economics training has models.

Even the normal person, the intuition is let's have more currencies. I'm from the Caribbean. The Caribbean proper has a lower population than London yet has 13 currencies.

John: Yeah. And one of the genius things that's genius to the United States is we have one currency, right? Even though economic conditions between New Mexico and California are so different.

So I agree. That's why I started with the example of common weights and measures. I think that it's perfectly clear that there's just no useful purpose and just having countries have separate ones and we don't set, we don't have the Bureau of Weights and Measures say, oh, there's a recession on.

Why don't you cut the yard down a couple of inches? 'Cause that'll help the tailors to move more suits at a lower cost. Yeah, that would be crazy.

Now, what it does mean is, that, is that you have to allow economic adjustments. So the whole argument is that instead of having an economic adjustment in the country, what you have is you devalue the currency to offset the law and demand to try and goose the economy a little bit with inflation to make up for the economic adjustment.

For example, people say it's harder in Europe because it's harder for people to move, and you don't have as much fiscal union as the US has, and so forth. But maybe people moving is a good thing, right? And maybe businesses adjusting is a good thing, and maybe prices adjusting to what they should be, prices having their Hayek signal of things rather than having those signals be obscured by trying to do it via the currency, is a good thing.

Because if Spain leaves the Euro and starts devaluing, all businesses have to devalue the same amount. Maybe not all businesses want to change prices by the same amount. Maybe the tourism industry is booming and that should be raising prices, and maybe, I don't know- what do you make?

You must have silly things that you make in Spain. Those things should have lower prices, the overall currencies, the sum of thousands of prices, half of which are going up and half of which are going down. I tend to favor, yes, this is as much philosophical as it is economic.

Rasheed: There's a central banker I know, he's the former governor of the Central Bank of Barbados. His name is Delisle Worrell. He's very well known for this particular view that you have, which is that Barbados has had the same exchange rate for 40-some years. One US dollar is two Barbados dollars.

It has not changed at all. That's a policy he was well-defined to help create, 'cause he was there when they started the bank in the 1970s. And his stance is this: you never change the exchange rate. You always do fiscal adjustments, even if you think it's more painful, you always do fiscal adjustments.

John: Yeah. So you can see that's a pre-commitment. He's playing a nice game of chicken with the fiscal authorities. "I am not going to bail you out. So you had better mind your manners here." And I think especially for small countries, that makes abundant sense. So, partly, however, I am skeptical for historical reasons of the wisdom of central bankers.

Not because they're bad people. I couldn't do any better.

It's just an impossible task to try to micromanage the response to shocks. And if that were better done, then perhaps there'd be an argument. But you look around the world, and very few central bankers can pull this off.

Rasheed: There's one line from the book that I liked quite a lot.

It was "the treaty's flaw", the treaty for the EU, "is being silent on the issue, allowing an expedient ambiguity, but that ambiguity proved costly." This is, of course, about having a monetary union without a fiscal union. But the book also makes the argument that a monetary union is feasible without a fiscal union.

This is pretty much contrary to the prevailing opinion.

John: Oh, thank you. Yeah. Let me pound my fist on the table! Monetary union without fiscal union is feasible. Now, Europe may want a fiscal union. In some sense, I'm American, so I like my country, and I think moving from the Articles of Confederation to the Constitution was a good thing in the US. Hamilton was a good guy. But you don't have to do it. So, a common currency, like a common set of weights and measures. We don't have to have a fiscal union to all use the meter, and we can certainly define a common currency that we all use, the euro or, for a thousand years in Europe, gold coins.

We all used gold coins, and we didn't have, God knows, we didn't have fiscal union, 'cause Europe was busy butchering each other with various wars for a thousand years. So it's perfectly possible. Now, what it means is that a common currency without fiscal union means that governments that can't pay their debts must go bankrupt.

They must be able to default on their debts. And that was the point where the architects of the Euro, who, as we look back, did a fabulous job, especially when you think about the 1990s, when nobody was thinking about debt crises and financial crises and all the other things that happened.

They thought through a lot of the details, but they were iffy on, "look, if this is a monetary union without fiscal union, countries have got to be able to default, just like companies." If a company can't pay its bills, it doesn't have to exit the Eurozone and start its currency. No! It defaults, and its bondholders don't make money.

They don't get, they get a restructuring, they get 80 cents on the Euro or whatever back. So countries have to be the same way. And they didn't quite wanna say that. Now that's understandable too. We're getting together. This is politically difficult. We're all gonna throw our lot in together.

You, especially I'm not gonna try to do a German accent, but you don't wanna start doing, "Hey you Italy, now if you can't pay back your bills, we're gonna set up the mechanism where you default." That's our example in the book, how hard do you wanna argue about the prenup on wedding night?

We're all gonna be good. Nobody's gonna cause trouble. And there are some debt and deficit rules. If you obey those, nobody will have any trouble. But that was left hanging. Now, of course, the people who put this together did what everybody does on the wedding night.

We don't need a prenup, we'll hash it out later, right? And rules would happen and that kind of never happened. So we pretend that sovereign debt is risk free. Banks are allowed to hold sovereign debt as risk-free assets on their bank balance sheets, even now after the sovereign debt crisis.

So we pretend it's risk-free. We pretend that the ECB won't come and bail everybody out. But of course, the ECB ended up bailing out governments. So that is, I think, the fundamental issue that never got resolved. Yes, you can have a- I'm gonna repeat it, sorry, 'cause it's so important.

You can have a monetary union without a fiscal union, but it means that countries must be able to default. And if they're not able to default, that means the central banks will always come and print money to bail them out, and then they have no incentive to actually control their debt and deficits. And you don't want to have that.

Rasheed: So there is a related argument when it comes to the Euro bond, essentially. So Washington has a deep treasury market. Brussels doesn't have a single safe bond collectively. But is there a real need to have a collective EU bond? It seems to me that the EU should be doing less stuff, and the permanent bond system would encourage it to do more stuff.

John: Yeah, no, we're into the politics of the European Union. But certainly, the next gen EU issue of Euro bonds, I would rate as not an enormous success in terms of debt being issued. With a very clear statement of how that debt is going to be repaid. And then the proceeds are being used widely, wisely on very important investments.

And here, the poster child is Italy's super bonus.

So the Italian government took this money and decided they would give a 110% tax credit for energy efficiency upgrades. 110%.

Rasheed: Yeah.

John: So that means Italians are very creative and entrepreneurial. "Luigi, the bill on that energy efficiency upgrade isn't high enough. Do you think we could maybe gold plate those new windows?" And so, just money went down the rabbit hole.

Rasheed: And Spain, the next gen got just pushed anywhere.

John: Yes, exactly. Now we're into the political economy of debts. The other problem with the NextGen EU is not very clear how it's gonna get repaid.

Let me again, make my ad for Alexander Hamilton. We had a federal government, which assumed the state debts and therefore had US debt to be repaid. But as a result that federal government needed the ability to tax , to tax directly. Not to just have contributions from the member states to pay this off someday, somehow. The federal government had the ability to tax.

Now it was via tariffs, but you wanted a federal government that could raise its own money to repay its debts. And if you're gonna have a Euro-wide bond, you need to have Euro-level taxing authority. And then you need a more functional European-level democracy.

'Cause you don't want the kind of technocrats in Brussels who are there to decide what kind of ham gets to call itself prosciutto and Spanish ham can't call itself prosciutto. Those people can't be in charge of setting your taxes.

Taxation needs representation. Another lesson, sorry. It's the 250th anniversary of the US. So taxation representation is really important, guys. And effective. So now there's this big enthusiasm for the Euro bonds. Maybe we're gonna drive out of the US as a safe asset after the US has a debt crisis.

Only if Europe has a way of paying back the Euro bonds that's more reliable than the US debt crisis. And so much public policy is an answer in search of a question, and you just did that. Euro bond, that's an answer. What's the question? If we define the question, then maybe we can create a safe asset that's useful for repo markets?

Is it creating something that banks can hold instead of holding sovereign debt? There are other ways to do all of those. The one we talk about in the book is, you could take the current sovereign debts and put them in a money market fund or a mutual fund, or an ETF structure, and then you have a diversified portfolio of European sovereign debt.

And one of the big problems is that Spanish banks hold Spanish government debt. Greek banks hold Greek government debt. Italian banks hold Italian government debt. So if any country gets into trouble, its banks get into trouble. Why aren't the banks holding diversified portfolios of European debt so that if Spain goes down, the Spanish banks say, "Okay, we lost 5%, big deal."

Spanish regulators love Spanish banks to hold Spanish debt. And so that's one of the purposes of a Euro bond. But it can also be a diversified portfolio of existing debts. You don't have to create a new instrument for that. For that question, there are other answers.

And if we're gonna go deeper into Eurobonds, let's define what we want? And then how do you structure a Eurobond to be that thing?

Rasheed: I find, I guess, depending on which level of conversation this narrative pops up in. But least on the- call it politics, which is where it mostly comes up in public. On a political level, usually, when, for example, the commission says we should have a Euro bond, it's so they have more money. That just feels like the only contemplation they're making when it comes to this. "We want to spend more on random things; therefore, we should have more money." It's only recently, at least, much more frequently,

recently you will see, for example Christine Lagarde, ECB, trying to use the lesbians be a haven for us money rationale for the Euro bond in this case. But then, here's the other question, then. Even if you somehow have a Euro bond, there's no actual capital market if you want to put the money into it anyway.

So again, your point is like, what's the actual thing you have to optimize? And not even the basic bare bones of the system to have a counterweight to the US reserve currency status aren't even there at all.

John: That's funny. Of course, the Trump administration now thinks reserve currency status was a terrible thing.

'Cause us printing up money and sending it abroad, and they give us stuff for free, that was off. Maybe you could take over that. China sends you stuff for free. There are just so many things in what you said there. So one purpose of a Euro bond- I'm surprised, Lagarde ought to think hard about this.

The ECB has all these national bonds. And is intervening very much to keep afloat , all the national bonds. So one of our proposals is if there is a Euro bond, the ECB may only buy Euro bonds and may not buy, and therefore prop up national bonds which the ECBC's, fragmentation and market dysfunction anytime yields go up.

So be careful what you wish for. You might just get it.

Rasheed: So I want to pick up on that a bit, but I wanna move away a bit from the ECB first. So the Fed has essentially flooded the system with more reserve floors currently, and the ECB still uses a corridor, but it's creeping lower all the time.

Does this difference matter for the inflation fight, or is it just a plumbing detail?

John: So both the ECB and the US Fed are now, I think, the ECB is still a floor in the sense that the deposit rate is the rate that moves interest rates. Okay, let's, lemme try to define things here.

There's the interest rate at which a bank can deposit money at the ECB, and there's a higher interest rate at which a bank can borrow money from the ECB. So market rates are gonna be in between those things, right? If the market rate is above the borrowing rate, then banks borrow from the ECB instead, and that brings it back.

And historically, the ECB started mostly at the borrowing limit. Banks were borrowing reserves from the ECB, and that was the crucial rate. And there weren't many deposits. With the huge QE, there were so many reserves that were on deposits that mattered. Now, plus or minus, I don't care.

The fed is still at the deposit rate because our lending facilities don't work as well as the European lending facilities. But if the Fed ever really wants to lower interest rates, push 'em down, it may find it has to start lending more accurately. So I would rate that as mostly a plumbing issue.

Neither Central Bank is having trouble right now, moving short-term market interest rates to where it wants them to go. The larger question is how much Central Banks can fight inflation by moving short-term market interest rates with abundant reserves?

That's a deep theoretical question. I'm not sure that's where you were going, so I'll let you ask that if you want to go with it.

Rasheed: No, yeah!

John: I would rate that as a plumbing question to first order.

Rasheed: Okay. So in a similar area, generally speaking, you rather a price level, not an inflation target. But now, in the EU, 2021 now finance is administered in the Euro area, how could the ECB sell the idea without really setting off a political earthquake to change how that system is targeted?

John: Firstly, they'd have to want to. Now this is an important question. Let me unpack it for your listeners. The ECB's mandate is price stability. That's what's written in the trade treaty, and the US Feds' mandate is price stability and maximum employment. But the first one is price stability. Oh yeah, that seems pretty clear, right?

Price stability. Both the ECB and the Fed decided to interpret that mandate as 2% inflation forever. Now wait a minute. The meter was designed for length stability, and nobody said you'd cut two centimeters off the meter every year, right? What do you mean by Bureau of Weights and Measures? So, first, they interpret that as 2% inflation.

And second, the ECB is particularly clear about this. But any mistakes are forgiven. So suppose you have a 10% inflation history, you say, "Oh, too bad we're targeting 2% going forward in the medium term." So you might think, for example, as many inflation targeting countries did, that there would be a, it's like five years, and we tied up what was average inflation in the last five years?

How'd you do? Was it 2% or was it 8%? We do not try to get that backward-looking average to 2%. We want our forecasts for the medium term to be 2%. And if we screw up one way or the other, "oh forget it." So now, we have a bunch of issues. If you wanna think about what mandates we want Central Banks to follow.

Do you want them to follow inflation, 2% per year forever, or do you want them to aim for 0% inflation, meaning the price levels stay? If there's a mistake, if there's a spout of inflation, do you want them to have future inflation a little bit lower so that the long-term average inflation is 2%? Or do you want them to just forget about mistakes and try to get back to 2%?

And so what about what happened? Or even a more price level target, suppose the level of prices went up? So this is what happened: the level of prices went up, and then you go back to prices not rising, meaning zero inflation. Was that good enough? Or if the level of prices goes up, do you want them to slowly bring the level of prices back to where they used to be?

Which is, over centuries, the way things were in Europe. Under the gold standard, there would be inflation and deflation. But after a period of inflation, prices would come back. So the level of prices was constant over long periods. Okay, so I keep redefining things.

I hope this helps you, listeners. So, among this plethora of possibilities, I prefer a price level interpretation of what price stability means. And if you have a bout of inflation over a period of 10 years, you will slowly bring the price level back to where it was if you have the capacity to. Why? The meter is what it is. Prices should be informative over long periods. I don't see any need for steady 2% inflation. There are 10 arguments on the other side, which I will not go through unless you ask me. But I don't think those arguments hold water. But the biggest one is that periods of low inflation or deflation are somehow bad for the economy.

And if you look back at those periods they seem to be just fine for the economy. There's a theory that by having low inflation, you're in danger of a deflation spiral breaking out. That never happened, 30 years in Japan with a steady price level. There was never a deflation spiral that uncontrollably broke out.

So I think that's a fantasy. So, that's the main reason not to want it. So that's why I always like the cleanest, simplest answer and price level; that's what I think they meant when they said price stability. And fundamentally, inflation is a set of units.

Do we measure things? Do you measure paintings in dollars, Euros, or Lira? It doesn't matter. You can measure 'em in inches and centimeters or furlongs if you want. The real thing is the real thing. So that's why I like the clarity of units, of measurement.

Rasheed: So the Euro crisis toolkit kept growing: SMP, OMT, PEPP, PSPP, TLTRO, you name it.

If you were to design a pre-approved rescue fund that still keeps markets honest, what guardrails would you put on it?

John: Yeah, I am impressed by the ECB’s ability to create an alphabet soup of acronyms. I thought only the US was the world leader in this, but my hat's off to the ECB.

What each of these was, let's go back to try to unpack these. The ECB started with almost a law, but certainly a tradition, we do not buy government bonds. Because we're not in the business of financing government deficits. But of course, starting with the financial crisis and then certainly in the sovereign debt crisis, and then in crisis after crisis ever since.

And then in the ECBs desire to deliberately inflate during COVID pandemic, they bought sovereign bonds like crazy. But we all understand the danger of unlimited sovereign bond buying in a common currency without fiscal union. It's already a problem for a government like the US that the central bank buys government debt monetizes it, that causes inflation and leads to more deficits.

It's even worse in a currency union because an individual country, if it knows the ECB will bail it out, just borrows like crazy. You mentioned euro bonds. They put in euro bonds because they wanted to spend more.

That's a fundamental misunderstanding of what government debt is about. Spending is always paid for by taxes. It's either taxes now or taxes later. So that if you're issuing government debt, you're issuing promises to tax later. And if you want Euro bonds, you don't want Euro bonds 'cause you want to spend more, you want it 'cause you want to spend now and tax later. But without the tax, later you just get inflation anyway.

There was this tradition, we didn't buy government bonds, but then one by one, they did. And since it was questionably legal, there were several court cases about whether the ECB could even do this. And to their credit, to try to contain the moral hazard, to try to say, if they just say "we buy government bonds, just, call us and say crisis, and yeah, we'll buy whatever it takes."

They didn't want to do that for obvious reasons. They don't want countries to feel that no matter what happens, we'll always come in. So there are always limits, and so on. But one by one, the limits have gone away. Currently, we need a diagnosis of market fragmentation or dysfunction, but since no central banker ever trusted a market, the market's always fragmented, dysfunctional. And the current ones are unlimited. I know I've talked to ECB officials who say, "No, we have all sorts of rules." Markets certainly think there are no rules. But any blip up in, in Italian or Spanish spreads will be met by, "Oh, this is market dysfunction."

Now, in the book, my co-authors persuaded me that some ECB bond buying was useful with limits. And here's the case. And my hat's off here to my co-author, Klaus Masuch, who was basically in charge of Greece at the ECB and put together a lot of these programs.

It came kinda late. But if you have a currency union without a fiscal union and you have sovereign debt, I'm the hard ass. That means you've got default. But there's no default mechanism. So default in corporate debt, there's a bankruptcy court and order of precedence, and there are rules on how you default.

At least you need those rules on how to make these defaultable securities. And what are the rights of creditors? Can they seize assets? How do you get some, and their bankruptcy, like IMF programs, you try to avoid a chaotic default. You try to avoid situations that a current country can't pay back now, but might be able to put affairs in order.

A mechanism that comes in and says, look, we, the collective, the rest of Europe. We were not gonna print money to help your debt, but if you're getting in trouble, we will have a mechanism that lends you money in the short run. In return, you will finally get around to those microeconomic reforms that you've been putting off for 20 years.

You'll free up your labor markets and get rid of a bunch of protections and get rid of a bunch of subsidies, and we'll have a program that credibly gets your fiscal things back in order, in return for support. And so that's the useful sort of institutions involving some limited amount of government bond buying that I think would be important.

First of all, there's always the backstop. A country can default, and it won't be chaotic. If you don't have that backstop threat, then the second step doesn't work at all. Because if we're in negotiations about a rescue plan, but default is impossible, you just sit back. A default is impossible.

Bring it on, right? No. So that has to be there, and it has to be functional. You cannot have a default bring down all the banks. It has to become defaultable debt that is risky on the bank balance, and banks have to account for it and diversify that debt. And so then the second step, you need an institution that can step in and forestall default by providing coordinated fiscal help subject to conditionality; the country will work out a plan where you start growing and you're able to pay back at least some of this debt. Depositors will take haircuts, as in all these things. You're all getting 80 cents, you're getting a rescheduling of the debt, putting off some interest.

Yes. And the depositors, debt holders can't be banks that will instantly fail. You need that sovereign debt to be held by people who can take those risks and earn a premium for it. But those kinds of mechanisms are necessary.

And you asked when you can buy sovereign debts? And in the context of those mechanisms, I think now you have mechanisms that allow you to get through problems without destroying the incentives for countries to issue debt wisely.

Rasheed: So I seem to be the only person in my circle of libertarian people in Madrid who tend to like the idea of a digital Euro, the central bank to the currency project of the ECB. I'm in the very, very small minority in that camp.

I don't know how much you've looked into the actual project of the digital Euro at the ECB. It's a lot more advanced than people think it is, and a lot more sophisticated than people think it is, in my view. But generally speaking, what's your view on a European digital currency, or if you have looked into this particular project, the current architecture they're trying to push for? Especially given that we did discuss TARGET2 earlier. One of the important things people forget when talking about the digital Euro is that the ECB already has a TARGET2 instant payment settlement, so the TIPS system. Which is perfectly suited to run any CBDC project, and it's already technically used pseudo-CBDC by some institutions.

John: Ah, I hope you weren't hoping for a small answer here. You're a libertarian circle in Spain, and there are three of you. Bring the other two on. And I also travel in libertarian circles, and we all get along fine until the question of money comes up.

Why should the government provide money? Scottish free banking! And I am a practical, empirical libertarian. There are a few things that the government can do pretty darn well. And one of them is to provide a currency. Why? Because a currency is fundamentally backed by something.

And so, in the absence of a government, paper money is backed by loans, but loans sometimes go bankrupt. And so there are runs on banks, whereas government money is backed by the present value of future taxes. And that's a darn good backing for money if the government is at all responsible.

Now, true libertarian, so the government's never responsible, but it's a problem of being a libertarian. You get involved in the "should the government issue pilot’s licenses" and go, maybe not. Of the catastrophes lying in front of us, there's 999 in front of privatizing pilot licenses.

And so money is, I think, one of those. Preamble, the digital euro. There's this fascination in the U.S., too, in part, with the blockchain question. So we should separate by digital Euro, do you mean a blockchain, or do you mean a central ledger? And as you pointed out, we have a digital Euro.

We have a digital dollar. It's called reserves. We have completely digital currency that is maintained in a central ledger at Central Bank and is transferable back and forth between banks using 1970s technology that could be updated. Why do you need something else? Now we do need digital money, it's very useful.

I don't carry cash anymore. Most black people don't carry cash anymore, but we kinda have digital money. We have you own an account at a bank, which has an account at, which has euro deposits or reserves at the Fed, and you can digitally transfer that money to someone else. So you got digital Euros, they're private, digital Euros backed by, and ideally in my world, we would have narrow banks that are a hundred percent backed by reserves.

If I were in charge, that's where I'd go. Our plan for a digital currency is narrow banks. A hundred percent backed by reserves cannot fail. Zero financial crisis, zero run ever. And then they transfer money back and forth rather than the Central Bank doing it. Why? 'Cause I'm appealing to your libertarian sympathies.

I like private markets wherever possible. The government is good at providing this asset, a nominally risk-free security. But the government is not great at providing efficient consumer-facing websites. " Oh. I lost my password. Hey, JD Powell, could you reset my password?" When have you seen an efficient government?

If you wanna run a payment system in our countries, you need a massive consumer protection regulation, anti-money laundering scam protection. Private companies are much, much better at actually enforcing government regulation. Could you see the ECB or the Fed trying to implement a website that is compliant with all of its regulations?

It's no way they could do it, let alone implementing the quite effective anti-fraud, anti-money laundering things without bringing the whole thing. So privately run with the government backing i is my answer to the question also because of the privacy problem.

Rasheed: Okay. I was gonna say this project, as you might know, the digital Euro is done via the commercial banks and not via the Central bank, correct?

John: Yes.

If the government watches every single transaction you make, the implications are staggering. We had the Canadian truckers who had a protest against COVID and were shut out of their bank accounts. You wanna run for office, and somebody can leak every purchase you ever made.

Maybe you stopped, maybe you had a receipt for a parking ticket for parking in front of a cancer center. What were you doing there? So that by having it private and then backed by the government, then at least the government needs a subpoena in order to be able to access your financial records.

Now, the digital Euro seems to be deliberately hobbled. So you're allowed to have a digital euro as a person, but it's only 3000 Euros.

Rasheed: 3000, correct.

John: 3000 euros. What's the point of that? And now I have asked an ECB official. And it has to be linked to a bank account.

Because they said, we want this to be a means of payment, not a store of value. What's wrong with it being a store of value? Central Banks fundamentally love banks, and they subsidize the banking system, and they're fairly straightforward about it.

If we put in a digital euro, that is a very low-cost, seamless way of making all of your transactions, you will just store your money in the digital Euro, not in the local bank. And the local bank won't go on and buy government debt or invest in that local supermarket or all the things we love the local bank to do.

So it's trying to maintain the profitability of the existing banks and the structure of the current banking system. And so I asked, "Well, okay. So the way it works is if you spend 1500 Euros, then it automatically refills from your bank account.

What if you want to buy a car? How do you buy a car with a 3000 euro limit? Does it do, six times, and then refill it?" How does a business how does a business make business-to-business transactions with a digital Euro if it's limited to 3000? So it seems deliberately hobbled not to work. And I think the emergent thing is stablecoins, which amount to the stablecoins or narrow banks. If you have a stable coin that is a hundred percent backed by short-term government debt- you understand our Central Banks are just money market funds.

They issue euros or dollars interest interest-paying and they buy government debt. So, a stablecoin, and money market fund, and a Central bank are all the same things. They issue one Euro interest-paying deposit, and they hold government debt. So I think stablecoins are gonna be the big challenge.

Not for any real technological reason. They just allow an end run to the regulatory structure that has been there to defend the profits of the existing banks. And our Fed has rather scandalously not allowed narrow banks to come into being.

Rasheed: Why is that?

John: I have read the document issued by the New York Fed about why they did it, and it is a fantasy of various things that could go wrong. Now, why is that? I have a principle: don't assign motives to people without evidence.

But boy, does it look like they want to keep intact, if not the profits that cross subsidies implied by the local banks. But eventually, as we libertarians know, such efforts fall apart, and stablecoins, I think, are the way to go. The digital Euro, as it currently is, seems designed to assuage a political crowd that wants a digital Euro without creating something that will actually work.

And then there's the question of why we are doing this? Rather than having a central ledger-based, efficient payments system run through private intermediaries that are a hundred percent backed by reserves.

And that was the short answer.

Rasheed: But, so on that the narrow banking idea, stablecoin, CBDC meta idea is sometimes a bit confusing to people. More so because of the profit. Obviously, I know how stablecoins make money, but the intuition, so how then does a company make a profit if they're just doing narrow banking or such a money market fund?

I don't know if the ECB restricts narrow banking. I don't know if they have any here. But what is the basic intuition why people generally, you know, not just ECB or Fed staff, generally do not see why narrow banking is good?

John: There are a hundred fallacies out there.

So the main one is that somehow allowing narrow banks will reduce the supply of credit. The pizza is what it is, and how you slice it up makes no difference. So then it's about a cross-subsidy. The hope is that by allowing banks to have access to very low interest deposits that they will pass along those lower interest rates to lenders out of the goodness of their hearts.

When was the last time a monopolist lowered prices? If you had a monopoly on your inputs, you would lower the price of your outputs rather than just raise your profits. Things go back hundreds of years in a 19th-century economy with a very small federal debt; there was a need for money, and there was a need for lending. So it might've been fairly natural that banks issued notes, money-like liabilities that they used to, and those were, went into the safest kinds of assets they had, which were real estate loans. But that was the 19th century.

So we have enough government debt to back any possible amount of transactions, balances you could need, and much safer. And then that same money, it's just the form of the investment. The same money that is now being invested in banks via government-insured deposits could be invested in banks via equity and long-term debt.

And you would get a better return out of it, and the banks would pass on at the market rate of interest. Now, perhaps they would have to charge higher interest on their loans, but where is the low interest coming from now? It's coming from the taxpayer. Right now, we have a system where the banks issue deposits that are insured by the government, and every time there's a crisis are bailed out by the government.

And that's why the banks can pay such a low amount on deposits and turn them into risky loans. If you wanna subsidize risky loans from the taxpayer, why don't we just do it directly, rather than every 10 years, have a financial crisis and bail everybody out, rather than having a deposit insurance system that is undercharged?

And every time there's a crisis, they ensure something else, like they did in SBB. If you want taxpayer subsidies for lending rates, pass 'em. And, rather than hide it under granting banks this monopoly privilege and these implicit taxpayer subsidies.

Rasheed: So I have two more questions. So around the year 2000 thousand one, the US federal budget was about 4 trillion, and now it's over 7 trillion. And of course, that's not sustainable, that's gonna have a lot of debt pressure. But how do you think the US feasibly gets to a more sustainable budget point?

John: Economically feasible is easy, politically feasible, that's not my job. Economically feasible: reform the insane tax code. Just look at the news coverage of the Big, Beautiful Bill. Oh my god, what a mistake. Horrendous. We can have a tax code that raises revenue for the government at minimal economic distortion, and that would be great. I would just have a value-added tax. If you throw out the income tax, you throw out all the deductions and exclusions with it. You don't have to fight for 'em one by one.

The deduction for mortgage interest, the deduction for employer-provided healthcare, the deduction for my neighbor's Tesla, the Swiss cheese of our tax code.

Just throw the whole business out, the consumption tax is easy. Now you've raised 20% of GDP for the government with almost no economic damage. And there's a whole bunch of tax lawyers and accountants, and lobbyists who can drive for Uber, and it's wonderful. We can stop spending like a drunken sailor.

You look at what the US spends money on. And get outta the way for microeconomic growth. The best way for tax revenue is not higher tax rate, but higher income. Tax revenues is tax rate times income, raise income. And America we're only half as bad as Europe in regulatory sclerosis.

Right now, Europe has stopped its growth. The US growth is half what it should be. So that's the Cochrane program, which will grow the economy like crazy. And also make that easier. What are we gonna do? Both Europe and the US are wonderful places that we've had spectacular economies for hundreds of years now.

Surely we are not gonna go through a debt crisis simply because we can't do the obvious things. Surely we're not going to kill our economies with taxes. Tax austerity doesn't work. It just kills the economy. It does not engender a stable fiscal policy.

And surely we're gonna reform our spending. I use the word reform rather than cut. 'Cause we don't have any external problems. Nobody is invading us. Yeah, we have military problems, but compared to World War II, this is just nothing.

From an economic perspective, it's easy. From a political perspective, that's harder.

Rasheed: Last question. I've always been curious about this weird thing in the US, where it feels to me like the payment system in the US is very antiquated, especially relative to the weight dominance importance. The advanced financial instruments in the US are beyond par, but just the basic payments infrastructure is so old. I can send money to my friend here in, in Finland from Spain instantly. It takes days to send anything from Florida to California sometimes. Is there some reason for that?

John: Yeah. Our banking system is not particularly competitive, and I'm just gonna presume there are regulatory problems. It is so frustrating. I had to make a big payment recently, and my mutual fund no longer has check-writing privileges. So it took two days to get it from a federal money market fund into a bank.

And then I had to wire transfer from the bank, and I could, I had a $50,000 a day limit. So it took a while and 25 bucks a shot , 4% to use Visa and MasterCard. I haven't really looked into it, but my libertarian prejudices say there's regulations that are having the politically powerful feet at the trough, but absolutely, yes, this needs cleaning up.

Rasheed: So, John, thank you so much for joining me on the podcast. It's been a delightful conversation.

John: Thank you, and thanks for putting up with my lectures as answers. Your questions are fantastic, and I hope this has been useful for our listeners.

Rasheed: Thank you.

How To Fix A Central Bank

A conversation with Economist John Cochrane on the Rasheed Griffith Show

Or listen on Spotify

Show notes

Recommended

This transcript was automatically generated by AI and lightly edited by our team. We don’t catch every error, so if you spot one, send us a message/email via shem@cpsi.org.

Discussion about this post