Taxes drive Money but not quite in the way Daniel Gros thinks

John McHale in the Irish Economy blog picked up on yet another piece by Daniel Gros on the Eurozone and the Irish problem.  Gros sees an important link between sovereignty and taxation but does not quite make the leap to Modern Monetary Theory.  The Euro is a foreign currency for every member state using it.  The taxation issue is important but not in the way he thinks.  He overlooks the need for the ECB to act as lender of last resort in cyclical downturns to member states or to be more accurate, spender of last resort.  A true sovereign does not have to raise taxes nor sell bonds in order to spend.

In recent articles, Daniel Gros has emphasised the importance of a country’s financial wealth for its solvency.     He further develops his controversial arguments in this VOX piece, with particular emphasis on the distinction between external and domestic debt.  An extract:

In a monetary union, the usual assumption that public debt is riskless is not valid. Countries like Greece don’t have access the ultimate option of printing money. In this sense, the public debt of Eurozone countries resembles that of emerging markets (Corsetti 2010).

The crux of the importance of external debt lies in the fact that even Eurozone nations retain full sovereignty over the taxation of their citizens. The logic is somewhat subtle and best explained by an extreme example that makes the point extremely clear. Suppose a nation’s entire debt is held by one man and the nation faces a debt crisis. If this bond holder is a resident of the nation, the government could impose a tax on him equal to, say, 50% of the value of his government bond holdings. Using this new tax revenue, the government could pay down its debt by 50%. Of course this would be an outrageous expropriation and make it harder to issue debt in the future, but it would not be a default.

By contrast, suppose the sole bond holder where a foreign citizen living abroad. In this case, the government could no longer freely tax the individual. Governments do not have a free hand in taxing non-citizens; they are bound by existing treaties and international norms.

The baseline point is that as long as Eurozone members retain full taxing powers, they can always service their domestic debts, even without access to the printing press. For example, governments could reduce the value of public debt held by residents by some form of lump-sum tax, such as a wealth tax. The government could just pass a law that forces every holder of a government bond to pay a tax equivalent to 50% of the face value of the bond.2 The value of public debt would thus be halved, much in the same way as it would be if the government ordered the central bank to double the money supply, which would presumably lead to a doubling of prices.

This is why, I believe, it is foreign debt that constitutes the underlying problem for the solvency of a sovereign, even in the Eurozone.

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