Wynne Godley wrote an article in the London Review of Books in 1992 commenting on how and why the idea of a European Monetary Union is doomed to fail. LRB today removed the “paywall” so that the article is accessible to everyone.
click to view the tweet on Twitter
FT Alphaville also wrote on this.
If you read my posts or look at the “Tag Cloud” on the right, you will recognize what a big fan of Wynne Godley I am :-).
Above is an Observer article from 1991. Click the newspaper clip to enlarge.
Quoting from the end of the article:
If we are to proceed creatively towards EMU, it is essential to break out of the vicious circle of ‘negative integration’— the process by which power is progressively removed from individual governments without there being any positive, organic, all-European alternative to transcend it. The nightmare is that the whole country, not just the countryside becomes at best a prairie, at worst a derelict area.
In a recent post Chart: Euro Zone Indebtedness, I graphed the Net International Investment Position (the negative of “external debt”) for EA17 nations to highlight the severity of internal imbalances within the Euro Area. I found a source of data for the current account balance as a percentage of GDP in the IMF’s latest World Economic Outlook and am posting a screenshot below of the table I am talking about.
(It’s a bit of hard work to get this otherwise). Click the image to enlarge. You can see that around 2007, the imbalances grew out of control but continued to grow in 2008.
The International Monetary Fund, IMF has one full chapter devoted to the subject of “twin deficits” in their latest issue of World Economic Outlook. The subject of “twin deficits” is full of complications and can invoke the deepest emotions from economists. Naively, the argument goes as follows: The “three financial balances” identity can be written as
NAFA = DEF + BP
where NAFA, DEF and BP stand for the Net Acquisition of Financial Assets of the private sector, Government Deficit, and the current Balance of International Payments. From the above, if the government deficit increases, for a constant NAFA (rather a constant NAFA/GDP), an increase in DEF causes BP to reduce, i.e., reduces the current account balance or causes the current account deficit to increase.
Now, this is hardly the best way to put it – because it is mistaking an accounting identity for a behavioural relationship. For example, in conjecturing, one is implicitly assuming that the budget deficit is exogenous or fixed by the government. It is then argued that to reduce the current account deficit (or BP with a minus sign), the government should cut its budget deficit.
There is some truth to “twin deficits”, in my opinion. A lot actually! However, conclusions from any analysis need to be studied in a proper framework and stock-flow coherent macroeconomics is the only way to do this. Money is automatically endogenous in “SFC” models – it cannot be otherwise.
The government sets its fiscal policy or fiscal stance. This can be approximated to be G/θ, where G is for government expenditures and θ is the tax rate (as opposed to total taxes). The budget deficit is out of the control of the government and is dependent among other things, the private sector propensity to consume, the exports and imports. Assuming exports remain constant, relaxing the fiscal stance (i.e., an increase of G/θ) leads to an increase in domestic demand, ceteris paribus. An increase in demand leads to an increase in imports. (If people have higher incomes, they will purchase more imported products). This leads to the widening of the current account deficit and hence through the sectoral balances identity a widening of the budget deficit.
Various things can be said about what is written in the last paragraph. Take the case when ceteris is not paribus. An increase in the propensity to save (i.e., a decrease in propensity to consume) can lead to a higher NAFA and DEF and increasing BP (as a result of lower domestic demand and hence lower imports).
Come back to ceteris paribus: assume that demand abroad has increased for some reason. This could be due to an increase in the fiscal stance of the foreign government or a private sector led credit expansion abroad. This will lead to an increase in exports for the country we are discussing. So in such a scenario, an increase in the fiscal stance – up to some limit – will not lead to a widening of CAD, i.e., decrease in BP.
Wynne Godley put it best in a Levy article in 1995 (always perfect with his wording):
Refuting the “Saving is Too Low” Argument
It is sometimes held that, in the words of the Economist (May 27. 1995, p. 18), “America’s current account deficit is enormous because its citizens save so little and its government spends too much.” The basis for this proposition is the accounting identity that says that the private sector’s surplus of saving over investment is always equal to the government’s deficit plus (or minus) the current account surplus (or deficit). As this relationship invariably holds by the laws of logic, it can be said with certainty that if private saving were to increase given the budget deficit or if the budget deficit were to be reduced given private saving, the current account balance would be found to have improved by an exactly equal amount. But an accounting identity, though useful as a basis for consistent thinking about the problem can tell us nothing about why anything happens. In my view, while it is true by the laws of logic that the current balance of payments always equals the public deficit less the private financial surplus, the only causal relationship linking the balances (given trade propensities) operates through changes in the level of output at home and abroad. Thus a spontaneous increase in household saving or a spontaneous reduction in the budget deficit (say, as a result of cuts in public expenditure) would bring about an improvement in the external deficit only because either would induce a fall in total demand and output, with lower imports as a consequence.
How is protectionism related to all this? When nations face severe balance of payments issues, they are forced to deflate demand in order to bring the balance of payments at sustainable levels. If that doesn’t work either, nations may try to directly reduce imports. This works via reducing the propensity to import and hence imports. However, it is difficult to take such a step because it can lead to retaliation. As John Maynard Keynes once put it:
During most of the period in which the modern world has been evolved … the failure to solve this problem has been a major cause of impoverishment and social discontent and even of wars and revolutions.
i.e., the failure to resolve the balance of payments problem. The only way to peacefully resolve this issue is by working toward a solution which is good for all. Even the Bank of England (and Mervyn King) has realized this. Else we will just have a long period of low demand and high unemployment, leading to social unrest. More on that some other time.
[Update, 3 Jan 2012: Fixed some errors]
There’s a new article from the Federal Reserve Bank of New York – Saving Imbalances and the Euro Area Sovereign Debt Crisis by Matthew Higgins and Thomas Klitgaard.
The abstract
For several years prior to 2010, countries in the euro area periphery engaged in heavy borrowing from foreign private investors, allowing domestic spending to outpace incomes. Now these countries face debt crises reflecting a loss of investor confidence in the sustainability of their finances. The result has been an abrupt halt in private foreign lending to these economies. This study explains how the periphery countries became dependent on foreign borrowing and considers the challenges they face reigniting growth while adjusting to greatly reduced access to foreign capital.
which is almost right.
The Euro Zone nations have run massive current account deficits and foreigners allowed this game to go on. The deficit nations became more and more indebted to the rest of the Euro Zone. This process can go on as long as foreigners allow it but with rising negative net asset position relative to gdp, the processes have to stop somewhere leading to a collapse in demand.
The authors point out how yields on government bonds of various nations were close to each other before crisis hit. This is consistent with Wynne Godley’s stand that there is no signal that something is wrong or can go wrong when unsustainable processes are building up, until something goes awfully wrong.
The article also has a section on the TARGET2 payment and settlement system. TARGET2 flows is one of my favourite topic. I will write about it sometime in the same spirit as my previous post on domestic payments.
The article however puts the blame on deficit countries which is inaccurate from a Post-Keynesian perspective. The problem was with the design of the Euro Zone itself. The problem was also the ideology that “market forces” work to achieve results which is best for everyone.
There are some behavioural hypothesis/assumptions used in the article which are not quite right, but I won’t go into them.
There are some interesting charts in the article, for example
Martin Wolf used the three financial balances approach in his blog recently. Here’s the chart from that post:
Via NYT:
Few posts back, in More On Horizontalism, it was mentioned how loans make deposits. The unanswered question in the post was If loans make deposits, why do banks require funding? That will still be left unanswered for the time being, but in this post we will discuss simple payment systems and settlement. Hopefully it was clear in the post how banks occupy a central position in the process of money creation.
Before we go into payment systems, first let me introduce to Augusto Graziani’s concept of money, which I really like [1].
- since money cannot be a commodity, it can only be a token money;
- the use of money must give rise to an immediate and final payment and not a simple commitment to make a payment in the future; and
- the use of money must be so regulated as to give no privilege of seignoriage to any agent
So the process of settlement involves more than two agents and in most cases, the payer, the payee and a bank. Even in cases, when the payer pays the payee in currency notes, the transaction secretly involves central bank money because currency notes are liabilities of the central bank.
How do banks settle among themselves? A simpler but not often asked question is why banks need to “settle” amongst themselves? This will be answered soon but the answer to the first question is central bank money. Banks cannot keep telling each other “I owe you”. Central banks haven’t existed since the beginning of time, and banks would earlier settle among themselves in gold. Why gold? is a slightly difficult to answer but at this point it’s sufficient to say that the properties of gold have made it attractive for settlement.
Before we get into payment systems, let us for the sake of formality, categorize payments into two types [2]- credit transfers (“push”) and debit transfers (“pull”). Most transfers are credit transfers and are initiated by the payer. Debit transfers are transfers initiated by the payee. Example: a cell phone company making a payment instruction to its customer’s bank to transfer funds to its own bank account at the end of a bill cycle to settle the monthly bill, after the customer has allowed the pull transaction to take place periodically. We will worry about only push transactions.
The following diagram from GAO’s report Payments, Clearance And Settlement – A Guide To The Systems, Risks And Issues is a good illustration of a transfer transaction. (Click for higher resolution version)
Technology has advanced so much that such payments happen fast! RTGS – Real Time Gross Settlement is a feature banks offer (for a minimum transaction size) in which transactions are settled in real-time with instant irrevocable finality. In the Euro Area, the European System of Central Banks have developed a system called TARGET2, which I believe settles all payments real-time.
So in the above diagram, customer A who banks at Bank A transfers funds to customer B who banks at Bank B. After the payment instruction is initiated, Bank A owes $1m to Bank B. Since everyday, there are zillions of transactions happening in both ways, banks try to keep a balance at the central bank. These are called reserves but modern central bank articles use the phrase settlement balances more often these days.
What happens if banks do not have sufficient funds at the central bank? Is that allowed? Since central banks require that funds be transferred as soon as possible, they allow banks to go into an overdraft. How much overdraft does the central bank provide? In principle – as much as possible, provided banks provide good quality collateral. Central banks have standards on what collateral is acceptable and these may change from time to time. Typical requirements include good rating by the rating agencies. Since the market value of the collateral can fluctuate and it is risky for the central bank, they require a haircut. This roughly means that for borrowing (i.e., going into an overdraft at the central bank) say $1m, banks need to provide a collateral whose market value is say $1.1m. This is a topic in itself, and no more will be said for now – maybe a good topic for a future post!
This brings me to the final part of this post. What about settlement between a bank and its customers? Bank employees, for example, are encouraged to open an account at the same bank and their monthly salary is credited at the end/beginning of the month. Is this settlement? A rough answer to this question is that bank money is convertible. There is nothing preventing a bank customer from transferring funds to another bank. If the customer does so, the diagram above shows that the bank has to settle the amount with another bank or the central bank and has to attract funds from various sources. Else, the bank has to offer an alternative to the customer such as paying interest on the deposits and requiring in exchange that the customer is not able to withdraw funds for a fixed term. Needless to say, the bank also needs to maintain good relations with the customer.
Finally, the topic of international money flows is dear to me and will be taken up in another post.
References
Via Reuters
Barrack Obama and Angela Merkel spoke on the phone over the weekend and agreed on the importance of concerted action.
“The two leaders agreed on the importance of concerted action, including through the G20, to address current economic challenges and to spur growth and job creation in the global economy,” the statement said.
I am reading Dani Rodrik’s The Globalization Paradox and borrowed the title for this post.
I am curious as to what Barry Eichengreen has to say in his talk at the Federal Reserve’s annual forum at Jackson Hole, Wyoming. He is the author of the book Exorbitant Privilege: The Rise And Fall Of The Dollar And The Future Of The International Monetary System – one of the books I want to read soon. The phrase Exhorbitant Privilege was coined in the 1960s by the then French Finance Minster Valéry Giscard d’Estaing. The term refers to the high ability of the United States (and directly and indirectly, the United States government) to borrow in US$ to finance its balance of payments deficit.
To some extent, the scale and timing of the Federal Reserve’s emergency operations during the credit crisis which started around 2007 has helped maintaining the hegemony of the US$ for a while and Barry Eichengreen knows that. This United States Government Accountability Office (GAO) report Federal Reserve System – Opportunities Exist To Strengthen Policies And Processes For Managing Emergency Assistance is a nice reference for the kind of operations done by the Fed, especially international swap lines. Many central banks made use of the swap lines and lent large quantities of US$ to the banking system because banks were facing funding issues in dollars.
Back to the Jackson Hole Symposium. Everyone is waiting for the ECB Chairman Jean-Claude Trichet’s talk. Meanwhile Christine Lagarde, IMF’s chief touched on some issues about imbalances in her speech. She rightly points out that
… risks have been aggravated further by a deterioration in confidence and a growing sense that policymakers do not have the conviction, or simply are not willing, to take the decisions that are needed.
which is quite right, IMO because this crisis needs coordination at a scale never seen before. She also points out that
As we all know, a major cause of the crisis was too much debt and leverage in key advanced economies. Financial institutions engaged in practices that magnified, disguised and fragmented risk, while households borrowed too much. Experience tells us that these excesses (combining both housing and financial crises) take a long time to work off—and require decisive action. We have made some progress, but not enough to unshackle growth.
I am by no means downplaying what has been done. In 2008, governments took bold action to prevent a calamitous collapse in demand. They offset private contraction with fiscal expansion and used public resources to recapitalize financial institutions. They strengthened financial regulation, and reinforced the capacity and resources of international institutions. And monetary authorities did their part as well.
But today, it is public sector balance sheets themselves that are in the firing line. Today, the headline problems are sovereigns in most advanced economies, banks in Europe, and households in the United States. Adding to this—global growth is also being held back by policies that slow demand in some key emerging market economies while balance sheet risks are increasing in others.
The fundamental problem is that in these advanced economies, weak growth and weak balance sheets—of governments, financial institutions, and households—are feeding negatively on each other. If growth continues to lose momentum, balance sheet problems will worsen, fiscal sustainability will be threatened, and policy instruments will lose their ability to sustain the recovery.
which is quite right. Fiscal expansion has helped nations recover from the private sector imbalance but fiscal policy alone cannot achieve everything. However, somewhere her message won’t work well because she mentions earlier in her speech that
Two years ago, it became clear that resolving the crisis would require two key rebalancing acts—a domestic demand switch from the public to the private sector, and a global demand switch from external deficit to external surplus counties. On the first, the idea was that strengthened private sector finances would allow the engine of growth to switch back from the public to the private sector. On the second, the idea was that higher demand in surplus countries would make up for a lower spending path in deficit countries. But the actual progress on rebalancing has been timid at best, while the downside risks to the global economy are increasing.
implying thereby that coordinated fiscal policy (expansion) has no role in the long run, at least giving the impression to the reader/listener. However, she is right in stressing that surplus nations need to take up the task of rebalancing.
While talking of “urgent recapitalization” banks in Europe require, Lagarde also talks of a common vision for Europe:
Third, Europe needs a common vision for its future. The current economic turmoil has exposed some serious flaws in the architecture of the eurozone, flaws that threaten the sustainability of the entire project. In such an atmosphere, there is no room for ambivalence about its future direction. An unclear or confused message will add to market uncertainty and magnify the eurozone’s economic tensions. So Europe must recommit credibly to a common vision, and it needs to be built on solid foundations—including, for example, fiscal rules that actually work.
but no mention of a fiscal union! Most people – economists at least – would take the above to mean a plan to work toward achieving targets for deficits and public debt – an impossible dream.
Lagarde’s conclusions are right
There is a clear implication: we must act now, act boldly, and act together.
but this comes only by at least and not limited to coordinating fiscal policies not by “fiscal consolidation” – a phrase which literally suggests a fiscal contraction.
Conclusion
The IMF is a part of the problem but Christine Lagarde’s heart is in the right place – she needs to carefully think about how fiscal policy really matters and convey to others some of the ideas she has thought of, since they are slightly different from the IMF’s traditional beliefs. How far she goes will be interesting to see.
The sectoral balances identity
NAFA = PSBR + BP
(where NAFA is the private sector net accumulation of financial assets, PSBR is the public sector borrowing requirement to finance its deficit and BP is the current balance of payments) and the approach which is built around this, implies that if the public sector wants more saving, the government has no choice but to accommodate this demand unless it is prepared to run the economy at less than full employment. However, it doesn’t mean that the government has the ability to fully relax its fiscal stance up to constraints from the supply side, because if domestic demand starts expanding faster than domestic output, the nation’s balance of payments situation will suffer and this can be resolved only by correctly negotiated international policies which is good for all. The IMF should look at it that way instead of recommending fiscal expansion as a temporary measure.
Update
For a different take on Lagarde’s speech check Zero Hedge
Update 2:
Financial Times has a post Lagarde calls for urgent action on banks on this. The writer points out that
On fiscal policy, she continued the IMF’s change of emphasis away from immediate fiscal tightening, and towards fiscal programmes that reduce deficits over the long-term but which allow spending to continue while economies stay weak.