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Mario Draghi – Euro Saviour?

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Recently Mario Draghi, the European Central Bank President, has been going around telling everyone that “fiscal consolidation” is the absolutely essential to resolve the Euro Area crisis, given some positive developments. Although, this view of his is known and this has had a big influence on policy, he has become more and more vocal about it in recent weeks. He has also signalled a “positive contagion” – a phrase he seems to have coined.

Here is Mario Draghi talking at the recent annual conference at Davos to John Lipsky. (Link no longer works)

If Draghi is to be believed, “fiscal consolidation” is an absolute necessity for the Euro Area to come out of the crisis.

In a recent press conference from January 10, Draghi said the same:

Question: Could Outright Monetary Transactions (OMTs) lose their magical effect in the markets if no country asks for them?

Second question: Jean-Claude Juncker has said that too much fiscal consolidation could have a negative effect on countries like Spain, because unemployment is so high. What can you say about that?

Draghi: On your first question, you do not have to ask me, ask the markets.

On the second, many comments of this type have been made about several countries in the euro area. My answer to this is that so much progress has already been made, accompanied by so many enormous sacrifices. So reverting to a situation which has been found to be untenable would not be right. We should not forget that this fiscal consolidation is unavoidable, and we certainly are aware that it has short-term contractionary effects. But now that so much has been done I do not think it is right to go back.

[emphasis: mine]

Back in July 2012, when Spanish government bond prices were plunging, Mario Draghi came up with a plan to save the Euro Area by first announcing on July 26 in a conference in London that “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro,” and after a pause, “And believe me, it will be enough.”. In the monetary policy meeting on September 6, he outlined a plan by the Eurosystem to buy government bonds without any ex-ante quantitative limits, provided the nations asking this facility agree to terms and conditions – mainly on fiscal policy.

This was greeted with great optimism and the “state of confidence” of the financial markets greatly improved in the next few months. Mario Draghi eventually became the FT Person Of The Year. The fact that nations have a backstop meant that the financial sector has been more willing to finance the governments and the nations actually haven’t felt the need to use the facility so far.

At the time, there was an urgent need to do something and the European Central Bank responded positively to prevent a financial and economic collapse.

While the condition that governments asking for the ECB’s help have to meet is unavoidable for any such plan, Mario Draghi seriously misunderstands the nature of the problem. While it is true that there needs to be structural reforms so that struggling Euro Area countries become more competitive relative to their partners and aim to improve their exports to reduce imbalances within the Euro Area, a Euro-Area wide fiscal contraction will fail to achieve this in any sustainable way. Structural reforms aka wage cuts, will further deflate demand in those nations as Michal Kalecki taught us.

Take Spain for example. Its current account is coming back to balance but this has been the result of a huge deflation of domestic demand and no wonder its unemployment rate hit 26% recently. Statements such as “fiscal consolidation is unavoidable” put all the burden on weaker nations. The Euro Area actually needs a fiscal expansion in creditor nations and although a relatively tighter fiscal policy in the debtor nations compared to creditor nations, an expansion compared to the present state nonetheless. In the long term it needs to form a political union – not like the ones floated by European leaders.

The weaknesses of the Euro Area going forward has been highlighted by Charles Goodhart in a recent appearance in the Economic and Financial affairs session of the UK Parliament. Here is the link to the video.

Also, in December 2012, Draghi and the EU leaders presented a plan Towards A Genuine Economic And Monetary Union. Again this approach has the same errors as the plans floating around since decades and debunked by Nicholas Kaldor in 1971 in one of the most prescient articles ever written.  See this post Nicholas Kaldor On European Political Union. The European leaders are seriously mistaken to think of any of their plans as “genuine”.

Somehow, the Monetarist counterrevolution of the 1970s seems to have forever distorted the vision of economists and economic advisers to politicians even if they do not think they are Monetarists.

Macdougall Report

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Charles Goodhart and Dirk Schoenmaker just released their article on a game plan for saving the Euro, which is approaching its endgame. According to them,

An EZ Minister of Finance without money is like an emperor without clothes. There are proposals to have tax capacity capable of funding a budget of about 2% of European GDP (Marzinotto et al 2011; Goodhart 2011). This 2% should cover most eventualities, including effective stabilisation policies. Yet there may be exceptional circumstances, for example, relating to banking resolution where more is needed (the deep pockets of government).

Given the severe imbalances in the Euro Area, this looks too low. Really 2%? A recent empirical study done by The Economist for the United States suggests otherwise.

What is wrong with the Euro Area? Wynne Godley said this best in an article (written in 1991) in The Observer titled “Commonsense Route To A Common Europe”. Scan here

But more disturbing still is the notion that with a common currency the ‘balance or payments problem’ is eliminated and therefore that individual countries are relieved of the need to pay for their imports with exports.

Quite the reverse: the existence or a common currency makes a country more directly dependent on its ability to sell exports and import substitutes than it was before, particularly as it will then possess no means whereby it can (in the broadest sense) protect itself against failure.

All of this was recognised in the Macdougall Report of 1977 which correctly argued that if a monetary union were not later to fly apart it would be necessary to have a Community budget at least seven times larger than existed then, with most of the increase going into the social and regional fund. The object of having a greatly enlarged budget would, of course, be to carry out the kind of fiscal equalisation that is at present performed by national budgets, and which is essential if a minimum standard of living is to be maintained throughout the Community.

[emphasis added ;-)]

The Macdougall Report is available from the European Commission website: Part 1 and Part 2. Haven’t read it, so my knowledge is restricted to the above quote, and it adds to my huge list of things to do.

At the time of writing, I believe the situation was much different. The imbalances in the “three sectors” (public, private and external) is now severe in the Euro Area. (Three for each country, so actually 17 x 3)

Sir Donald Macdougall died in 2004 and according to The Guardian‘s obituary:

His career – as an Oxford don, a London “special adviser”, a mover and shaker in Whitehall and Westminster – started before the second world war, and wound down with skilful “letters to the editor” against the euro.

There have been so many proposals on attempts to rescue the Euro Area. Ideas termed “monetary financing” by the European Central Bank carry tremendous risks of exacerbating imbalances within the Euro Area, because nations will keep relying on the Eurosystem’s financing and is a potential political time-bomb. And, there are those simpletons, who argue that nations should just walk away! As if …

To me, it looks as if the European leaders know that the size of the central government and the fiscal transfers would be substantial given Macdougall’s estimations were done when the situation was much different and a redoing may prove this. It is the political unacceptability of this, which will finally lead to Eurocalypse.

Krugman, Wolf And Goodhart

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Paul Krugman has a blog  post today titled Death By Accounting Identity, commenting on Martin Wolf’s FT Article Why cutting fiscal deficits is an assault on profits, where Wolf talks about the sectoral balances identity made famous by Wynne Godley. I guess the better way to put it is that Martin Wolf is trying to make the accounting identity famous.

A Damascene Moment

In his book with Marc Lavoie, Wynne Godley wrote in his part of Background memories (by W.G.)

… In 1970 I moved to Cambridge, where, with Francis Cripps, I founded the Cambridge Economic Policy Group (CEPG). I remember a damascene moment when, in early 1974 (after playing round with concepts devised in conversation with Nicky Kaldor and Robert Neild), I first apprehended the strategic importance of the accounting identity which says that, measured at current prices, the government’s budget deficit less the current account deficit is equal, by definition, to private saving net of investment. Having always thought of the balance of trade as something which could only be analysed in terms of income and price elasticities together with real output movements at home and abroad, it came as a shock to discover that if only one knows what the budget deficit and private net saving are, it follows from that information alone, without any qualification whatever, exactly what the balance of payments must be. Francis Cripps and I set out the significance of this identity as a logical framework both for modelling the economy and for the formulation of policy in the London and Cambridge Economic Bulletin in January 1974 (Godley and Cripps 1974). We correctly predicted that the Heath Barber boom would go bust later in the year at a time when the National Institute was in full support of government policy and the London Business School (i.e. Jim Ball and Terry Burns) were conditionally recommending further reflation! We also predicted that inflation could exceed 20% if the unfortunate threshold (wage indexation) scheme really got going interactively. This was important because it was later claimed that inflation (which eventually reached 26%) was the consequence of the previous rise in the ‘money supply’, while others put it down to the rising pressure of demand the previous year. …

I believe Wynne Godley discovered this identity while working for the British Treasury in the ’60s – at least the identity relating two sectors – domestic private sector and the government sector, but the damascene moment happened in 1974. The accounting identity is also used heavily in his 1983 book Macroeconomics, with Francis Cripps.

Charles Goodhart

Charles Goodhart also seems to be making use of the accounting identity (and a mental model built around this identity) in his recent Voxeu post Europe: After the Crisis. The difference is that in Charles Goodhart’s writing, fiscal policy is given less importance than monetary policy.

He talks of three implicit and incorrect assumptions:

  • The first, and most important, incorrect assumption was that a private-sector deficit in any country, matched by a capital inflow (current account deficit), should not be potentially destabilising.

The thinking was that the private sector must have worked out how to repay its debts before incurring them.

  • The second misguided assumption was that, in a single monetary system, local current account conditions not only cannot be calculated, but do not matter.
  • The third was that the public sector deficit of a member country is just as damaging when it is matched by a national private sector surplus, as by capital inflows.

I think each of these points is really insightful.

The first assumption is reminiscent of the economic agent in models who has a perfect foresight. The agent must have seen the future very well and would have calculated well in advance that things will go well. Consolidate all agents and we have the first assumption.

The second assumption is extremely well presented. People, especially economists asked – if the states in the United States used the same currency, why not Europe? The pitfall in this assumption is assuming away the U.S. Federal Government which makes fiscal transfers without anyone noticing.

The third assumption has to do with the lack of understanding the various causalities linking the three financial balances.Goodhart also goes into providing ideas for the design of “The fiscal counterpart to a monetary union”. One point I liked was on transfer dependency: 

For a stabilisa­tion instrument to be pure and effective, three principles are key (see Goodhart and Smith 1993 for details):

  • The instrument should be triggered following changes in economic activity but its intervention should be halted as soon as no further changes occur, irrespective of the level at which the economy has again become stable.

Otherwise, the instrument would perform not only a stabilisation function, but also play a redistribu­tive role. Such an ‘impurity’ is typical for traditional fiscal policy measures, but should be avoided in the Community context as it may perpetuate adjustment problems and induce transfer dependency.

….

Goodhart also makes a nice point on Japan – something (a part of it) you can see me writing in the Chartalists’ blogs’ comments section:

This analysis implies that the Eurozone needs a wholesale reorientation of the stability conditions. They must be refocused towards concern with external debt, and deficit, conditions and much less single-minded focus on the public sector finances.

If a member country is in a Japanese condition with a huge public-sector debt, but fully financed domestically, with a current-account surplus and large net external assets, then its debt should entirely be its own concern, and not subject to censure or control by any outside body, whether in a monetary union, or not. Of course, such greater attention to external, especially current-account, conditions needs to be more nuanced, since deficits, and external debts, incurred to finance tradeable goods production subsequently should provide the extra goods to sell to pay off such debts.

Japan’s public debt of 200% of GDP is quoted in rhetoric about public debt, but it is forgotten that Japan is a creditor nation and hence not always great to compare it with other nations.

Another recent article by Goodhart starts off well:

There are two main problems to be faced in any attempt to improve the architecture of international macro‐economic and financial oversight. The first is structural; the second is analytical. The first difficulty resides in the discord between having a system of national sovereignty at the same time as an international market economy, …