Tag Archives: euro area

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.

“Maastricht Is A Half-Baked Half-Way House”

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I frequently quote Wynne Godley’s Maastricht And All That written for the London Review Of Books in 1992. Here’s from another article (paywalled) for the same magazine from 1993:

I am in favour of Britain having much closer ties with other European countries, provided that appropriate institutions are created and the whole thing is brought under effective political control …

… The tract made only two points: that a single currency would remove the instability caused by fluctuating exchange rates, thereby enabling business to plan more reliably, and that international traders would no longer incur ‘transaction costs’ in the form of the small margin they now have to pay dealers when they buy and sell foreign exchange. It was as simple as that! The brief contained no reference whatever to the obvious fact that by joining a currency union, member countries would be giving up powers of independent action which at present they possess. It follows a fortiori that the document said nothing about who those powers would be given up to, and how the new authorities would exercise them …

… And if an individual country cannot issue its own money, it has no more power to conduct an independent fiscal policy than has a local authority, say, or an erstwhile colony in an imperial system …

… But to the extent that national governments can no longer be effective, this points to a pressing need for some supranational authority, call it a federal government, to carry out these functions …

… It is a good moment to start again. I think the Maastricht enterprise was built on a premise that has turned out to be completely mistaken: namely, that there can exist some kind of union between countries which is much more than a community of independent nations with special trading arrangements but much less than a full-blown political union. Maastricht is a half-baked half-way house and, with the CAP always at the back of my mind, I cannot agree that it is right to support it on the grounds that it is the only route ahead, the full nature of which will only be revealed in due course. Going forward should now mean that we explicitly hand over the main instruments of independent policy-making to some properly constituted body under appropriate political control. If this is not what Britain wants, is it completely out of the question that we now deliberately go backwards?

[italics in original, boldening mine]

– Wynne Godley in Derailed, London Review Of Books, 1993

Money Supposedly Became Fiat And Hence Balance Of Payments Does Not Matter Kind Of Argument

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So Karl Whelan wrote another article on TARGET2 claiming once more that a loss of TARGET2 claims of the Bundesbank does not matter at all to Germany. He has a new paper as well. Earlier he was arguing there was no loss at all.

His argument roughly is that since there is no longer trade settlement in gold, money is thence fiat and the loss does not matter.

Closed economy monetary economics is confusing enough for most monetary economists but when matters of open economy are discussed, it is a Herculean task for them to make sense of simple things. Some economists are better but end up making a mess.

First there is this story of “fiat money”. Supposedly after 1973 – when the Smithsonian Agreement broke down – money or currencies became fiat according to many theories. I guess this is generally the notion made popular by Austrian economists as far as I can tell and (is the root of all evil in this story). But this is strange. If “fiat money” has any meaning to it, money was equally fiat before – either during the Bretton Woods system or in any monetary institutional setups before that. So the US Dollar was as fiat as in 1920 as in 2012. There’s no meaning to saying that currencies became fiat suddenly.

Of course, in the Bretton Woods system, nations’ governments were required to redeem official foreign balances either in gold (till 1968), SDRs (after 1968) or in the currency of the member making the request (if any). In addition, there was a system of market convertibility in addition to official convertibility. In addition, the US volunteered to convert official foreign balances to gold till 1971.

So one could say that international trade was settled in gold. However, since money is credit, international trade would also settle by borrowing from foreigners – not just the official sector borrowing but other resident sectors borrowing from foreigners. The proper way to understand this is to study how balance of payments accounting is done and it was no different now than what it used to be.

A nation which runs a trade deficit need not lose gold reserves because the current account deficit could be financed via the financial account. If there is a problem in inflow, changes in interest rates by the central bank would attract funds from foreign financial centers.

More generally as always, it is income changes which works to bring imbalances back to balance. Sometimes things get out of hand, leading to a loss of gold reserves and the need for international financial help for exceptional financing of the balance of payments. But even in the supposedly new fiat world, things can get out of hand and require exceptional financing transactions.

Before Bretton Woods, nations had less formal agreements and typically the central bank and/or the government would promise to convert currency notes into gold at the request of the holder and not just official balances. It was thought that this made currencies acceptable and that the central bank should not issue more currency notes than the amount of gold they held. This story however, has no empirical support. It was however thought that the amount of currency notes is some multiple of the amount of gold and perhaps this is the origin of the story of the multiplier. But this is a troublesome story and there is some sort of view that money is exogenous in such monetary setups but endogenous otherwise – which makes no sense at all. Money is always credit-led and demand-determined and hence endogenous.

[To be more complete, some nations do not have a legal tender of their own and use other currencies as per law]

Now, economists argued that in the era of fixed exchange rates, an outflow of gold would lead to an automatic contraction of the money stock – the underlying theory being that of the money multiplier. This is presented as the Mundell-Fleming approach. Wages would reduce and this will lead to more competitiveness in international markets and bring the trade imbalance back into balance. This didn’t work because the whole notion was based on ideas of the money multiplier and notions such as that. (In addition it ignores the crucial aspect of non-price competitiveness).

So Emperor’s New Clothes – economists figured that floating exchanges would do the trick. Even a great economist such as Nicholas Kaldor believed so (while he was warning about troubles with the Bretton Woods system in the 1960s) but he was the first to point out that it doesn’t do the trick – soon in the 1970s.

More troublesome is the notion that if a nation is indebteded to foreigners in the domestic currency, it doesn’t owe foreigners anything and that this debt is just technical. The reason given is that nations are relieved to convert balances of foreign governments and/or central banks in the new era (the ones floating their exchange rates). But this is highly mistaken. While it is untrue (official convertibility still exists), it ignores the more important concept of market convertibility. The “reason” is dubious. It is true that it doesn’t cost the central bank anything if banks ask for currency notes to satisfy the demand for their customers, it doesn’t mean much. The private sector net wealth and aggregate demand is affected by net government expenditures and precisely when the nation has a balance of payments crisis, does the government have less power. It however is useful to have the government to make expenditures and take other emergency actions to handle a crisis in the external sector (with the exception of governments in a monetary union and nations which have “dollarization”). Debt denominated in domestic currency is useful for another reason. Assuming foreigners do not repatriate funds abroad when the currency is depreciating, it prevents a revaluation loss on liabilities. Indebtednesss in foreign currency on the other hand, leads to revaluation losses – implying more is needed from export receipts to prevent the debt from getting out of hand.

The fact that in any monetary setup nations face a balance of payments constraint has led nations to grow via success in international trade. Those who understood this trick early gained market and their success led to more success. This in turn puts a handicap on the rest of the world. The ‘mercantalist’ nations while didn’t believe the invisible hand (according to Keynes) nevertheless gain tremendously from the present system of free trade. As long as free trade is maintained, it is advantageous to nations to have strong external positions – in trade and in claims held on foreigners.

Now to the paper of Karl Whelan.

For Whelan, the external assets of a nation – including the claims of the government on non-residents – does not matter at all.

When considering the loss of the Bundesbank’s TARGET2 claim, it is important to distinguish between implications that matter and those that don’t.  Most of the commentary on this issue has focused on implications for the Bundesbank itself and the need for a hugely costly recapitalisation of the central bank.  For example, Burda (2012) argues that “Germany has now become a hostage to the monetary union, since a unilateral exit would imply a new central bank with negative equity.” However, there are a number of reasons why the capital position of the central bank is something of a red herring when considering a break-up scenario.

The first reason for this is that despite the common belief that central banks need to have assets that exceed their notional liabilities, there is no concrete basis for this position. Systems like the Gold Standard required a central bank to “back” the money in circulation with a specific asset but there is no such requirement when operating a modern fiat currency.  A central bank operating a fiat currency could have assets that fall below the value of the money it has issued – the balance sheet could show it to be “insolvent” – without having an impact on the value of the currency in circulation. A fiat currency’s value, its real purchasing power, is determined by how much money has been supplied and the factors influencing money demand, not by the central bank’s stock of assets. As discussed in the attached box, close examination reveals little merit to the various arguments that are put forward for the idea that a central bank must have positive capital to achieve its goals.

The second reason the focus on central bank capital is a red herring is that, even if it is decided after a break-up that Germany must recapitalise the Bundesbank, rather than being hugely costly, this recapitalisation would have no impact on either the net asset position of the German state or its budget deficit.  Let’s assume the German government recapitalises the Bundesbank by providing it with an interest-bearing government bond.  While the government’s gross debt will increase, the government bond becomes an asset of the Bundesbank, so the total public net debt does not change.

Similarly, suppose the new debt provides interest payments of €3.9 billion (equal to the annual interest that would be generated by the September 2012 level of Bundesbank net Intra-Eurosystem claims). This payment would raise the profits of the Bundesbank by this amount, thus raising the amount the Bundesbank can return to the German government by the same amount, resulting in no change in the budget deficit.

So the issue facing Germany in case of a loss of its Intra-Eurosystem claims is not the insolvency of the Bundesbank or the costs associated with recapitalising it.  The real issue is simply that the Bundesbank had a large asset and this asset will have disappeared. Still, despite the eye-popping level of the Bundesbank’s TARGET2 claim, the disappearance of the net income from the Intra-Eurosystem claims would have a very modest impact on the annual German budget. At an interest rate of 0.75 percent, the yield of €3.9 billion on the net Intra-Eurosystem claims of €516 billion as of the end of September represents only 0.15 percent of German GDP. Rather than a huge potential loss keeping Germany hostage within the Eurozone, I suspect this is a loss than many Germans would shrug off as perhaps being smaller than the likely costs associated with the sovereign bailout funds aimed at saving the euro.

Although Whelan accepts there is a loss (although he wasn’t earlier), there is hodge-podge here in the whole write-up. Whether there is gold involved in settlement of international debt or if the government promises to convert currency notes into gold (to keep its currency acceptable and which is just an illusion in any case) is an entirely irrelevant issue. The potential of a loss of huge amounts (given that a panic can lead to further losses for the German public sector – to see how see this post) is dreadful to Germany. The seigniorage calculation is hardly useful. It is like telling someone that a $1m loss doesn’t matter because it only earns $2,500 per year – given current interest rates. His point that there is “no change in the budget deficit” if Bundesbank’s foreign assets get replaced by German government debt has a simple calculation mistake – in one case the public sector is receiving interest income from abroad and in the other it isn’t.

(Apologies for misspelling Whelan earlier in some places in earlier version)

Nicholas Kaldor On European Political Union

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It is sometimes said that a fiscal union would be the best solution to the Euro Area crisis – perhaps it is the only solution. Indeed while the German leaders Angela Merkel and Wolfgang Schäuble have been trying to promote “more Europe” to achieve this objective, their plan is still defective since it is likely to be based on old plans of a political union.

The idea that the Euro Area needs a political union was known from before – as mentioned by the Werner Report from 1971. Nicholas Kaldor wrote an article in the same year (In The Dynamic Effects Of The Common Market first published in the New Statesman, 12 March 1971 and also reprinted (as Chapter 12, pp 187-220) in Further Essays On Applied Economics – volume 6 of the Collected Economic Essays series of Nicholas Kaldor) highlighting the serious defects in the plan.

See my post Nicholas Kaldor On The Common Market. In the post I missed out Kaldor’s important points about the plan for the fiscal union itself.

If the leaders of Europe are proposing to have a plan such as in the Werner report, then Europe is in more trouble. “What is not envisaged is that the main responsibility for public expenditure and taxation should be transferred from the national Governments to the Community.” According to Kaldor, this is bound to fail for reasons mentioned below.

This fault was also noted by Philip Arestis and Malcolm Sawyer recently in their article The Dangers Of Pseudo Fiscal Union In The EMU.

I am reproducing here the relevant section of Kaldor’s essay (pp. 202-207) for the sake of completeness:

THE CONSEQUENCES OF A FULL ECONOMIC
AND MONETARY UNION

The events of the last few years – necessitating a revaluation of the German mark and a devaluation of the French franc – have demonstrated that the Community is not viable with its present degree of economic integration. The system presupposes full currency convertibility and fixed exchange rates among the members, whilst leaving monetary and fiscal policy to the discretion of the individual member countries. Under this system, as events have shown, some countries will tend to acquire increasing (and unwanted surpluses) in their trade with other members, whist others face increasing deficits. This has two unwelcome effects. It transmits inflationary pressures emanating from some members to other members; and it causes the surplus countries to provide automatic finance on an increasing scale to the deficit countries.

Since exchange-rate adjustments or “floating rates” between members are held to be incompatible with the basic aim of economic integration (and are incompatible also with the present system of common agricultural prices fixed in international units) the governments of the Six, at their Summit meeting in The Hague in December 1969, agreed in principle to the creation of a full economic and monetary union, and appointed a high-level committee (the so-called “Werner Committee”) to work out a concrete programme of action.

The Werner Committee’s recommendations have not yet been adopted in detail, though its principal objectives have been confirmed by the Community’s Council of Ministers.

The realisation of economic and monetary union, as recommended in the Werner Report, involves three kinds of measures, each introduced in stages: monetary union, tax harmonisation, and central community control over national budgets.  It envisages a three-stage programme, with each stage lasting about three years, so that the whole plan is designed to be brought into operation by 1978-80.

In the monetary field in the first stage the interest and credit policy of each central bank is increasingly brought under common Community surveillance and permitted margins of variations between exchange rates are reduced or eliminated. In the second stage exchange rates are made immutable and “autonomous parity adjustments” are totally excluded. In the third stage the individual central banks are abolished altogether, or reduced to the status of the old colonial “Currency Boards” without any credit creating power. [footnote: Different currencies (marks, francs, etc.) might be nominally retained so long as each currency has always a 100 per cent. backing in terms of the Community’s reserve currency.]

In the field of tax harmonisation it is envisaged that each country’s system should be increasingly aligned to that of other countries, and that there should be “fiscal standardisation” to permit the complete abolition of fiscal frontiers, which means not only identical forms but also identical rates of taxation, particularly in regard to the value added tax and excise duties.

In the field of budgetary control the Werner Report says “the essential elements of the whole of the public budgets, and in particular variations in their volume, the size of balances and the methods of financing or utilizing them, will be decided at the Community level”.

What is not envisaged is that the main responsibility for public expenditure and taxation should be transferred from the national Governments to the Community. Each member will continue to be responsible for raising the revenue for its own expenditure (apart from the special taxes which are paid to finance the Community’s own budget but which will remain a relatively small proportion of total public expenditure and mainly serve the purposes of the Agriculture Fund and other development aid).

And herein lies the basic contradiction of the whole plan. For the Community also envisages that the scale of provision of public services (such as the social services) should be “harmonised” – i.e., that each country should provide such benefits on the same scale as the others and be responsible for financing them by taxation raised from its own citizens. This clearly cannot be done with equal rates of taxation unless all Community members are equally prosperous and increase their prosperity at the same rate as the other members. Otherwise the taxation of the less prosperous and/or the slower-growing countries is bound to be higher (or rise faster) than that of the more prosperous (or faster-growing) areas. [footnote: A further reason for differences in the burden of taxation necessary to provide a given level of service lies in differences in demographic structure – e.g., some countries have a larger proportion of pensioners or schoolchildren than others.]

The Community will control each member country’s fiscal balance – i.e., it will ensure that each country will raise enough in taxation to prevent it from getting into imbalance with other members on account of its fiscal deficit. To ensure this the taxes in the slow growing areas are bound to be increased faster; this in itself will generate a vicious circle, since with rising taxation they become less competitive and fall behind even more, thereby necessitating higher social expenditures (on unemployment benefits, etc.) and more restrictive fiscal policies. [footnote: It is for this reason that in most countries it has been found necessary to transfer a rising population of social expenditure (on poor relief, education, roads etc.) from local authorities to the Central Government, and to supplement an increasing proportion of local tax revenues by grants from the Centre (such as the rate-equalisation grants in the U.K.).] A system on these lines would create rapidly growing inequalities between the different countries, and is bound to break down in a relatively short time. [footnote:  To imagine the consequences one should ask what would happen if the inhabitants of each county in the U.K. were required to finance all their social expenditure by local taxes. Living in Cumerland would be enormously penalised; living in Surrey would be a tax haven.]

This is only another way of saying that the objective of a full monetary and economic union is unattainable without a political union; and the latter pre-supposes fiscal integration, and not just fiscal harmonisation. It requires the creation of a Community Government and Parliament which takes over the responsibility for at least the major part of the expenditure now provided by national governments and finances it by taxes raised at uniform rates throughout the Community. With an integrated system of this kind, the prosperous areas automatically subside the poorer areas; and the areas whose exports are declining obtain automatic relief by paying in less, and receiving more, from the central Exchequer. The cumulative tendencies to progress and decline are thus held in check by a “built-in” fiscal stabiliser which makes the “surplus” areas provide automatic fiscal aid to the “deficit” areas.

Even so, there is need for special regional policies – such as the U.K. differential grants and subsidies to the development areas – to alleviate the problems of growing regional inequalities. The need for the latter is recognised (in a vague way) in the Werner Report, which mentioned “community measures which should primarily concern regional policy and employment policy” and whose “realization would be facilitated by an increase in financial intervention at the Community level”. What the Report fails to recognise is that the very existence of a central system of taxation and expenditure is a far more powerful instrument for dispensing “regional aid” than anything that special “financial intervention” to development areas is capable of providing.

The Community’s present plan on the other hand is like the house which “divided against itself cannot stand”. Monetary union and Community control over budgets will prevent a member country from pursuing full employment policies on its own – from taking steps to offset any sharp decline in the level of its production and employment, but without the benefit of a strong Community government which would shield its inhabitants from its worst consequences.

Some day the nations of Europe may be ready to merge their national identities and create a new European Union – the United States of Europe. If and when they do, a European Government will take over all the functions which the Federal government now provides in the U.S., or in Canada or Australia. This will involve the creation of a “full economic and monetary union”. But it is a dangerous error to believe that monetary and economic union can precede a political union or that it will act (in the words of the Werner report) “as a leaven for the evolvement of a political union which in the long run it will in any case be unable to do without”. For if the creation of a monetary union and Community control over national budgets generates pressures which lead to a breakdown of the whole system it will prevent the development of a political union, not promote it.

But it would be also dangerous to dismiss the Werner Report on the ground that it is not likely to be implemented, particularly if Britain is inside the Community and will have a voice in deciding what happens. For the problems that led to The Hague decisions and to the Werner Report are genuine enough: the framework of institutions and arrangements which make up the present European Community do not constitute a viable system. The Community must either go forward towards full integration (via a political union) or else relax the rigidity of its present arrangements, particularly in regard to agriculture and exchange rates. And it would be hopeless for Britain to join the Community not knowing whether it wishes to move in one direction or the other.

[italics in original, boldening mine]

Not A Balance-Of-Payments Crisis?

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Here’s a new piece by Randall Wray on Economonitor claiming current accounts do not matter (once again!) and didn’t have much of a role on the Euro Area crisis. Part of his arguments are the same as those who participated in public debates 1991 (most, not all) and claimed the balance-of-payments doesn’t matter.

Perhaps he should revise his study of sectoral balances.

Before I consider his analysis, let me remind you why current account deficits matter. A current account deficit is the deficit between the income and expenditure of all resident units of an economy and because it is a deficit, it needs to be financed. Cumulative current account deficits lead to a rise in the net indebtedness of a nation (i.e., consolidated net debt of all resident sectors of an economy) and cannot keep rising forever relative to output. This is because a deficit in the current account is equal to the net borrowing of the nation which has to be financed and secondly, the debt built up needs to be refinanced again and again.

Here’s via Eurostat

It is clear from the chart that nations with high negative NIIP (and hence high net indebtedness) were/are the ones in trouble.

The accounting identity which connects the NIIP to CAB is:

Δ NIIP = CAB + Revaluations

Most of the times, revaluations have less of a role in explaining the NIIP. Of course one can always come up with exceptions – such as for the United States with huge revaluations due to outward FDI and Ireland. It should however be noted that Ireland also had high current account deficits.

Here is data from the IMF on the current account balances:

From this you can see “Germany is not Greece”, “Netherlands is not Spain”, “Finland is not Cyprus” and so on and also the relation of CAB to NIIP.

Let me turn now to what Wray has to say:

Yesterday one presenter at this conference provided a lot of interesting data on cross border lending by European banks, most of which consisted of lending to fellow EMU members. He showed a strong correlation between cross border lending and cross border trade. Hence, posited a link between flows of finance and flows of goods and services. So far, so good. He also accepted a comment from the audience that correlation doesn’t prove causation, and that flows of finance are orders of magnitude larger than trade in goods and services—in other words, most of the financial churning has nothing to do with “real” production.

So atleast Wray accepts there is a correlation of some kind. For causation, see the arguments presented at the beginning of this post.

I won’t rehash that argument. Balances do balance, after all. For every current account deficit there’s a capital account surplus. It seems to me that the claim that the EMU suffers from “imbalances” is on even shakier ground. After all, they all use the same currency, so there’s no chance that an “imbalance” will lead to a run on the currency and to exchange rate depreciation (a usual fear following on from a current account deficit).

This argument was made by neoclassical economists around late 80s and early 90s when Europe was planning to form a monetary union. See this post Martin Wolf Pays A Generous Tribute To Anthony Thirlwall. Wray misses the point that a balance-of-payments crisis also leads to a deflationary spiral and that even though there is no exchange rate collapse, there is deflation in the Euro Area – exactly as predicted by those economists who thought the notion “current account deficits do not matter” was precisely wrong in the early 1990s.

Then Wray goes on to suggest that banks creating a boom and bust in Germany would have looked different:

Yes. But in what sense is that an “imbalance”? Look at it this way. What if instead of running up real estate prices in the sunny south—so that Brits and northern Europeans could enjoy vacation homes—the German banks had instead fueled a real estate bubble in Berlin? What if they had eliminated all underwriting standards and lent until the cows come home on the prospect that Berlin house prices would rise at an accelerating pace? Speculators from across the world would buy a piece of the bubble on the prospect that they’d reap the gains and sell-out at the peak. Construction activity would boom, workers could demand higher wages and would increase consumption, and Germany would have experienced higher price inflation than the rest of Euroland.

In the hypothetical case of Wray where German banks lend the non-financial sectors till the “cows come home”, domestic demand would have risen sharply (which he himself suggests) and this would have had the adverse effect on the balance of payments. Germany would have started running current account deficits because imports are dependent on domestic demand. Germany would have suffered similar fate but in the end it would have depended on how fast the domestic demand rose.

Wray should be careful in doing sectoral balances.

Bad bank behavior can boom or bust an economy—with or without current account deficits. And that’s pretty much what happened in Spain and Ireland (and also in Iceland).

Wray would have sounded right if he had given examples of nations having current account surpluses but from IMF’s table above it can be seen that both Spain and Ireland had huge current account deficits.

What about Iceland?

The data is from 2004-2011 and you can see that in 2008, Iceland had a current account deficit of 28.4%.

Wray then compares the Euro Area to the United States:

In Euroland, all use the same euro currency, and clearing is accomplished among the central banks and through the ECB (that is where Target 2 comes in). It works about as smoothly as the US system. But here’s the difference: the ECB “district banks” are national central banks. It is thus easier to keep mental tabs on the “imbalances” by member states in the EMU than in the USA.

Yes keeping mental tabs on imbalances (and not “imbalances”) can have its effect, but Wray crucially misses the point that in the United States, there is an automatic mechanism of compensating for trade imbalances via fiscal transfers. This acts via lower total taxes paid by regions facing slowdown caused by trade imbalances (not to be confused with lesser taxes paid due to reduced tax rates if any). A rise in public expenditure (not necessarily discretionary but resulting from government guarantees made beforehand) also helps.

Wray however quotes Mosler but he misses the point as well since it talks of directed government spending as opposed to a built in automatic mechanism which (the latter) prevents a crisis at this scale/type from happening.

Generally speaking, Wray seems to suggest that the crisis happened because the private sector credit-led boom went bust and this has nothing to do with current account imbalances. While it is true that the private sector credit-led boom ended in a bust and caused a crisis, what Wray misses is that the current account deficits contributed to exacerbating the crisis because nations in trouble built up huge indebtedness to the rest of the world and had troubles to refinance their debts. If all sectors of an economy have a consolidated net indebtedness position to the rest of the world, they will have issues borrowing and refinancing since – as a matter of accounting – foreigners have to attracted. Foreigners were unwilling because of doubts and also because there was/is a crisis in the world economy, they changed their portfolio preferences – making the whole issue of financing even more difficult.

A Digression On TARGET2

It can be argued that since the TARGET2 mechanism has a stabilizer of some sort – that since the Eurosystem TARGET2 claims arising due to capital flight from the “periphery” is an accommodative item in the balance-of-payments, current account deficits shouldn’t have been an issue.

The error in this argument is that while it is true that capital flight is automatically financed by the resultant Eurosystem TARGET2 claims and that this is helpful, it depends on the hidden assumption that banks have unlimited/uncollaterilized overdrafts at their home central banks. We have seen in various scenarios – such as with procedures such as the Emergency Liquidity Assistance (ELA) – that banks in the “periphery” can either run out of sufficient collateral needed to borrow from their home NCB or have chances to run out of collateral. They hence need to attract funds from abroad. The nation as a whole is dependent on foreigners. Current account deficits are not self-financing.

20 Years Of Maastricht And All That

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I recite all this to suggest, not that sovereignty should not be given up in the noble cause of European integration, but that if all these functions are renounced by individual governments they simply have to be taken on by some other authority. The incredible lacuna in the Maastricht programme is that, while it contains a blueprint for the establishment and modus operandi of an independent central bank, there is no blueprint whatever of the analogue, in Community terms, of a central government. Yet there would simply have to be a system of institutions which fulfils all those functions at a Community level which are at present exercised by the central governments of individual member countries.

The counterpart of giving up sovereignty should be that the component nations are constituted into a federation to whom their sovereignty is entrusted. And the federal system, or government, as it had better be called, would have to exercise all those functions in relation to its members and to the outside world which I have briefly outlined above.

That was published 8th October 1992 – exactly 20 years back!

Worth your time if you haven’t read it yet. Even if you have, worth reading it again!

Here’s the link to the full article Maastricht And All That by Wynne Godley.

Wynne Godley

(photo credit: King’s College, Cambridge)

Also check out John Cassidy’s post The Man Who Saw Through The Euro written for The New Yorker last year.

Why Paul De Grauwe Is Wrong About TARGET2

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The financial and non-financial resources at the disposal of an institutional unit or sector shown in the balance sheet provide an indicator of economic status. These resources are summarized in the balancing item, net worth. Net worth is defined as the value of all the assets owned by an institutional unit or sector less the value of all its outstanding liabilities. For the economy as a whole, the balance sheet shows the sum of non-financial assets and net claims on the rest of the world. This sum is often referred to as national wealth.

– 13.4, System of National Accounts 2008 (pdf)

Recently, Paul De Grauwe joined the long debate on TARGET2 with a paper What Germany Should Fear Most Is Its Own Fear: An Analysis Of Target2 And Current Account Imbalances. He is supposed to be the top economist in both public and academic debates about the Euro Area but unfortunately, there are glaring errors in his paper.

This paper was aimed at Hans-Werner Sinn who started ringing alarm bells on the huge TARGET2 claims of the Deutsche Bundesbank. The claim of this post (and some more in the past in this blog) is that while Prof Sinn may be wrong on many issues in the debate, he is right about a few important issues. Needless to say, his prescriptions are not defended by me. I am a fan of Nicholas Kaldor’s ideas as quoted in my post Nicholas Kaldor On The Common Market.

De Grauwe’s argument is slightly more nuanced that others such as Karl Whelan. While Whelan dismisses any argument that a loss of creditor nations’ TARGET2 claims on the periphery Euro Area nations is a loss, De Grauwe modifies this to say that the repatriation of funds by Germans (individual investors and institutions) does not increase Germany’s risks.

So we have this claim in his paper:

Thus the increase in the Target2 claims of the Bundesbank should not be interpreted as an increase of foreign claims of Germany, and thus as an increase of risk from higher foreign exposure. Using the Target claims as a measure of risk incurred by the German population is therefore erroneous. As we have seen earlier, after 2010, the Target claims of Germany (and other Northern countries) increased dramatically and much more than the current account surpluses during this period. This increase in Target2 claims cannot be interpreted as an increase in the foreign exposure (net foreign claims) of Germany, except to the extent that they were the result of current account surpluses. What changed dramatically is the nature of these claims. Prior to 2010, these claims were mainly claims held by private German agents (mainly financial institutions). Similarly the liabilities of the peripheral countries were held by private agents (financial institutions). The eurozone crisis led to a dramatic shift. As a result of the breakdown of the interbank market, a large part of these private claims and liabilities were transformed into (public) Target claims and liabilities (Buiter et al., 2011), without however changing the total net foreign claims and liabilities of these countries. Thus, the explosion of the Target claims of Germany since 2010 cannot be interpreted as an explosion of the risk of foreign exposure for Germany.

Ignoring the fact that the repatriation of funds by German residents back to Germany puts the risks on the public sector’s books and awards the (ex-) German lender, there is some element of truth to the above claim. The repatriation of funds does not increase Germany’s gross international investment position (assets and liabilities) but just changes the composition. It however ignores the fact that nonresidents also reallocate their portfolios in German assets and this increases Germany’s gross foreign assets and liabilities and in case there is a default by the periphery on the TARGET2 liabilities (in case they leave the Euro Area), Germany suffers a loss. We will see this with an example below. Before that let me highlight one misleading claim in the paper:

The value of the money base is exclusively determined by its purchasing power in terms of goods and services. This value is independent of the value of the assets held by the central bank. In fact in the fiat money system we live in, the central bank could literally destroy the assets without any effect on the value of the money base. In order to stabilize the value of the money base, the central bank should keep the right supply of money base, i.e. a supply that will maintain price stability.

That is Monetarist handwaving. Won’t say anything further!

When the central bank acquires assets, mainly government bonds, it issues new liabilities. The latter take the place of the government bonds in the portfolios of private agents. It is as if the government debt has disappeared. It has been replaced by central bank debt. The central bank could literally put the government bonds in the shredding machine. This would not affect the value of the central bank debt as the central bank has made no promise to redeem its debt (money base) into government bonds. And as long as the central bank maintains price stability, agents will willingly hold the new debt (money base) issued by the central bank.

That is incorrect. The People’s Bank of China cannot shred US Treasuries into a dustbin and claim it does not matter to the Chinese people.

Now to the main point about this post: foreigners shifting funds into assets issued by German residents.

Here is from the Bundebank’s statistical supplement for Germany’s international investment position:

Aktiva is Assets, Passiva is Liabilities and Saldo is Net.

Germany’s assets and liabilities can increase as a result of a nonresident (such as from Spain) buying German Bunds (government bonds). If an institution in Spain liquidates its position in Spanish assets and transfers the funds to purchase  Bunds, Bundebank’s TARGET2 claims will increase (in the current scenario).

Let us use these numbers to see how Germany’s IIP changes if there is a purchase of €100bn of German assets by German nonresidents (but residents in Euro Area for simplicity).

Initially,

Germany’s Assets = €6,843bn

(of which TARGET2 claims = €727bn)

Germany’s Liabilities = €5,829bn

NIIP = €1,014bn

Now assuming a nonresident purchases €100bn of German government bonds from a German resident,

Germany’s Assets = €6,943bn

(of which TARGET2 claims = €827bn)

Germany’s Liabilities = €5,929bn

NIIP = €1,014bn

So while Germany’s gross assets and liabilities have increased by €100bn, its net position is the same.

However this is not the end of the story. When nonresidents purchase €100bn worth of German securities, the TARGET2 claims of the Bundesbank (or more generally creditor nation’s TARGET2 claims) increases by €100bn. If there is breakup of the Euro Area position at this point in time, this will leave the creditor EA nations with an additional liability of €100bn (incurred just before the breakup) while at the same time losing the €100bn of assets (TARGET2) acquired (in addition to other assets) and hence an NIIP worse than the case if the transaction had not occurred.

This number can be much higher because when there are tensions building up in the financial markets, foreigners may shift funds into Germany and if a breakup really is forced upon the Euro Area, it will leave Germany with additional liabilities and a lower NIIP than before and a huge loss of wealth.

At any rate, a non-negligible part of the German international investment position can be due to foreigners already having shifted funds in German assets (as the gross assets and liabilities position indicates).

But De Grauwe claims (thanks to JKH for pointing):

It is surprising that these simple principles are not widely understood.

!

Recently, the ECB announced a plan which substantially reduces the risks of a breakup of the Euro Area. In the absence of a breakup, discussions such as these are purely academic. However, the story has new twists and turns, and one can never be sure what is going to happen. It is however counterproductive to claim there is no risk/loss (in select scenarios) when there is indeed one.

Needless to say this analysis is not a defense of the German position either. Free trade has helped them a lot and it is time they increase domestic demand and help reduce global imbalances.

OMT! Enter The Draghi

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As leaked earlier by Bloomberg, Mario Draghi in a press conference today, presented his big plan to save the world.

This will involve OMTs (Outright Monetary Transactions) – in which a Euro Area nation central government requesting aid from the EFSF/ESM will also be provided help by the ECB. Under this plan, when a nation’s government asks for financial aid (and a big if), the ECB/Eurosystem may buy government bonds in the open markets to bring the yields down.

The Eurosystem will buy bonds with maturities between one and three years and will accept credit risk on these bonds and will not ask for a seniority status in case of default. Of course, this will come with strict conditions – the government asking for aid would need to commit to a tighter fiscal policy and promise supply side reforms. There will be no upper limit to the  amount of bonds purchased by the Eurosystem.

The full details are here: Introductory statement to the press conference, 6 September 2012 – Technical features of Outright Monetary Transactions.

During the press conference (actually a bit before as well – after Bloomberg leaked a part of the plan), government bond yields had huge moves (e.g, Spanish ten year yields decreased 39bp). Now, if the yields do not reverse and deteriorate again soon, governments requiring help may just delay asking for aid. However, sooner or later bond yields may rise again – especially if foreigners holding the bonds start to get nervous.

My own view is that this plan significantly reduces the risk of an exit by a Euro Area member. Unlike previous plans (SMP, EFSF, ESM) this has no limit on the amount of funds needed. There is no need to wait for parliaments and courts to approve any transaction or aid.

Of course this is not a happy set of affairs. Forcing governments into retrenchment will lead to economic conditions deteriorating further. One however needs to realize that an independent fiscal policy for the troubled nations – while it (an expansion) increases national income and output – will have the adverse effect of deteriorating the balance of payments – resulting in the public debt and the nation’s net indebtedness to foreigners (and the latter is already high for troubled nations) rising without limit relative to output. The plan will look good in retrospect if it is supposed to be a bridge toward a political union with a central government.

Join, Or Die. aka “I Want Europe”

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Join, Or Die by Benjamin Franklin (Source: Wikipedia)

It is possible – in my opinion – that the September Constitutional Court Ruling in Germany may indicate that Germany should move toward a European Integration where European nations surrender powers to the European Union. Angela Merkel has been pushing for this but her critics argue that this is a surrender of sovereignty. They should realize that by giving the power to make a draft at their central bank, European governments have already given up their sovereignty – but without any central government to whom this is entrusted. The integration is a right move in that direction.

However, there is a general lack of trust and this has to be created – else there is no solution to than a breakup with unknown consequences.

Hence Merkel is launching a campaign “I Want Europe”.

Interesting reads on the future of Europe:

The Man At The Heart Of The European Economic Storm (Irish Times article on Wolfgang Schäuble)

Excerpt:

A crucial difference lies in their political styles: while Merkel bases her euro zone strategy on an emotionless, cold-eyed analysis of Europe’s future – unite or die in a globalised world – Schäuble makes the same argument with a passionate eye on the past.

Full Interview

Excerpt:

Q:  At some point it will come to a referendum in Germany on greater European integration. Are you concerned that, by then, German critics of your crisis strategy will have poisoned enough of public opinion here to torpedo the project?

A:  We might need a referendum at some point because it’s in our constitution that, when we transfer considerable parts of our sovereignty to the EU, Germans will at that point have to give themselves a new constitution. When that day comes we will have to lead a big campaign and I am confident we have a good chance it will go well. Germans are in general very pro-European. But it’s not a question of now.

Merkel Joins Lahm, Schmidt In Campaign To Promote Europe (Bloomberg)

Merkel Launches New Pro-EU Campaign (Sky News)

Nicholas Kaldor On The Common Market

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… Some day the nations of Europe may be ready to merge their national identities and create a new European Union – the United States of Europe. If and when they do, a European Government will take over all the functions which the Federal government now provides in the U.S., or in Canada or Australia. This will involve the creation of a “full economic and monetary union”. But it is a dangerous error to believe that monetary and economic union can precede a political union or that it will act (in the words of the Werner report) “as a leaven for the evolvement of a political union which in the long run it will in any case be unable to do without”. For if the creation of a monetary union and Community control over national budgets generates pressures which lead to a breakdown of the whole system it will prevent the development of a political union, not promote it.

[italics in original]

That was written in 1971! In The Dynamic Effects Of The Common Market first published in the New Statesman, 12 March 1971 and also reprinted (as Chapter 12, pp 187-220) in Further Essays On Applied Economics – volume 6 of the Collected Economic Essays series of Nicholas Kaldor.

Further excerpts from the article:

Page 202:

The events of the last few years – necessitating a revaluation of the German mark and a devaluation of the French franc – have demonstrated that the Community is not viable with its present degree of economic integration. The system presupposes full currency convertibility and fixed exchange rates among the members, whilst leaving monetary and fiscal policy to the discretion of the individual member countries. Under this system, as events have shown, some countries will tend to acquire increasing (and unwanted surpluses) in their trade with other members, whist others face increasing deficits. This has two unwelcome effects. It transmits inflationary pressures emanating from some members to other members; and it causes the surplus countries to provide automatic finance on an increasing scale to the deficit countries.

Page 205:

… This is another way of saying that the objective of a full monetary and economic union is unattainable without a political union; and the latter pre-supposes fiscal integration, and not just fiscal harmonisation. It requires the creation of a Community Government and Parliament which takes over the responsibility for at least the major part of the expenditure now provided by national governments and finances it by taxes raised at uniform rates throughout the Community. With an integrated system of this kind, the prosperous areas automatically subside the poorer areas; and the areas whose exports are declining obtain automatic relief by paying in less, and receiving more, from the central Exchequer. The cumulative tendencies to progress and decline are thus held in check by a “built-in” fiscal stabiliser which makes the “surplus” areas provide automatic fiscal aid to the “deficit” areas.

[italics in original]

Page 206:

…What the Report fails to recognize is that the very existence of a central system of taxation and expenditure is a far more powerful instrument for dispensing “regional aid” than anything that special “financial intervention” to development areas is capable of providing.

The Community’s present plan on the other hand is like the house which “divided against itself cannot stand”. Monetary union and Community control over budgets will prevent a member country from pursuing full employment policies on its own- from taking steps to offset any sharp decline in the level of its production and employment, but without the benefit of a strong Community government which would shield its inhabitants from its worst consequences.

page 192:

Myrdal coined the phrase of “circular and cumulative causation” to explain why the pace of economic development of the various areas of the world does not tend to a state of even balance, but on the contrary, tends to crystallise in a limited number of fast-growing areas whose success has an inhibiting effect on the development of others. This tendency could not operate if changes in money wages were always such as to offset difference in the rates of productivity increase. This, however is not the case; for reasons that are not perhaps fully understood, the dispersion in the growth of money wages as between different industrial areas tends always to be considerably smaller than the dispersion in productivity movements. It is for this reason that within a common currency area, or under a system of convertible currencies with fixed exchange rates, relatively fast-growing areas tend to acquire a cumulative competitive advantage over relatively slow growing areas. “Efficiency wages” (money wages divided by productivity) will, in the natural course of events, tend to fall in the former, relatively to the latter – even when they tend to rise in both areas in absolute terms. Just because the differences in productivity increases, the comparative costs of production in fast-growing areas tend to fall in time relatively to those in slow-growing areas and thus enhance their competitive advantage over the latter.

I don’t have the copyrights to reproduce the whole article The Dynamic Effects Of The Common Market, so this is so much I can quote. You can read the rest from the book (Collected Essays 6). Also, there are five chapters on the Common Market.