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Random Tidbits On National Accounts And Keynesian Models Of Income And Expenditure

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I came across this article (via a Tweet from Stephen Kinsella): Accounting As The Master Metaphor Of Economics by Arjo Klamer and Donald McCloskey which discusses how the framework of national accounts has been pushed to the background in economic analysis over the years.

It is a nice read – although boring in a few places. I found this reference to John Hicks’ 1942 book The Social Framework: An Introduction To Economics in the above article and managed to get a copy – although a used one but with almost no usage. As described in the Klamer-McCloskey’s article, Hicks’ textbook really goes into details of national accounts and he seems to have had a great intuition of how it all works.

John Hicks - The Social Framework

Hicks’s book gives a nice introduction to how important national accounts are in understanding and describing the production process and economic cycles.

Here is a scan of two pages on the balance of payments – the topic I like the most.

John Hicks Balance Of Payments

(click to enlarge)

Hicks understood how weak balance of payments can cause troubles. Of course, it took the genius of Nicholas Kaldor to realize the supreme importance of balance of payments in the determination of national income and expenditure. Leaving that aside, the text has nice ideas and discussions on how stocks and flows feed into one another.

John Hicks is famous for an entirely different reason – the IS/LM model. Later he accepted it was a huge mistake, but put it mildly: “… as time as gone on, I have myself become dissatisfied with it”. But economists still keep using it and keep erring.

Also, Hicks was to soon abandon/forget his own social accounting approach as per Klamer-McCloskey’s article. Perhaps, not really.

In an extremely important paper, Wynne Godley said:

To come down to it, the present paper claims to have made, so far as I know for the first time, a rigorous synthesis of the theory of credit and money creation with that of income determination in the (Cambridge) Keynesian tradition. My belief is that nothing the paper contains would have been surprising or new to, say, Kaldor, Hicks, Joan Robinson or Kahn.

John Hicks also had another nice book called A Market Theory Of Money written in 1989. Here is a great insight (also the view of Kaldor) from Page 11, Chapter 1 named “Supply And Demand?” on how to create a dynamic Keynesian theory of determination of national income and expenditure:

… The traditional view that market price is, at least in some way, determined by an equation of demand and supply had now to be given up. If demand and supply are interpreted, as had formerly seemed to be sufficient, as flow demands and supplies coming from outsiders, it is no longer true that there is any tendency over any particular period, for them to be equalized: a difference between them, if it were not too large, could be matched by a change in stocks. It is of course true that if no distinction is made between demand from stockholders and demand from outside the market, demand and supply in that inclusive sense  must be equal. But that equation is vacuous. It cannot be used to determine price, in Walras’ or Marshall’s manner. For what matters to the stockholder is the stock that he is holding: the increment in that stock, during a period is the difference between what is held at the end and what was held at the beginning, and the beginning stock is carried over from the past. So the demand-supply equation can only be used in a recursive manner, to determine a sequence (It is a difference or a differential equation); it cannot be used directly to determine price, as Walras and Marshall had used it.

I came across a reference in the book (The Social Framework) to a paper by James Meade and Richard Stone on concepts on national accounts: The Construction Of Tables Of National Income, Expenditure, Savings And Investment written in 1941. It has the following interesting table:

James Meade & Richard Stone - Sectoral Balances

which is the now famous sectoral balances identity! Incidentally, it also includes Kalecki’s profit equation. In the above “Foreign Investment” shouldn’t be confused with Foreign Direct Investment flows in the financial account of the balance of payments. The authors define it as:

… equal to income generated by receipts from abroad less current expenditure abroad.

So can we call the profit equation SMK equation? 🙂

James Meade and Richard Stone were pioneers of national accounts. Incidentally, James Meade wrote a famous textbook on balance of payments.

Of course the way this is presented doesn’t make the connection between the financial account and current accounts. The sectoral balances was usually written by Wynne Godley as:

NAFA = PSBR + BP

where NAFA is the net accumulation of financial assets of the private sector, PSBR is the net public sector borrowing requirement, and BP is the current account balance of international payments. More on this connection below.

How it is to be derived in a stock-flow consistent framwork of Godley/Lavoie? If you click on this search Transactions Flow Matrix, you will find some blog posts on the background. First, we construct a flow matrix like this:

Simplified National Income Matrix

The last line is essentially Kalecki’s profit equation.

The above construction however raises an important question. Godley and Lavoie’s textbook (Chapter 2) quotes a famous 1949 article of Morris Copeland on this:

When total purchases of our national product increase, where does the money come from to finance them? When purchases of our national product decline, what becomes of the money that is not spent?

Copeland’s work was highly successful and established the flow of funds accounts of the United States in 1952.

Here is a republished version of the article (via Google Books):

click to preview on Google Books’ site

Incidentally, Copeland was motivated to prove the quantity theory of money wrong when he did this work! Also Godley/Lavoie point out that John Dawson (the editor of the above book) says:

the acceptance of…flow-of-funds accounting by academic economists has been an uphill battle because its implications run counter to a number of doctrines deeply embedded in the minds of economists.

in an article from the chapter The Conceptual Relation Of Flow-Of-Funds Accounts To The SNA of the same book.

Over time, the system of national accounts (with its first version in 1947) has used some of the concepts of flow of funds accounting and now the framework is much more wider than usual textbook guides of national accounts. The flow of funds still retains importance because it has information which the system of national accounts such as (2008 SNA) doesn’t handle.

Here’s the UN website for the historical versions of the system of national accounts.

How does one look at this in a stock-flow coherent framework? Simple, we need a full transactions flow matrix – which not only includes income/expenditure flows but also financial flows. The following is how it looks like for a simple model:

Transactions Flow Matrix 3

(Click to zoom)

Of course, identities themselves shouldn’t be looked at as models. One needs a fully coherent accounting model of the economy based on behavioural assumptions and “closures”. See this essay Keynesian theorising during hard times: stock-flow consistent models as an unexplored ‘frontier’ of Keynesian macroeconomics Camb. J. Econ. (July 2006) 30(4): 541-565 by Claudio Dos Santos and also Wynne Godley and Marc Lavoie’s book Monetary Economics. As Dos Santos quotes Lance Taylor in the article:

Formally, prescribing a closure boils down to stating which variables are endogenous or exogenous in an equation system largely based upon macroeconomic accounting identities, and figuring out how they influence one another.

Jan Hatzius On Sectoral Balances

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Business Insider’s Joe Weisenthal interviewed Goldman Sachs’ Jan Hatzius recently with questions aimed at his usage of the sectoral balances approach:

…

BI: Back to the balance sheet, multi-sectoral framework of looking at the economy. How did you come to this view? On Wall Street this is still very rare. I don’t see many economist talk about the economy this way, recognizing this identity and making projections based on it. How did you come to see this as the framework by which we should be looking at the economy right now?

HATZIUS: I’ve long been fascinated with looking at private sector financial balances in particular. There was an economics professor at Cambridge University called Wynne Godley who passed away a couple of years ago, who basically used this type of framework to look at business cycles in the UK and also in the US for many many years, so we just started reading some of his material in the late 1990s, and I found it to be a pretty useful way of thinking about the world.

It’s usually not something that gives you the secret sauce at getting it all right, because there are a lot of uncertain inputs that go into this analytical framework, but I do think it’s a reasonable organizing framework for thinking about the short to medium term ups and downs of the business cycle.

Basically, in order to have above trend growth, a cyclically strong economy, you need to have some sector that wants to reduce its financial surplus or run a larger deficit in order to provide that sort of cyclical boost, most of the time.

There are other factors at play in the business cycle – I’m certainly not claiming that ‘this is it!’ – but I have found it to be pretty useful.

…

The full interview: Goldman’s Top Economist Explains The World’s Most Important Chart, And His Big Call For The US Economy

“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

Origins Of The Sectoral Balances Identity

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I thought I should share what I found recently about who was to state the sectoral balances identity first – since it comes across as enlightening to say the least. I found the identity in Nicholas Kaldor’s 1944 article Quantitative Aspects Of The Full Employment Problem In Britain. It was published as Appendix C to Full Employment In A Free Society by William Beveridge.

(If you find the mention of this identity anywhere before, please let me know!)

Here’s a Google Books screenshot of the page:

The article also appears in Kaldor’s Collected Essays, Vol 3 (Chapter 2, pp. 23-82).

The ‘net’ is net of consumption of fixed capital. Also ‘balance of payments’ is used for the current balance (footnote 1, page 28). (In The Scourge Of Monetarism, Kaldor used ‘net saving’ as saving net of investment).

Anthony Thirlwall wrote a biography of Kaldor in 1987 and he mentions that Kaldor kept pushing the implications of the identity in the 1960s (page 251). He managed to convinced some of his colleagues such as Wynne Godley and Francis Cripps and pick up public fights with others such as Richard Kahn.

Wynne Godley recalled how he came to appreciate this identity in his book Monetary Economics with Marc Lavoie. In Background Memories (W.G.) he wrote:

… 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 …

Canada’s Mark Carney To Head The Bank Of England

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So the news is that Mark Carney – the Governor of the Bank of Canada will now be the next Governor of the Bank of England.

Wynne Godley would have been happy – had he been alive and known that Carney is perhaps the only central banker to have recognized his foresight. (Carney probably is also the only central bank head to have named some names.)

In a speech From Hindsight To Foresight from 17 Dec 2008, he said:

… Few forecast these events; although, in an outbreak of retrospective foresight, an increasing number now claim they saw it coming. The reality is that among all the banks, investors, academics and policy-makers, only a handful were able to identify ahead of time the causes and potential scale of the crisis. …

with an attached footnote:

Examples include Bill White, formerly of both the Bank of Canada and the Bank for International Settlements; Harvard University’s Ken Rogoff; Nouriel Roubini of New York University; Wynne Godley of Cambridge; and Bernard Connolly of AIG Financial Products.

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.

More On Wynne Godley’s Methodology

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Matias Vernengo has a post on Stock-Flow Consistent Macroeconomics: Stock-Flow With Consistent Accounting (SFCA) Models.

He has a nice way of giving a short description of pricing in the G&L models:

In my view, the stock-flow and the demand driven (and I should say, the fact that price dynamics is orthogonal to the income flow determination structure) is the essential characteristic of this approach.

—

Also, Simon Wren-Lewis (from Oxford) has a new blog post on the sectoral balances approach – Sector Financial Balances As A Diagnostic Check, where he mentions Martin Wolf’s recent post on Wynne Godley’s approach. He (Wren-Lewis) has been admitting recently that DSGE models are not useful.

In the comments section Simon Wren-Lewis has this to say:

Martin Wolf sent me the following comment, which I am sure others will also find interesting:

“I used sectoral financial balances before the crisis, following Wynne. I argued that what was going on in the US external and household sectors were evidently unsustainable. This allowed me to argue that when the latter’s deficits were eliminated, there would be a recession and a huge fiscal deficit. What I had not expected was that the turnaround in the household sector would trigger a meltdown of the financial system.

“This makes it clear that one has to link the flow sectoral balances to the balance sheets in the economy. In this case, my mistake was not looking closely enough at the balance sheet of the financial sector. Good macroeconomic analysis has to examine the flows and stock meticulously and seek to assess whether the behaviour we see is sustainable. The assumption that private agents cannot make huge mistakes about the sustainability of what they are doing is, in my view, the biggest mistake in macroeconomics.”

Back to DSGE models. I think they are totally useless. I like this quote by Francis Cripps from an article in The Guardian from 27 Feb 1979: Economists With A Mission:

 

Martin Wolf On Wynne Godley’s Sectoral Financial Balances Approach

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Martin Wolf who usually writes good articles on macroeconomic developments wrote recently on the sectoral balances approach (which he uses frequently anyway).

In his recent post The Balance Sheet Recession In The US he writes:

… I look at this through the lens of “sectoral financial balances”, an analytical framework learned from the work of the late Wynne Godley. The essential idea is that since income has to equal expenditure for the economy, as a whole, (which is the same things as saying that saving equals investment) so the sums of the difference between income and expenditures of each of the sectors of the economy must also be zero. These differences can also be described as “financial balances”. Thus, if a sector is spending less than its income it must be accumulating (net) claims on other sectors.

The crucial point is that, since sectoral balances must sum to zero, a rise in the deficit of one sector must be matched by an offsetting change in the others. It follows that if the fiscal deficit is increasing, the sum of the surpluses of the other sectors of the economy must be increasing in a precisely offsetting manner.

These are tautologies. But the virtue of this framework is that it forces us to ask what drives what: are, for example, fiscal deficits in the US (or UK) driving the surpluses in other sectors or are the surpluses in the other sectors driving the fiscal deficit? We can obtain answers by examining what behaviour is changing…

and that:

… The idea that the huge fiscal deficits of recent years have been the result of decisions taken by the current administration is nonsense. No fiscal policy changes explain the collapse into massive fiscal deficit between 2007 and 2009, because there was none of any importance. The collapse is explained by the massive shift of the private sector from financial deficit into surplus or, in other words, from boom to bust…

Nice read: The Balance Sheet Recession In The US.

The sectoral balances approach should always be handled with supreme care. There are causalities running in all directions and one needs to ask what brings them to equivalence, what the value of policy instruments are, how is output changing etc.

The following is from Wynne Godley himself:

From the Levy Institute article The U.S. Economy – Is There A Way Out Of The Woods, November 2007

Although the three balances must always sum to exactly zero, no single balance is more a residual than either of the other two. Each balance has a life of its own, and it is the level of real output that, with minor qualifications, brings about their equivalence. Underlying the main conclusions of our reports is an econometric model in which exports, imports, taxes, and private expenditure are determined as functions of such things as world trade, relative prices, tax rates, and flows of net lending to the private sector. However, neither the knowledge that this is the case nor the perusal of any list of econometric equations will, on its own, impart any intuition as to why output moved as it did over any set period.

[boldening: mine]

Here’s from the article The U.S. Economy – A Changing Strategic Predicament, March 2003

It is well known to students of the National Accounts that the surplus of private disposable income over expenditure is equal to the government balance (written as a deficit) plus the current balance of payments (written as a surplus). While these balances are related to one another by a system of accounting identities, each has, to some extent, a life of its own that is reconciled with the other two via the aggregate income flow. The way the balances evolve provides a useful armature around which to organise a narrative account of economic developments, because any one of them is necessarily implied by the other two. Furthermore, the balances may give an early warning that unsustainable processes are taking place, for any high or rising balance implies a change in public, private, or foreign debts, which cannot grow without limit relative to income.

Wynne Godley with his CEPG partner Francis Cripps
(from Cambridge Group Sings The Blues, The Guardian, 17 April 1980)

“Not In My Lifetime” – The Muddled Road Toward An Integrated Europe

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Both Angela Merkel and the German Finance Minister Wolfgang Schäuble have been quoted in the media as saying that they won’t go ahead with the “€-bills” and plans like that in their lifetime! Of course such quotes are incompletely reported and what they mean is that they won’t have a plan such as that without a common fiscal policy.

In the ongoing Summit, European leaders came up with a few plans which led to financial markets rallying. The Italian FTSE MIB Index was up 6.59% today!! There was one plan which didn’t take off and this was the plan of having a “redemption fund”. The formal proposal is here: TOWARDS A GENUINE ECONOMIC AND MONETARY UNION Report by President of the European Council Herman Van Rompuy

Of course this didn’t go through because the two German leaders wouldn’t have allowed it in their lifetimes! So what does Germany really want?

To understand this we must first understand that – as argued by Wynne Godley in 1992 – to join a monetary union nations should surrender their sovereignty with this sovereignty being taken over by a supranational authority (which was absent in the Maastricht Treaty):

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.

Merkel and Schäuble want to move ahead with the full creation of a federation – presumably headquartered in Brussels and they have the task of managing the fiscal decisions for the whole of the Euro Area. Since this institution will run deficits, it is natural that it will finance the difference between expenditure and taxation by issuing bills and bonds (which will be the real €-bonds). Hence the two leaders have qualified their statements but this has been quoted everywhere as some kind of comedy of errors!

The two leaders have the double task of convincing the German politicians and German public on the one hand and politicians from the rest of the Euro Area on the other hand. In the middle of this, they see this plan from Herman Van Rompuy, José-Manuel Barroso, Jean-Claude Juncker and Mario Draghi adding to confusions. The plan from the four EU leaders still has no supranational institution which makes financial decisions for the whole Euro Area but only a special purpose entity presumably retired after 25 years.

The important difficulty in the creation of a supranational institution which will manage the finances of the whole Euro Area (and not any “sinking fund”) is that the current setup is an incomplete one where nations’ governments still have a good amount of power in spite of them having surrendered most of their sovereignty.

While convincing the German citizens may be a hard task, Merkel and Schäuble are facing difficulties also in convincing other European leaders. Other nations do not wish to surrender whatever powers they still have but in the process do not understand what an integration means. Their leaders could have chosen to not join the Euro Area – just like what Mrs Thatcher did for the UK. Now that they have joined it and given it is difficult for any one nation to leave, it is in their best interest to go ahead with the full integration which has a supranational fiscal authority but this comes with surrendering more powers!

As Wynne Godley argued further:

If a country or region has no power to devalue, and if it is not the beneficiary of a system of fiscal equalisation, then there is nothing to stop it suffering a process of cumulative and terminal decline leading, in the end, to emigration as the only alternative to poverty or starvation. I sympathise with the position of those (like Margaret Thatcher) who, faced with the loss of sovereignty, wish to get off the EMU train altogether. I also sympathise with those who seek integration under the jurisdiction of some kind of federal constitution with a federal budget very much larger than that of the Community budget. What I find totally baffling is the position of those who are aiming for economic and monetary union without the creation of new political institutions (apart from a new central bank), and who raise their hands in horror at the words ‘federal’ or ‘federalism’. This is the position currently adopted by the Government and by most of those who take part in the public discussion.

As Jim O’ Neill of Goldman Sachs mentions in a recent interview to Bloomberg, the Germans are open to this but unfortunately, the French have objections to this route.

In the above video (edit: no longer available), O’ Neill (jokingly called Governor O’Neill by Tom Keene of Bloomberg because he is said to be the top man for the post of the chief of the Bank of England when Mervyn King’s term ends soon) argues the Europeans are known to leave it till the last moment – when it’s on the brink. Till then they will continue to muddle. Unfortunately for Merkel and Schäuble, solving short term issues makes the financial market conditions ease substantially, the opposite of what they want, because only when other Euro Area nations are in a lot of trouble will they be ready to accept the German solution. Of course this is a sad way to solve the problem but Schäuble has been quoted in the press saying that the EA needs a crisis to make any progress.

Unfortunately the financial markets rally!

How ironic!

Toward A Higher European Integration?

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In an article today Europe Mulls Major Step Towards “Fiscal Union”, Reuters reports that Angela Merkel is pushing for a “giant leap forward”:

After falling short with her “fiscal compact” on budget discipline, German Chancellor Angela Merkel is pressing for much more ambitious measures, including a central authority to manage euro area finances, and major new powers for the European Commission, European Parliament and European Court of Justice.

She is also seeking a coordinated European approach to reforming labor markets, social security systems and tax policies, German officials say.

Until states agree to these steps and the unprecedented loss of sovereignty they involve, the officials say Berlin will refuse to consider other initiatives like joint euro zone bonds or a “banking union” with cross-border deposit guarantees – steps Berlin says could only come in a second wave.

“Kaldorians” jumped to highlight the serious defects in the European plan for integration when officials were working on the Maastricht Treaty. One of the implicit assumption on which the dogma of “free trade” is pushed is that current account deficits do not matter. The government’s task is to only make markets free in this view. The Euro Area was formed with the highly incorrect notion (among various others) that nations can simply solve their “balance of payments problem” by getting rid of it altogether.

I was reading this article by Ken Coutts and Wynne Godley from 1990 [1] where the authors point to different kinds of arguments put forward by others to defend this position (“current account deficits do not matter” provided markets are made free).

There appear to be six different lines of argument to the effect that the current account deficit can be ignored …

… (v) A different kind of argument makes a comparison between a nation with an external deficit and a relatively poor region within a nation. It is pointed out that there is no balance of payments problem for Scotland or for Northern Ireland and from this it is concluded that as soon as Britain joins a European monetary union its balance of payments ‘problem’ will disappear permanently …

… The argument (v) that a region within a country cannot have a balance of payments ‘problem’ ignores the fact that if a region imports more than it exports its trade deficit is automatically paid for by fiscal transfers.[footnote: Strictly speaking, the fiscal transfers will always exactly compensate for any trade deficit only after allowing for the acquisition of financial assets by the private sector as implied by the ‘New Cambridge’ identity (exports less imports equals net government outlays plus the ‘trade’ deficit). The identity says, of course, nothing whatever about the level of real income and output which trading performance will have generated]. The point may be illustrated by considering an extreme case where a region consumes tradables but cannot produce them at all. In this case there will be a trade deficit exactly equal to imports of tradables, but the flow of government expenditure and net transfers will provide a minimum level of income support and keep life of a kind going without any borrowing at all taking place. If an uncompetitive region were not in receipt of fiscal inflows, its inhabitants would have no alternative but to emigrate or starve. This example illustrates that merely by sharing a common currency with another area, a region or country does not automatically dispose of its balance of payments problems since its prosperity still depends on how successfully it can compete in trade with other areas. The Delors Report itself correctly observes that a monetary union transforms a weakness in the ability to compete successfully from being a balance of payments problem into a regional problem to which there is only likely to be a solution by using the instruments of regional policy.

The movement toward more integration by giving higher powers to the European Parliament was also suggested by Wynne Godley and Marc Lavoie in 2007 [2]:

… Alternatively, the present structure of the European Union would need to be modified, giving far more spending and taxing power to the European Union Parliament, transforming it into a bona fide federal government that would be able to engage into substantial equalisation payments which would automatically transfer fiscal resources from the more successful to the less successful members of the euro zone. In this manner, the eurozone would be provided with a mechanism that would reduce the present bias towards downward fiscal adjustments of the deficit countries.

References

  1. Prosperity and Foreign Trade in the 1990s: Britain’s Strategic Problem, Oxf Rev Econ Policy (1990) 6 (3):82-92. Link
  2. A Simple Model Of Three Economies With Two Currencies, Camb. J. Econ. (2007) 31 (1): 1-23. Link