Euro Archives

New Thinking in the News

These are the latest reflections from new thinkers around the on what should have been done already, what must be done next, and what the near future may look like:

1 | New Study Reveals Stark Picture of Bay Area Poverty Leading up to Covid-19 Pandemic, in Tipping Point Community, by john a. powell.

“Known for its progressive politics and rich diversity, the San Francisco Bay Area is no exception to patterns of systemic racial and economic inequality found across the nation,” said john a. powell, Director of the Othering & Belonging Institute at UC Berkeley. “In fact, the Bay Area’s hot housing market and booming economy may exacerbate these trends, making it harder for low-skilled workers to find affordable housing and pay their bills. This study, drawing upon an original survey of Bay Area residents and census data, gives us a vivid portrait of poverty and inequality, and what we should do about it, even before the COVID-19 pandemic occurred. Now this research is more urgent than ever.”

2 |30 million Americans are unemployed. Here’s how to employ them in Vox, by Pavlina Tcherneva

“But the program will actually stabilize these fluctuations. There are reasons unemployment feeds on itself. If you have this kind of preventative program, where people trickle into other employment rather than unemployment, their spending patterns are stabilized, so you have smaller fluctuations in the private sector. We see this in countries that have active labor-market policies, that do a lot more public employment than we do.”

3 | Messages from “Fiscal Space” in Project Syndicate by Jayati Ghosh

“Well before the pandemic arrived, it was evident that the financialization of the global economy was fueling massive levels of inequality and unnecessary economic volatility. In this unprecedented crisis, the need to rein it in has literally become a matter of life or death.”

4 | The ‘frugal four’ should save the European project in Social Europe by Peter Bofinger

“It is therefore crucial that the frugal four [Austria, Denmark, Sweden and the Netherlands] abandon their opposition to a joint financing facility at EU level. Only in this way will the European project be able to survive and Europe respond to this terrible crisis in a manner as effective as in the United States. For, as the US economist Paul Krugman has put it, paraphrasing Franklin Roosevelt, ‘The only fiscal thing to fear is deficit fear itself.’”

5 | Making the Best of a Post-Pandemic World, in Project Syndicate, by Dani Rodrik

“It is possible to envisage a more sensible, less intrusive model of economic globalization that focuses on areas where international cooperation truly pays off, including global public health, international environmental agreements, global tax havens, and other areas susceptible to beggar-thy-neighbor policies. Insofar as the world economy was already on a fragile, unsustainable path, COVID-19 clarifies the challenges we face and the decisions we must make. In each of these areas, policymakers have choices. Better and worse outcomes are possible. The fate of the world economy hinges not on what the virus does, but on how we choose to respond.”

6 | Two Rounds of Stimulus Were Supposed to Protect Jobs — Instead We Have Record Unemployment with Tom Ferguson in the Institute for Public Accuracy

“We all know that the U.S. response to COVID-19 has lagged far behind other countries. But now a real trap is closing. The public premise of the government stimulus programs was that they would be needed only for a short period and channeling aid to businesses would enable them to retain workers on their payrolls. So vast sums were handed out while the Federal Reserve intervened massively in financial markets. But now unemployment is soaring, in a country whose health insurance system is keyed to the workplace. Small businesses are collapsing and plainly never got much aid. Workers are also dropping out of the workforce in enormous numbers while a major health and safety crisis rages. Government policy has got to address these issues before it’s too late. It can’t simply grant blanket immunity to businesses for the sake of a hasty, premature reopening. A major re-calibration of policy is in order.”

Every week, we share a few noteworthy articles that showcase the work of new economic thinkers around the world. Subscribe to receive these shortlists directly to your email inbox.

Forget about the “Corona Bond.” Should the ECB Purchase Eurozone Government Bond ETFs?

By Elham Saeidinezhad | In recent history, one of a few constants about the European Union (EU) is that it follows the U.S. footstep after any disaster. After the COVID-19 crisis, the Fed expanded the scope and duration of the Municipal Liquidity Facility (MLF) to ease the fiscal conditions of the states and the cities. The facility enables lending to states and municipalities to help manage cash flow stresses caused by the coronavirus pandemic. In a similar move, the ECB expanded its support for the virus-hit EU economies in response to the coronavirus pandemic. Initiatives such as Pandemic Emergency Purchase Programme (PEPP) allow the ECB to open the door to buy Greek sovereign bonds for the first time since the country’s sovereign debt crisis by announcing a waiver for its debt.

There the similarity ends. While the market sentiment about the Fed’s support program for municipals is very positive, a few caveats in the ECB’s program have made the Union vulnerable to a market run. Fitch has just cut Italy’s credit rating to just above junk. The problem is that unlike the U.S., the European Union is only a monetary union, and it does not have a fiscal union. The investors’ prevailing view is that the ECB is not doing enough to support governments of southern Europe, such as Spain, Italy, and Greece, who are hardest hit by the virus. Anxieties about the Union’s fiscal stability are behind repeated calls for the European Union to issue common eurozone bonds or “corona bond.” Yet, the political case, especially from Northern European countries, is firmly against such plans. Further, despite the extreme financial needs of the Southern countries, the ECB is reluctant to lift its self-imposed limits not to buy more than a third of the eligible sovereign bonds of any single country and to purchase sovereign bonds in proportion to the weight of each country’s investment in its capital. This unwillingness is also a political choice rather than an economic necessity.

It is in that context that this piece proposes the ECB to include the Eurozone government bond ETF to its asset purchasing program. Purchasing government debts via the medium of the ETFs can provide the key to the thorny dilemma that is shaking the foundation of the European Union. It can also be the right step towards creating a borrowing system that would allow poorer EU nations to take out cheap loans with the more affluent members guaranteeing the funds would be returned. The unity of EU members faces a new, painful test with the coronavirus crisis. This is why the Italian Prime Minister Guiseppe Conte warned that if the bloc fails to stand up to it, the entire project might “lose its foundations.” The ECB’s decision to purchase Eurozone sovereign debt ETFs would provide an equal opportunity for all the EU countries to meet the COVID-19 excessive financial requirements at an acceptable price. Further, compared to the corona bond, it is less politically incorrect and more common amongst the central bankers, including those at the Fed and the Bank of Japan.

In the index fund ecosystem, the ETFs are more liquid and easier to trade than the basket of underlying bonds. What lies behind this “liquidity transformation” is the different equilibrium structure and the efficiency properties in markets for these two asset classes. In other words, the dealers make markets for these assets under various market conditions. In the market for sovereign bonds, the debt that is issued by governments, especially countries with lower credit ratings, do not trade very much. So, the dealers expect to establish long positions in these bonds. Such positions expose them to the counterparty risk and the high cost of holding inventories. Higher price risk and funding costs are correlated with an increase in spreads for dealers. Higher bid-ask spreads, in turn, makes trading of sovereign debt securities, especially those issued by countries such as Italy, Spain, Portugal, and Greece, more expensive and less attractive.

On the contrary, the ETFs, including the Eurozone government bond ETFs, are considerably more tradable than the underlying bonds for at least two reasons. First, the ETF functions as the “price discovery” vehicle because this is where investors choose to transact. The economists call the ETF a price discovery vehicle since it reveals the prices that best match the buyers with the sellers. At these prices, the buying and selling quantities are just in balance, and the dealers’ profitability is maximized. According to Treynor Model, these “market prices” are the closest thing to the “fundamental value” as they balance the supply and demand. Such an equilibrium structure has implications for the dealers. The make markers in the ETFs are more likely to have a “matched book,” which means that their liabilities are the same as their assets and are hedged against the price risk. The instruments that are traded under such efficiency properties, including the ETFs, enjoy a high level of market liquidity.

Second, traders, such as asset managers, who want to sell the ETF, would not need to be worried about the underlying illiquid bonds. Long before investors require to acquire these bonds, the sponsor of the ETF, known as “authorized participants” will be buying the securities that the ETF wants to hold. Traditionally, authorized participants are large banks. They earn bid-ask spreads by providing market liquidity for these underlying securities in the secondary market or service fees collected from clients yearning to execute primary trades. Providing this service is not risk-free. Mehrling makes clear that the problem is that supporting markets in this way requires the ability to expand banks’ balance sheets on both sides, buying the unwanted assets and funding that purchase with borrowed money. The strength of banks to do that on their account is now severely limited. Despite such balance sheet constraints, by acting as “dealers of near last resort,” banks provide an additional line of defense in the risk management system of the asset managers. Banks make it less likely for the investors to end up purchasing the illiquid underlying assets.

That the alchemists have created another accident in waiting has been a fear of bond market mavens and regulators for several years. Yet, in the era of COVID-19, the alchemy of the ETF liquidity could dampen the crisis in making by boosting virus-hit countries’ financial capacity. Rising debt across Europe due to the COVID-19 crisis could imperil the sustainability of public finances. This makes Treasury bonds issued by countries such as Greece, Spain, Portugal, and Italy less tradable. Such uncertainty would increase the funding costs of external bond issuance by sovereigns. The ECB’s attempt to purchase Eurozone government bonds ETFs could partially resolve such funding problems during the crisis. Further, such operations are less risky than buying the underlying assets.

Some might argue the ETFs create an illusion of liquidity and expose the affluent members of the ECB to an unacceptably high level of defaults by the weakest members. Yet, at least two “real” elements, namely the price discovery process and the existence of authorized participants who act as the dealers of the near last resort, allows the ETFs to conduct liquidity transformation and become less risky than the underlying bonds. Passive investing sometimes is called as “worse than Marxism.” The argument is that at least communists tried to allocate resources efficiently, while index funds just blindly invest according to an arbitrary benchmark’s formula. Yet, devouring capitalism might be the most efficient way for the ECB to circumvent political obstacles and save European capitalism from itself.

Elham Saeidinezhad is lecturer in Economics at UCLA. Before joining the Economics Department at UCLA, she was a research economist in International Finance and Macroeconomics research group at Milken Institute, Santa Monica, where she investigated the post-crisis structural changes in the capital market as a result of macroprudential regulations. Before that, she was a postdoctoral fellow at INET, working closely with Prof. Perry Mehrling and studying his “Money View”. Elham obtained her Ph.D. from the University of Sheffield, UK, in empirical Macroeconomics in 2013. You may contact Elham via the Young Scholars Directory

New Thinking in the News

Why women are crucial to our coronavirus response, how patents impede our progress towards resolving the pandemic, and what an erosion of trust means for our society. That and more in this week’s selection of #NewThinkintheNews.

1 | America’s coronavirus response must center on women. And the Black Plague helps show how in NBC by Lynn Parramore

“Feminist scholars have long pointed out that economists, political scientists and historians tend to think of the market and the state as the key spheres of reality — while regarding the home and the family as afterthoughts. But as the changes in medieval Europe in the wake of a terrible pandemic illustrate, when women are freed from burdens in the home and gain opportunities to participate fully in all aspects of life and work, the future grows brighter for everyone.”

2 | Patents vs. the Pandemic in Project Syndicate, co-authored by Arjun Jayadev and Joseph Stiglitz

“In responding to the pandemic, the global scientific community has shown a remarkable willingness to share knowledge of potential treatments, coordinate clinical trials, develop new models transparently, and publish findings immediately. In this new climate of cooperation, it is easy to forget that commercial pharmaceutical companies have for decades been privatizing and locking up the knowledge commons by extending control over life-saving drugs through unwarranted, frivolous, or secondary patents, and by lobbying against the approval and production of generics. … It’s time for a new approach. Academics and policymakers have already come forward with many promising proposals for generating socially useful – rather than merely profitable – pharmaceutical innovation. There has never been a better time to start putting these ideas into practice.”

3 | COVID-19 and the Trust Deficit, in Project Syndicate by Mike Spence

“The problem, as we warned back in 2012, is that we are living in an era of policymaking paralysis. “Government, business, financial, and academic elites are not trusted,” we wrote. “Lack of trust in elites is probably healthy at some level, but numerous polls indicate that it is in rapid decline, which surely increases citizens’ reluctance to delegate authority to navigate an uncertain global economic environment.” Change those last words to “navigate a highly chaotic public-health and economic shock,” and the statement loses none of its relevance today.

4 | Condivergence: Thinking fast and acting slow in the pandemic war in The Edge Malaysia by Andrew Sheng

“There will be no return to the old normal. Equilibrium was going anyway with the trade war. Technology was already changing the supply chains and business models. The pandemic only destroyed the old offline big mall business model faster as everyone shifts to online business. The only problem is that most policymakers do not have the data, or the understanding as to how, to make that transition without huge costs to jobs and businesses, at least in the short run, other than to run larger deficits…. The real winners will be those who learn, adapt and innovate so that all of us emerge stronger.”

5 | The EU should issue perpetual bonds, in Project Syndicate, by George Soros

“The EU is facing a once-in-a-lifetime war against a virus that is threatening not only people’s lives, but also the very survival of the Union. If member states start protecting their national borders against even their fellow EU members, this would destroy the principle of solidarity on which the Union is built… Instead, Europe needs to resort to extraordinary measures to deal with an extraordinary situation that is hitting all of the EU’s members. This can be done without fear of setting a precedent that could justify issuing common EU debt once normalcy has been restored. Issuing bonds that carried the full faith and credit of the EU would provide a political endorsement of what the European Central Bank has already done: removed practically all the restrictions on its bond purchasing program.”

Every week, we share a few noteworthy articles that showcase the work of new economic thinkers around the world. Subscribe to receive these shortlists directly to your email inbox.

Denouncing the Flaws of the EU is not Extremist, it’s Necessary

The main takeaway from the French presidential election is that criticism of the European Union (EU), including the eurozone, is not well received regardless of its validity. While Europe might currently be breathing a sigh of relief, the strategy of silencing and ridiculing those who express dissatisfaction with EU policies is dangerous for its future.

Presidential campaigns in France

During the campaign for the first round of the French presidential election, two candidates touted the possibility of leaving the euro: Jean-Luc Mélenchon, representing the leftist France Insoumise party, and Marine Le Pen from the extreme right-wing Front National. Most outlets considered their attacks on the euro to be a political liability with the mainstream electorate. The media slotted both candidates as “anti-European” extremists that should be feared. However, a closer look at the platforms of these two reveals that their critiques of the EU and their desired outcomes bear very few similarities.

Marine Le Pen promised a “France-first” approach and pledged to pull France out of the eurozone and close the country’s borders. Her platform plays on racism and xenophobia, and blames France’s woes on immigrants. It is important to note that she did propose strengthening the welfare state and extending benefits, but only for French people and not foreigners.

Mélenchon’s take on the EU was very different. His platform’s “Plan A” was to push for EU-wide reforms that aimed at bringing growth and strengthening mutual support amongst member states. He criticized the EU for becoming a place ruled by banks and finance, and his goal was to leverage France’s influence within the bloc to end austerity policies in all member states. If these negotiations with other EU members failed, then there was a “Plan B” that called for France to leave the euro and the EU in order to pursue a stimulus plan, which is not permitted under the deficit limits imposed by current EU regulation.

A large part of the media coverage received by Mélenchon centered on personal attacks, rather than on providing an accurate overview of his policies. He was accused of being a communist, both an admirer of Fidel Castro and Hugo Chavez, and a Russia sympathizer. With a significant social media following and energizing campaign, Mélenchon was able to surge in the polls late in the race. However, he did not manage to garner sufficient support to qualify for the second round of the election.

Plagued by scandals and voters’ discontent with the current administration, the candidates backed by the two traditionally mainstream parties in France, the Republicans and Socialists, did not make it past the first round. The run-off election will take place on May 7th between Le Pen and Emmanuel Macron.

Dubbed the establishment’s anti-establishment candidate, Macron describes himself as a staunchly pro-EU, pro-immigration, and pro-globalization centrist. Macron is backed by the party he created in 2016, “En Marche!,” and is successfully managing to brand himself as an outsider candidate. However, it should not be forgotten that as an economy minister in Francois Hollande’s government, who did not seek re-election due to extremely low approval rates, Macron was the architect of labor market reforms that weakened protections for workers and favored businesses. A close look at his program reveals his policies are strikingly similar to those of Hollande, just with different branding and rhetoric.

Macron’s platform consists of neoliberal platitudes that espouse values such as tolerance and acceptance of immigrants, while advocating for austerity and dismantling of social protections under the guise of increasing efficiency and “modernizing” the French economy. Macron pledged to reduce France’s deficit below 3 percent, as mandated by the EU, while also cutting taxes. To achieve both goals, Macron would undoubtedly have to slash government spending, which would most likely have a negative impact on the economy overall.

Macron’s uncritical embrace of the EU has gained him the praise and endorsement of other European leaders. Global financial markets that are reassured by his pro-EU stance are also celebrating the prospect of his victory. While his commitment to structural reforms and budget cuts is likely to please Germany and the European Commission, the question is if he can also satisfy the people of France.

Polls suggest that Macron will now win the run-off against Le Pen. However, concerns are mounting that if his government fails to deliver, the far right will be strengthened by the following election. Given how similar Macron and Hollande’s programs are (despite the different packaging) they are unlikely to deliver a different result.

The failed economic policies of the EU

The French economy struggles with high unemployment rates, particularly for young people, and is facing a decade of economic stagnation. Under increased pressure from the EU for France to abide by its deficit rules and reduce spending, previous governments have implemented harsh pension and labor reforms. These measures have failed to jumpstart the economy, and it seems intuitive that France should pursue different policies that could actually provide the much needed stimulus to its economy.

It’s not just France that is stagnating. Since the 2008 crisis, the entire Eurozone has seen a slow and uneven recovery. Particularly, the worst hit countries such as Greece, Italy, and Spain, are still dealing with the consequences of shrinking incomes and high unemployment. Nobel laureate Joseph Stiglitz showed how the structure and design of the euro were a key factors in holding back the recovery of the EU.

The structure of the euro was established by the Maastricht Treaty which laid down the groundwork for how the EU and the euro area ought to be set-up institutionally. The treaty arbitrarily established yearly deficit limits for countries at 3 percent of GDP. After the crisis, the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union expanded the influence of the European Commission, an unelected body, to impose policies on member states. EU institutions have used the deficit limit as justification to dictate a neoliberal agenda, characterized by imposing austerity measures and pro-business structural reforms on member states, with very little consideration on the worsening of unemployment, poverty, and other social indicators.

Considering the shortcomings of neoliberal policies imposed by the EU, perhaps Melélnchon’s “Plan A,” to push for EU-wide reform is not that “extremist” after all. Rather than crucifying him, he should have been given the chance to advocate for reform. The current direction taken by the EU is one that through austerity measures is slowly dismantling the European Social Model, which has traditionally been characterized by a strong safety net.

What the future holds

As long as the EU imposes and encourages a platform that hurts people, far right politicians like Marine Le Pen will continue to tap into those anxieties and gain popularity. The success of the Brexit campaign should serve as impetus for the EU to reevaluate its policies.

Politicians like Macron, who chose to ignore the flaws of the eurozone and advocate for more of the same unsuccessful policies may win popularity now, but set themselves up for failure in the long run. Macron’s unconditional praise of the EU’s virtues is somewhat similar to Hillary Clinton, who under a backdrop of suffering and social crisis, responded to Trump’s slogan “Make America Great Again,” by stating “America is already great!” This strategy failed and Clinton lost, with areas where jobs were under the most severe threats swinging towards Trump.

For the European project to succeed and continue bringing peace and unity to Europe, economic policy reform is necessary and austerity needs to end. Ignoring the economic struggles of the bloc and refusing to recognize the role of EU policy in exacerbating them will continue to fuel the rise of extremist right wing politicians. Calling those who advocate for socially inclusive reforms “extremists” is a strategy bound to backfire.

Germany Does Have Unfair Trade Advantages

In one of Donald Trump’s rants, he claimed the reason why there are so many German cars in the U.S. is that their automakers do not behave fairly. The German economy’s prompt response was that “the U.S. just needs to build better cars.” However, this time, probably without even realizing it, Donald Trump was on to something – Germany’s currency setup does give it unfair trade advantages.

While China is commonly accused of currency manipulation to provide cheap exports, the IMF has recently decided the renminbi (RMB) is no longer undervalued and added it in its reserve currency basket, along with other major currencies. However, an IMF analysis of Germany’s currency found “an undervaluation of 5-15 percent” for the Euro in the case of Germany. Thus for Germany, the Euro has a significantly lower value than a solely German currency would have.

Since the Euro was introduced, Germany has become an export powerhouse. This is not because after 2000 the quality of German goods has improved, but rather because as a member of the Eurozone, Germany had the opportunity to boost its exports with policies that allowed it to maintain an undervalued currency.

Germany and France are the largest Eurozone economies. Prior to joining the Eurozone, both countries had modest trade surpluses.

In the above figure we can see how following the implementation of the Euro, the trade balances of Germany and France completely diverged. The French moved to having a persistent trade deficit (importing more than they export), while Germany’s surplus exploded (exporting much more than they import). After a brief decline in the surplus in the immediate aftermath of the crisis, it is now again on the rise.

In the early 2000s Germany undertook several national policies to artificially hold wages down. These measures were seen as a success for Germany globally. By being part of the Eurozone and holding down wages, the Germans could export at extremely competitive prices globally. Had they not been part of the Eurozone, their currency would have appreciated, and they would not have the same advantages.

In the aftermath of the European debt crisis, Germany took a tough stance on struggling debtor countries. Under German leadership, the European Commission imposed draconic austerity measures on countries such as Greece to punish them for spending irresponsibly. Spearheaded by Germany, The EU (along with the IMF) offered a bailout to Greece so that it could pay the German and French banks it owed money to.

This bailout came with strict conditions for the Greek government that was forced to impose harsh austerity. The promise was that if the government cut its spending, the increased market confidence would help the economy recover. As a member of the Eurozone, Greece had very limited monetary policy tools it could use. Currency devaluation was no longer an option, the country was stuck with a currency that was too strong for its economy.

Meanwhile Germany prospered and enjoyed the perks of an undervalued currency. Being able to supply German goods at relatively low prices, Germany’s exports flourished. At the same time, Greeks, and other countries at the periphery of the union, were only left with the choice to face a strong internal devaluation, which meant letting unemployment explode and wages collapse until they become attractive destinations for investment.

Germany consistently broke the rules of the currency area, without ever being punished. When it first broke the deficit limits agreed upon by Eurozone members in 2003, the European Commission turned a blind eye. Germany is often considered to have set an example for other EU nations by practicing sound finance, and having a growing, healthy economy.

Greece, on the other hand is blamed for spending too much on social services, and many of its problems are blamed on being a welfare state. When you compare the actual numbers, however, Greece’s average social spending is much less than that of Germany. Between 1998 and 2005, Greece spent an average of 19 percent of GDP, while Germany spent as much as 26 percent.

To address these vast differences in the trade patterns of the EU nations, the European Commission introduced the so-called “six-pack” in 2011. These regulations introduced procedures to address “Macroeconomic Imbalances.” However, as found in the Commission’s country report “Germany has made limited progress in addressing the 2014 country-specific recommendations.”

Germany’s trade competitiveness comes at the price of making other members of the Eurozone less competitive. This is something that Germany needs to be aware of when responding to the problems other economies are facing. Currently Germany is demanding punishments for countries whose have few policy tools available to stimulate growth as Eurozone members.

However, Germany should keep in mind that the Euro is preventing the currency adjustments that would take away its trade competitiveness. Without a struggling EU periphery, there wouldn’t be a flourishing Germany.

Italy is Hungry for Expansionary Fiscal Policy

In a meeting with Angela Merkel and Francois Hollande on August 22, the Italian Prime Minister Matteo Renzi proudly announced that Italy has the lowest public deficit of the last 10 years, and will continue with structural reforms to reduce it further. Monti has long aimed to “restore credibility” by cutting the public deficit, and now the Finance Minister Pier Carlo Padoan enjoys praise on his achievement of a deficit as small as 2.4% of GDP. The FED (Financial and Economic Document) goes so far as say this makes Italy “among the most virtuous countries in the Eurozone.”

A closer look at Italy’s economy, however, shows this “virtuosity” has no basis in reality. In 2015, 1.5 million households lived in absolute poverty. Another 4.5 million individuals saw stagnant incomes. The situation has not been this bad since 2005. In addition, the Migrantes foundation informs us that there has been a boom of italians who go abroad, 107,000 in 2015 (+6,2%). Especially youth from 18 to 34 years old (36,7%).
Source: [Ansa.it “Rapporto fondazione Migrantes”]

The percentage of serious material deprivation index is 11,5% for total households members. Official unemployment rate is at 11,9% whereas the real unemployment rate is well above the 20%. The inactivity rate is at 36,0 % and the fixed capital investment ratio is stuck well below the pre-crises (2007-08) levels.
Source: [“Rapporto annuale Istat, 2016”]

It is clear that Italy is stuck in a deep depression. And it’s not alone. Many other euro countries are suffering the same fate. Cutting public spending cannot help them recover. We turn to Keynes to see why it cannot, and consult the work of Minsky and Wynne Godley to see what can.

Keynes and Aggregate Demand

In The General Theory, J.M. Keynes explains the challenges blocking achieving and maintaining full employment in a market economy. He argues that the booms and busts associated with capitalism make this state of equilibrium very difficult to reach. When a bust occurs, and businesses expect their profits to fall, there’s no reason to expect a magical market-force to step in and fix employment while costs are being cut.

This applies to Italy, too. After years of austerity and a Global Financial Crises, aggregate demand levels have declined sharply most people feel uncertain about the future. Additional demand for labor is close to zero and the private sector is pessimistic. Investment and spending is not sufficient to employ the unemployed. Cutting down government expenditure is not going to to help. It will simply make it worse.

Minsky and Fiscal Policy

A follower of Keynes, Hyman Minsky explained how any analysis of a monetary capitalist economy must start from the analysis of balance sheets and its relative financial interrelations ‘measured’ in of cash flows. If balance sheets and especially the relative financial relations are not taken into account within an analysis of an essentially financial and monetary economy, that analysis fails to reflect the full reality.

Minsky’s alternative analysis shows that in case of crisis, a nation needs a “Big Government” (The Treasury Department) and a “Big Bank” (The Central Bank) to step up. These institutions must focus on serving as an “Employer of Last Resort” and a “Lender of Last Resort”, respectively. This way, they can prevent wages and asset prices from dropping further, and tame the market economy. In the Euro-zone, this has not been realized. The Treasury Department is constrained, leaving them unable to reach full employment. Meanwhile, citizens continue suffer under austerity.

Wynne Godley and the Government Budget

Wynne Godley’s sectoral balance approach sheds more light on this Minskyian alternative. He shows the economy consists of two sectors: The government sector, and the private sector (all households and businesses).** The private sector can accumulate net financial assets only if the other sector, government, runs a budget deficit. That is, only if the flows of the government spends more than it receives in taxes. It is impossible for both sectors to run a surplus at the same time.

And as a simple matter of macro-accounting, for aggregate output to be sold, total spending must equal the total income generated in the production process. So given households’ decisions to consume and given firms’ decisions to invest, there will be involuntarily idle labour for sale with no buyers at current wages, if the government deficit spending is too small to accommodate the net desire to save of the private sector.

What Renzi and Padoan are Really Saying

We can now see what Renzi and Padoan are really congratulating themselves for. Having done nothing to lift a struggling private sector out of the recession, they patting themselves on the back for worsening it’s social and economic situation. Renzi may claim he will go to Brussels to “sbattere i pugni sul tavolo”, but his executives continue to respect the Stability and Growth pact regime, and decrease the deficit further.

From Wynne Godley, we know that further decreasing the government deficit corresponds to further deterioration the private sector surplus. So when the officials say they “need to put public accounts in order,” they are actually saying they will put households and business accounts in dis-order. So when they say that Italy has the lowest budget deficit of the last 10 years, they are actually stating that the government is draining more financial assets from the private sector than it has in a decade.

When they call Italy virtuous for keeping a smallest deficit, they assign virtue to the nation that most effectively perpetuates poverty and social disarray. When Renzi says that his non elected executive “will continue […] the reduction of the deficit for our children and grandchildren”, he is instead telling us that his government is going to reduce the net desire to save of the current population, to keep involuntary unemployment and part-time working levels high and to firmly deteriorate the (net) financial and real wealth of the future generations.

Unless Italy changes its approach and adopts expansionary fiscal policy, it will not serve the well-being of the society and its economy. The main goal of full employment will never be attained and maintained. Work will lack moral and economic dignity, public sector goods will fall short in quantity and quality, and basic human rights will be violated. Not only will policy goals fail to be achieved, they will be even farther out of reach. One thing is certain: either Renzi and his ministers don’t know what they’re doing, or they are doing it in bad faith. I am afraid of it may be both.

* To be as precise as possible, Italian public budget deficit has been systematically reduced from 1991, that is the year when the Treaty of Maastricht was ratified which, among other things, established the respect of the parameter of the 3% to the public deficit and 60% to the (flawed) public debt/gdp ratio.
** I do not take into account the foreign sector balance sheet, because the substance of my brief argument won’t be undermined.

Why is Austerity Still Being Prescribed?

After years of strict austerity and a worsening crisis, the Greek economy is still in a slump.

However, Eurozone officials continue to prescribe the medicine of austerity. The diagnosis for the Greek crisis was the fiscal profligacy of its government, and thus to restore the health of its economy, Greece simply had to slash its spending. As with any prescription, some short-term side effects were expected. However, year after year the side effects have gotten worse, with unemployment and poverty at all-time highs and demand at all-time lows. Meanwhile, the economy, in a deepening recession, is far from being cured. To make matters worse, despite the reduced fiscal deficits, the shrinking economy means the debt-to-GDP ratio is nevertheless growing.

In the aftermath of the Global Financial Crisis, Europe embraced austerity as the best medicine to cure its damaged economies. Conservative economists and leading institutions such as the European Central Bank (ECB) and International Monetary Fund (IMF) promoted the concept of austerity. The EU imposed spending cuts on all its members. It is using the dire situation of Greece as a warning against the accumulation of more debt. A council of Eurozone ministers, spearheaded by Germany, aggressively pushed for more austerity. Meanwhile, despite complying with the prescribed “medicine,” the health of the Greek economy grew increasingly worse…

However, the theoretical justification behind austerity is questionable. The fear of government deficits was backed by studies such as “Growth in a time of debt” by Carmen Reinhart and Kenneth Rogoff. This paper, published in 2010 predicted catastrophic economic consequences for any country surpassing a debt-to-GDP ratio of more than 90%. Backed by this research, high-ranking European officials made their case to abruptly cut government spending.

While Reinhart and Rogoff’s study created a buzz amongst conservative politicians when it was published. However, it was mostly ignored by the same politicians when it was discredited. In 2013, it was shown that the spreadsheet used for the calculations in the study was laden with mistakes. Its results were gravely exaggerated. After the errors were fixed, some correlation between government debt and slow growth remained but not one sufficient to establish causation. It is plausible to assume that slow growth is the cause of the increase in government debt. A summary of this controversy can be found.

In the early 2000s, the Greek government began to accumulate massive amounts of debt. By 2009, the government debt had reached almost 135% of GDP. The government quickly enacted extreme spending cuts. So, it is resulting in a ratio decrease that lasted until 2011. However, the Greek economy, in the midst of a deep recession. It did not respond very well to these cuts which came coupled with the added bonus of tax hikes. Domestic demand collapsed and unemployment soared. Moreover, overall confidence in the economy faded. Greek GDP fell, and the debt-to-GDP ratio exploded. Currently, that ratio is at about 180% of GDP and is projected to reach 200% by 2020. (OECD) The Greek economy is on a downward spiral in which imposed spending cuts reduce incomes, reduce spending, and further contract the economy, and limit its ability to repay its debts.

Despite the academic case for austerity weakening, the Greek parliament is forced to impose even deeper spending cuts to receive more funds from European institutions. Without additional loans, Greece would be unable to make the payments on its previous debt. However, most of the bailout money received by Greece has gone on payments for maturing loans.

The Greek sovereign debt has turned into a ponzi scheme. New loans are obtained to make interest payments on older ones, while the principals rise and the economy shrinks. The IMF, initially a main proponent of austerity, has recently come out in favor of restructuring Greece’s debt and allowing for some economic stimulus. It appears that EU officials are finally willing to listen, at least in respect, to debt restructuring. Last week, the council of Eurozone ministers agreed to discuss some debt relief. However, this comes with the same condition attached: more and even harsher austerity.

For a sick economy such as Greece, it is difficult to see how even aggressive spending cuts could nurse it back to health. After austerity has failed year after year in reducing Greek debt and revitalizing its economy, it is time to try a different medicine. Under EU agreements, countries are required to be fiscally conservative. Moreover, EU officials, under German direction, have refused to change their stance on weakening the austerity imposed on Greece. Greece’s suffering has become an example of what happens when those rules are broken.

However, if the EU wants Greece to repay its debt and recover, it needs to stop punishing it and give it room for growth. The European officials who continue to force austerity on Greece should take a step back and realize that the best way to reduce the Greek debt-to-GDP ratio and make it sustainable, is to allow for its economy to grow. Clearly, austerity measures have not brought about the desired growth and health. Greece needs a different prescription. One that would indeed stimulate its economy and not keep it locked in an ICU.

Written by Lara Merling
Illustrations by Heske van Doornen