4 Lectures on the €uropean crisis

Sergio CesarattoDipartimento di economia politica e statistica

Cesaratto@unisi.ithttp://politicaeconomiablog.blogspot.it/

Index

• 1) Theory:• Economic surplus, aggregate demand (AD) and

mercantilism • The theory of Optimal Currency Areas• 2) The events in Europe: emphimeral peripheral growth

and the German mercantilism• 3) The European policies after the crisis:• Target 2• Monetary policy • Banking Union• Fiscal policy and the keynesian multipliers• 4) What should be done• A big change in the European institutions• A euro break up?

Lecture 1 –Theory

• 1) Theory:

• Economic surplus, aggregate demand (AD) and mercantilism

• The theory of Optimal Currency Areas

Economic surplus and aggregate demand (AD) in capitalism

• My interpretation of the financial and economic crisis refers to the Classical economists’ surplus theory.

• Definition of economic surplus P – N = S.• Necessity for the capitalists to sell (to realise) the part of the surplus

they do not use themselves either as luxuries or as investment goods.

• Necessity of “external markets” (Rosa Luxemburg-Kalecki): government spending, exports, autonomous consumption (consumption financed by credit).

Economic surplus and aggregate demand (AD) in capitalism

• Golden age recipe (1950-1979): keep N high and S low; use the balance budget theorem to facilitate the absorption of S. A robust model.

• Origins of the golden age: first great crisis, war, soviet challenge• Problems with the golden age: full employment brings about social

indiscipline• Neo-liberal era (1979-199?): abandonment of full employment

policies and return of social discipline.• Great moderation recipe (199?-2007) : keep N low and S high; use

autonomous consumption to facilitate the absorption of S. A weak model.

• Financial liberalisation and deregulation functional to this model• Problems with the great moderation: middle-class household debt

became unsustainable. Great financial crisis (GFC).

Economic surplus and aggregate demand (AD) in capitalism. The mercantilist recipe

• Keep N low (at least in the non-tradable sector) and S high. • The (relative) depression of the internal market and a conservative

central bank keep inflation lower than competitors. Undervalued exchange rate.

• Use exports as an outlet for the part of the social surplus not consumed by the capitalists themselves.

• Finance with loans the external markets.• The model has been adopted by Germany during all the post-WW2

period, and in the EMU (and possibly before)• Problems with this model: deficit countries may accumulate an

unsustainable external debt

Economic surplus and aggregate demand (AD) in capitalism

• From a theoretical point of view we may now vindicate the mercantilist obsession with a trade surplus.

• They (albeit imperfectly) grasped the idea that net exports might render a low N and a high S sustainable from the point of view of aggregate demand.

• S = P – N; P = C + (X – M) = N + X; S = X - M• The German model has a strong ideological content by making the

obsession of a trade surplus the “sacred cow” of German politics.• The Buba was the watch-dog of the model.• The government has trade policy as the highest priority (as one

German President confessed, “we are in Afghanistan for commercial reasons”).

• We shall come back on this.

Optimal currency areas

• Mundell 1961 (but before Meade 1956).• Mundell defines a region as one area in which there is

labour mobility. A region is an OCA (“The optimum currency area is the region”).

• A currency union of dishomogeneus regions is not an OCA (“The optimum currency area is not the world”)

• He is pessimist that in a currency union, more competitive regions would expand their economies and let their inflation rate to rise to sustain less competitive regions.

• Less competitive regions are obliged to deflationary external adjustment policies

In a flexible exchange rate regime the trade balance is always in equilibrium (E E’) and the money supply is not affected by the external channel of money creation (the interest rate is not affected).

In a fixed exchange rate regime the trade balance is always in equilibrium (E E’’). The country loses official reserves and the money base contracts. In principles prices and output falls. This lead to an external adjustment. A rise of the interest rate might be necessary to attract external capitals. The country fixes the interest rate in view of the external equilibrium.

Deflation will move the IG curve back, and the real exchange rate devaluation might move the XG to the right. The adjustment might be helped if the surplus country does not sterilise the increase in the money base and lets inflation and demand growing. Mundell was pessimist. German behaviour has always confirmed this pessimism.

Similarities between UM and gold standard:

• “A system of flexible exchange rates was originally propounded as an alternative to the gold-standard mechanism which many economists blamed for the world-wide spread of depression after 1929. But if the arguments against the gold standard were correct, then why should a similar argument not apply against a common currency system in a multiregional country? Under the gold standard depression in one country would be transmitted, through the foreign-trade multiplier, to foreign countries. Similarly, under a common currency, depression in one region would be transmitted to other regions for precisely the same reasons. If the gold standard imposed a harsh discipline on the national economy and induced the transmission of economic fluctuations, then a common currency would be guilty of the same charges…”

• Feith in the trade adjustement properties of exchange rate flexibility (Friedman 195?), at least for large economies.

Optimal currency areas, Kenen (1969). Two points:

A) If regions have a diversified output, asimmetric shocks are less likely less likely chat asymmetrc shocks

• Endogenous OCA (Frenkel and Rose): even if a CU is not an OCA, with time economic integration and diversification will make it an OCA

deindustralisation in the periphery disconfirms this theory.

Optimal currency areas, Kenen (1969).

B) Otherwise, fiscal transfer may make it sustainable:• When one looks at fiscal policy in macroeconomic terms, one comes to

the unhappy view espoused by Mundell; budgetary policy cannot help but cause inflation in already-prosperous parts of an economy if they are designed to stimulate demand and thereby to eliminate local unemployment.

However:• This is not the only way to look at fiscal policy. Given the big numbers,

total taxation, and total expenditure, the budget can still combat localized recessions. When a region or community suffers decline in its external sales, a trade-balance deficit, and internal unemployment (here Kenen quotes himself) “… its federal tax payments diminish at once, slowing the decline in its purchasing power and compressing the cash outflow on its balance of payments. There is also an inflow of federal money – of unemployment benefits. Furthermore, a region can borrow (or sell off securities) in the national capital market more easily than countries can borrow abroad. Finally, regions can …obtain discretionary aid from the central government; special progress of financial and technical assistance to depressed areas have been enacted by a number of countries, including the Unites States.” On balance, then, a region may come out ahead by foregoing the right to issue its own currency and alter its exchange rate, in order to participate in a major fiscal system.

Barba De Vivo: federal budget irrelevant in the Eurozone (EZ)

Barba De Vivo: transfers irrelevant in the EZ compared to the States

Barba De Vivo: transfers irrelevant in the EZ compared to the States

Talks about a ridiculous EZ “fiscal capacity” have disappeard. A political union must precede monetary unification Kaldor (1971)

• …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.

The danger is chat:• 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.

Political union must preceed a monetary union

• “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. “

The hidden agenda: € as a pejorative version of the gold standard. Let us take a reactionary economist (Huerta de Soto)

• The gold standard put a check on governmental plans for easy money. It was impossible to indulge in credit expansion and yet cling to the gold parity permanently fixed by law. Governments had to choose between the gold standard and their — in the long run disastrous — policy of credit expansion. The gold standard did not collapse. The governments destroyed it. It was incompatible with etatism as was free trade. The various governments went off the gold standard because they were eager to make domestic prices and wages rise above the world market level, and because they wanted to stimulate exports and to hinder imports. Stability of foreign exchange rates was in their eyes a mischief, not a blessing. Such is the essence of the monetary teachings of Lord Keynes. The Keynesian School passionately advocates instability of foreign exchange rates. (emphasis added)

• Austrian economists defend the gold standard because it curbs and limits the arbitrary decisions of politicians and authorities. It disciplines the behavior of all the agents who participate in the democratic process. It promotes moral habits of human behavior. In short, it checks lies and demagoguery; it facilitates and spreads transparency and truth in social relationships. No more and no less.

the arrival of the Great Recession of 2008 has even further revealed to everyone the disciplinary nature of the euro: for the first time, the countries of the monetary union have had to face a deep economic recession without monetary-policy autonomy. Up until the adoption of the euro, when a crisis hit, governments and central banks invariably acted in the same way: they injected all the necessary liquidity, allowed the local currency to float downward and depreciated it, and indefinitely postponed the painful structural reforms that where needed and that involve economic liberalization, deregulation, increased flexibility in prices and markets (especially the labor market), a reduction in public spending, and the withdrawal and dismantling of union power and the welfare state. With the euro, despite all the errors, weaknesses, and concessions we will discuss later, this type of irresponsible behavior and forward escape has no longer been possible.

it is amusing (and also pathetic) to note that the legion of social engineers and interventionist politicians who, led at the time by Jacques Delors, designed the single currency as one more tool for use in their grandiose projects to achieve a European political union, now regard with despair something they never seem to have been able to predict: that the euro has ended up acting de facto as the gold standard, disciplining citizens, politicians, and authorities, tying the hands of demagogues and exposing pressure groups (headed by the unfailingly privileged unions), and even questioning the sustainability and the very foundations of the welfare state.

Rigid fixed exchange rate are inconsistent with national independent full-emplyment policy…

…with democracy and even with financial stability

Rigid fixed exchange rate are inconsistent with national independent full-emplyment policy with democracy and even with financial stability.

Comments

• In a currency union CA deficit countries suffers of higher interest rates given the “covertibility risk”, as in a fixed exchange rate regime.

• Fixed exchange rate regimes require wage and social right repression, that is they are inconsistent with democracy.

• Fixed exchange rate regimes and financial liberalisation stimulate the indebtness of deficit peripheral countries leading to financial crisis. This “this time is different” sequence has happened since the gold standard age.

So, why the European Currency Union?

• The American economists warned that the EZ was not an “optimal currency union” (they were accused of conspiracy against the European challenge to the US $).

• Political reasons (German unification)• France was paying a too high interest rate to keep the parity in the

EMS (Vianello)• Italy and others wanted to import the “German discipline”; Italian

fear to be excluded by a Franco-German Europe supposedly proceeding towards deeper unification

• Influence of monetarism: monetary policy is ineffective in the long run; necessity of an independent central bank with inflation control as the only target; nothing to lose in giving up monetary sovereignty; advantages of tying your hands.

The three monetarist pillars of European economic policy

• Balanced budget constraint (fiscal policy is viewed as a subtraction of private resources)

• Monetary policy managed by an independent Central bank (differences with the FED). Ineffectiveness of monetary policy.

• Employment policy is a national matter.

References• Cesaratto S., Stirati A. (2011) Germany in the European and Global Crises, International Journal of

Political Economy, vol. 39, no. 4, Winter 2010–11, pp.56–87; working paper version: http://www.econ-pol.unisi.it/dipartimento/it/node/1267

• Cesaratto S. (2011), Europe, German Mercantilism and the Current Crisis, Quaderni del dipartimento di economia politica, in Brancaccio E., Fontana G. (a cura di), The Global Economic Crisis. New Perspectives on the Critique of Economic Theory and Policy, Routledge, London. Working paper version Quaderni del Dipartimento di Economia politica,, n. 595 (www.econ-pol.unisi.it/dipartimento/it/quaderni)

• Frankel, J.A., Rose, A.K. (1996), The Endogeneity of the Optimum Currency Area Criteria, National Bureau of Economic Research Working Paper 5700.

• Friedman M. (1953), The Case for Flexible Exchange Rates, in Friedman M. (ed.), Essays in Positive Economics, University of Chicago Press, pp. 157-203. [due significativi passaggi del testo sono riportati qui: link]

• Godley, W. (1992), Maastricht and All That, London Review of Books, Vol.14, No. 19. [Goodhart, C.A.E. (1998), The Two Concepts of Money: Implications for the Analysis of Optimal Currency Areas , European Journal of Political Economy, Elsevier, vol. 14(3), pp. 407-432. [link]

• Kaldor, N. (1971), The Dynamic Effects Of The Common Market, in the New Statesman, 12 Marzo 1971; anche in Further Essays On Applied Economics, Cap. 12, pp 187-220, in The Collected Economic Essays series of Nicholas Kaldor, Vol 6. [link]

• Kenen, P.B. (1969), The Theory of Optimum Currency Areas: An Eclectic View, in R.A. Mundell and A.K.Swoboda (eds.), Monetary Problems of the International Economy, Chicago University Press, pp. 41-60.

• Mundell, R.A. (1961), A Theory of Optimum Currency Areas, American Economic Review, 51, pp. 657-665.

• C.A.E. Goodhart (1998), The two concepts of money: implications for the analysis of optimal

currency areas, European Journal of Political Economy, 14, 407-432;