A Euro Area Central Government Is The Only Way To Save The Euro Area

Joseph Stiglitz has written an article Seven Changes Needed To Save The Euro And The EU for The Guardian (also publish in Project Syndicate). None of the seven points say anything about a Euro Area central government. His point number 3 proposes “Eurobonds”, but this is not the same as having a federal government like the federal government of the United States.

Guess since nobody has said it, so I will: a Euro Area central government is the only way to save the Euro Area. Some patches can be done here and there such as the rescues done by the European Central Bank but this just helps remove some financial instability and doesn’t address the problem of economic stagnation. There is also a possibility of exiting the Euro Area but at this point in time, this is highly dangerous because debt levels are high and can cause a systemic crisis in not just the nation leaving but also the rest of the Euro Area and the rest of the world.

There is of course supranational institutions but these are not powerful enough. What one needs is a central government which has huge fiscal powers for making expenditures and receiving taxes from Euro Area economic units, just like federal taxes in the United States.

The most important economic reason is that the federal government will engage in automatic fiscal transfers which will stabilize output and debts of each Euro Area nation. Imagine if a nation such as Greece is allowed to expand output by fiscal policy or by private expenditure. Without a central government, a rise in output at say x% will require domestic demand to grow much faster and run into an unsustainable territory – mainly because of deterioration in the current account balance of payments.

Imagine Greece’s current account deficit hits 15% of GDP. This is not an exaggeration. At the peak of the crisis, Portugal’s current account deficit hit 12.6%. Because of the sectoral financial balance identity

NL = Govt DEF  + CAB

where NL is the private sector net lending, Govt DEF is the government’s deficit and CAB is the current account balance of international payments, a 15% current account deficit would imply atleast 15% government deficit. This is assuming private sector net lending is positive. Otherwise private sector net lending would turn negative, or it would have to become a net borrower.

But it’s not the case that there is an upper limit to the process. A steady rate of output would require an ever increasing rise in current account deficit, and an ever increasing debt/gdp which would stop eventually because foreign investors and institutions will not like it at some point. At that point, output will collapse and unemployment will rise.

By having a central government, such processes are prevented from becoming unsustainable. The difference between private receipts on exports less expenditure on imports will be compensated by the central government expenditure and tax receipts. So output is more stable and so is indebtedness to non-resident economic units.

So a Euro Area central government can raise output of the whole Euro Area and also keep indebtedness of Euro Area nations in check. Without a central government one is at the expense of the other. Right now, there is a deflationary bias to keep debts in check. Proposers such as Joseph Stiglitz want output to rise but do not realize that without a Euro Area central government, it comes at the expense of unsustainable debt.

Steve Keen On BBC HARDtalk

Steve Keen was recently on BBC HARDtalk, interviewed by Steven Sackur. It’s a nice interview. Sackur asks Keen whether he’s contrarian just for the sake for it and Keen comes up with good answers and why economic “experts” cannot be trusted.

At around 11:00, Keen also quotes Wynne Godley and his article Maastricht And All That and calls it the most prescient article ever written.

Steve Keen HARDtalk

click the picture to watch the video on YouTube.

Economics Without Mathematics?

Recently, Noah Smith wrote an article for Bloomberg View, titled Economics Without Math Is Trendy, But It Doesn’t Add Up.

Smith’s attitude is the following:

  1. Heterodox economics is vague and neoclassical economists are mathematical geniuses.
  2. Heterodox authors somehow manage to sneak in some model of the economy.

How about something opposite? That stock flow consistent/coherent models come close to describing the real world and neoclassical models don’t even start in the right foot? The usage of mathematics in neoclassical economics looks silly to me to say the least. Heterodox authors on the other hand have made important breakthroughs with stock-flow consistent models. In these models, the description of how stocks and flows affect each other leading to macrodynamics describing the real world is obtained.

Neoclassical models (which the phrase I use for the “new consensus”) not only doesn’t have anything as mathematical as this but it fails in the first place to identify the correct tools to describe economic behaviour.

Morris Copeland writing in Social Accounting For Moneyflows in Flow-of-Funds Analysis: A Handbook for Practitioners (1996) [article originally published in 1949] said:

The subject of money, credit and moneyflows is a highly technical one, but it is also one that has a wide popular appeal. For centuries it has attracted quacks as well as serious students, and there has too often been difficulty in distinguishing a widely held popular belief from a completely formulated and tested scientific hypothesis.

I have said that the subject of money and moneyflows lends itself to a social accounting approach. Let me go one step farther. I am convinced that only with such an approach will economists be able to rid this subject of the quackery and misconceptions that have hitherto been prevalent in it.

Morris Copeland’s work is what led the U.S. flow of funds which is published by the Federal Reserve every quarter. National accounts have also improved since their first version to incorporate Copeland’s ideas. See the 2008 SNA and the Balance of Payments And International Investment Position Manual, Sixth Edition for example.

Apart from stock-flow consistent/coherent models, models of the economy don’t even come close to describing the economy, because they miss the most important aspect: flow of funds.

So Goldman Sachs’ chief economist, Jan Hatzius for example uses this approach. See his paper The Private Sector Deficit Meets The GSFCI : A Financial Balances Model Of The US Economy, Global Economics Paper No. 98, Goldman Sachs, Sep 18, 2003.

So it is not that neoclassical economists have great mathematical tools. It’s that by failing to incorporate the framework of flow of funds, they are showing their incompetence in mathematical reasoning.

New Introductory Book On Macroeconomics

Louis-Philippe Rochon and Sergio Rossi have edited a new introductory book titled, An Introduction To Macroeconomics: A Heterodox Approach To Economic Analysis. 

Contents

Introduction: The Need for a Heterodox Approach to Economic Analysis
Louis-Philippe Rochon and Sergio Rossi

PART I ECONOMICS, ECONOMIC ANALYSIS, AND ECONOMIC SYSTEMS

1. What is Economics?
Louis-Philippe Rochon and Sergio Rossi

2. The History of Economic Theories
Heinrich Bortis

3. Monetary Economies of Production
Louis-Philippe Rochon

PART II MONEY, BANKS, AND FINANCIAL ACTIVITIES

4. Money and Banking
Marc Lavoie and Mario Seccareccia

5. The Financial System
Jan Toporowski

6. The Central Bank and Monetary Policy
Louis-Philippe Rochon and Sergio Rossi

PART III THE MACROECONOMICS OF THE SHORT AND LONG RUN

7. Aggregate Demand
Jesper Jespersen

8. Inflation and Unemployment
Alvaro Cencini and Sergio Rossi

9. The Role of Fiscal Policy
Malcolm Sawyer

10. Economic Growth and Development
Mark Setterfield

11. Wealth Distribution
Omar Hamouda

PART IV INTERNATIONAL ECONOMY

12. International Trade and Development
Robert A. Blecker

13. Balance-of-payments Constrained Growth
John McCombie and Nat Tharnpanich

14. European Monetary Union
Sergio Rossi

PART V RECENT TRENDS
15. Financialization
Gerald A. Epstein

16. Imbalances and Crises
Robert Guttmann

17. Sustainable Development
Richard P.F. Holt

Conclusion: Do we Need Microfoundations for Macroeconomics?
John King

Index

An Introduction To Macroeconomics - Louis-Philippe Rochon, Sergio Rossi

You can preview the book on Google Books here and the publisher’s site for the book is here.

IEO On The Euro Area’s Balance Of Payments Problems

The IEO, Independent Evaluation Office of the IMF has come up with a report The IMF And The Crises In Greece, Ireland, And Portugal in which it discusses how the IMF rejected the possibility of a balance of payments crisis in a monetary union without a full political union such as in the Euro Area.

Ambrose Evans-Pritchard of The Telegraph quotes an important passage from the report in an article:

“The possibility of a balance of payments crisis in a monetary union was thought to be all but non-existent,” it said. As late as mid-2007, the IMF still thought that “in view of Greece’s EMU membership, the availability of external financing is not a concern”.

At root was a failure to grasp the elemental point that currency unions with no treasury or political union to back them up are inherently vulnerable to debt crises. States facing a shock no longer have sovereign tools to defend themselves. Devaluation risk is switched into bankruptcy risk.

The quote is in page 25 (page 33 of pdf) of the article, linked on top of this page.

Some economists clearly saw it coming. Here’s Wynne Godley from his 1991 article Commonsense Route To A Common Europe for The Observer:

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

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

Why doesn’t it happen to a state in say the United States? This is because, there’s a federal government which is engaged in automatic fiscal transfers. Weaker states as a whole will receive more from the government than what it sends as taxes, especially during downturns. This has the effect of stabilizing the current account balance of payments of the whole region and prevents its indebtedness from exploding relative to its economic output. The Euro Area clearly does not have it.

A Short Note On George Soros’ Principle Of Reflexivity

There’s a nice paper by George Soros from 2014, titled Fallibility, Reflexivity, And The Human Uncertainty Principle in which he gives a good alternative description of financial markets. It’s a kind of a review article of his own ideas he has developed over the years. This is in sharp contrast to the “efficient market hypothesis”.

Here I wanted to discuss just one aspect. In section 4.1 of the paper, Soros says:

Let me state the three key concepts of my approach, fallibility, reflexivity, and the human uncertainty principle as they apply to the financial markets …

Second, reflexivity. Instead of playing a purely passive role in reflecting an underlying reality, financial markets also have an active role: they can affect the future earnings flows they are supposed to reflect. That is the point that behavioral economists have missed. Behavioral economics focuses on only half of the reflexive process: cognitive fallibility leading to the mispricing of assets; they do not concern themselves with the effects that mispricing can have on the fundamentals.

Although, in neoclassical economics, it is difficult to see how this is the case, it is easy in stock-flow coherent macro models. Without writing equations, let’s see how this works.

  1. A rise in expectations of equity prices will lead to a rise in the actual value of equity prices.
  2. Higher equity prices implies holding gains (capital gains) for the holders ultimately households.
  3. This raises consumption (and purchases of houses) as households are richer.
  4. This rise in domestic demand raises output as producers will produce more to meet the demand.
  5. Higher production means higher profits.
  6. A boom in financial markets also leads to a rise in firms’ capital formation (“investment”). Investment is self-financing as investment expenditure for one firm is a source of revenue for another.

Of course, there are feedback effects as well and this may become a bubble which goes bust, but this is the basic mechanism by which reflexivity works.

Although this appears simple, this cannot happen in neoclassical economics because the “production function” is at the heart of it.

Back to Soros. In the paper, he has a nice chart with an explanation of it.

George Soros - Stock Prices Affecting Fundamentals

Soros explains:

A typical market boom– bust. In the initial stage (AB), a new positive earning trend is not yet recognized. Then comes a period of acceleration (BC) when the trend is recognized and reinforced by expectations. A period of testing may intervene when either earnings or expectations waiver (CD). If the positive trend and bias survive the testing, both emerge stronger. Conviction develops and is no longer shaken by a setback in earnings (DE). The gap between expectations and reality becomes wider (EF) until the moment of truth arrives when reality can no longer sustain the exaggerated expectations and the bias is recognized as such (F). A twilight period ensues when people continue to play the game although they no longer believe in it (FG). Eventually a crossover point (G) is reached when the trend turns down and prices lose their last prop. This leads to a catastrophic downward acceleration (GH) commonly known as the crash. The pessimism becomes over done, earnings stabilize, and prices recover somewhat (HI).

Of course, it’s more complicated. There can be other factors leading to the fall of both equities and earnings. But importantly, the fall in equity prices can—via the wealth effect and a fall in firms’ capital formation (“investment”)—lead to a fall in earnings.

George Soros’ criticism of neoclassical economics is great and he’s quite correct in getting an important causality. His description however lacks a mechanism. This can be provided with a demand-led stock-flow coherent behavioural model without any production function.

Joseph Stiglitz On The European Union

In this interview (linked below) with The New York Times, Joseph Stiglitz points out the response of the EU to the UK EU referendum vote and its authoritarianism. He says that after the Brexit vote, Jean-Claude Juncker, who is the President of the European Union said that the EU will act tough on the UK to make sure other European Union members do not leave. Stiglitz then says that you want to believe that people want to stay in the EU because it brings benefits to them but, no, that is not the way Juncker is thinking. He wants people to stay because of fear and is issuing a threat.

Joseph Stiglitz Interview

click the picture to see the video on NYT’s Facebook page.

Discussion around 19:00

Another important point Stiglitz makes about the Euro Area is about a system of progressive taxation. This point is often less discussed. If France raises taxes, it makes it easier for economic units to move to another place inside the Euro Area and hence it is difficult to create a system of progressive taxation.

I find it disappointing that many heterodox economists support the European Union. Will the Juncker threat make them realize?

Milton Friedman On Free Trade

I always like watching Milton Friedman, not because I like him but for something totally opposite. It helps in knowing what the exact position of economists is. Milton Friedman has been hugely influential on how economists think. Almost everyone is just rambling what Friedman said, so why not listen to their master?

This is a lecture given in 1978 on free trade.

Milton Friedman Lecture On Free Trade

click the picture to watch the video on YouTube

A claim made by Friedman in the video is that market mechanisms work to resolve balance of payments problems. “Balance of payments is not a problem”, says Friedman. Of course that’s all wrong but economists continue to believe in such things.

Another claim made by Friedman is that protectionism is because few industries lobby for it. While that is certainly true, how about “free trade” itself? Producers with market share in international markets influence their governments to push for free trade internationally. Why didn’t he talk of those things?

MoneyWeek Interviews Steve Keen

In this interview, Steve Keen talks of Europe post the UK EU Referendum (“Brexit”).

Steve Keen talks of various things such as the importance of manufacturing etc. In the first four minutes, he also refers to Wynne Godley’s 1992 LRB article Maastricht And All That.

Steve Keen MoneyWeek Interview

click the picture to see the video on MoneyWeek’s website. 

Nice interview.

A few complaints. Although Steve Keen is correct about the importance of debt, he is still holding on to his equation, “aggregate demand = gdp + change in debt”. Also in the interview Keen talks of quantitative easing is about banks selling bonds to the Fed. Although banks in their role as primary dealers do sell the bonds to the Federal Reserve, the counterfactual is not banks holding all the bonds.

I also do not believe in debt jubilees (except in exceptional case such as farmers with huge debt in India). Debt jubilee is unfair to the people who didn’t go into debt. Good initiatives are things such as forgiving medical debt as done by John Oliver.

Never Trust An Economist

“Never trust an economist, including myself”, says Ha-Joon Chang in this wonderful video titled, Economics Is For Everyone.

Ha-Joon Chang

click the picture to see the video on YouTube.

Ha-Joon Chang is definitely sounding like Joan Robinson. In a lecture in Delhi in 1955, she said:

The purpose of studying economics is not to acquire a set of ready-made answers to economic questions, but to learn how to avoid being deceived by economists.

More from her in this post Joan Robinson On Economists