The Financial Times has a column titled Europe’s Fiscal Union Envy Is Misguided. The author echoes a recent article in The New York Times (referred here in my blog). According to the FT columnist, in the United States,

… The bulk of the risk-sharing happens through credit and capital markets – that is to say, private lending, borrowing and investment returns do most of the job of evening out regional shocks.

and,

… The best thing the eurozone can do to promote risk-sharing is to stop flirting with its own disintegration: as long as investors suspect politicians might let the currency unravel, they will hunker down behind national borders. Next, get cracking on developing the capital markets union – where there is much more reason to envy the Americans.

In addition, the FT author presents the following graph.

FT Image 20 July 2015Now, there are several things wrong with this. It’s true that risk-sharing happens through credit and capital markets, the argument ignores that fiscal transfers improve the net indebtedness of regions. Financial markets may improve risks by the way they work, but they cannot change net indebtedness of regions in significant ways. Borrowing is not comparable to fiscal transfers. It’s vague what “capital income and insurance flows” is.

Let’s see how a federal system works.

There are regions with local governments but there is also a federal government which raises taxes from economic units of all regions and spends on the units. Some regions will be net recipients of such flows of funds — the government expenditure toward these regions is higher than what it receives in taxes — while others will pay more taxes than what they receive from the government. These needn’t sum to zero, as the federal government may be in a deficit.

There is one peculiar thing in the way such accounting is done. The federal government is outside all regions when studying balance of payments of each region. However for the whole group, the federal government is inside. The Sixth Edition of the IMF’s Balance Of Payments And International Investment Position Manual (BPM6) does this in a similar way for monetary unions, such as for the Euro Area. In that case, the European Central Bank and the European Parliament and other such supranational institutions are considered to be outside each nation when nations’ balance of payments statistics is produced, but inside when the balance of payments of the whole region is studied.

Now, some regions may see an improvement in their balance of payments compared to the case where there is no federal government. There are four kinds of flows which are important here when thinking about the current account balance of payments of a region:

  1. Exports
  2. Imports
  3. Federal government expenditures and transfers
  4. Federal taxes and transfers.

Of course, expenditure of the federal government in the region itself may be thought of as an export, so exports in the list above is meant to exclude that and include transactions such as a private sector producer selling a car to a household in another region.

So one can roughly identify surplus regions as ones which have higher exports than imports in the definition above and others as deficit regions. These transactions of course also affect the capital and financial accounts of the balance of payments and the “regional investment position”.

Usually, one thinks of “fiscal transfers” as affecting aggregate demand. But from the above analysis, it should be clear that it also affects the regional investment position. Economic units in deficit regions also see an improvement in their net asset position. Economic units in deficit regions in aggregate will typically receive more federal government payments than what they send in taxes. The counterpart to this in the capital and financial account of the balance of payments is an improvement in their net acquisition of financial assets and net incurrence of liabilities, as compared to the case where there is no federal government. This is turn improves the regional investment position.

Of course there is still a possibility that the private sector of a union with a federal government as a whole may turn unsustainable but at least there is a regional mechanism of improvement compared to the case when there is no federal government.

To summarize, the point of the above analysis is that the financial sector as a whole cannot achieve this on its own. It takes a federal government to not only affect demand in all regions but also keep their debts in check. The workings of finances of a federal government affects the asset and liability positions of any region as a whole. The financial sector cannot take up the task of a federal government.

Leave A Comment

Ben Bernanke Embracing Heterodox Ideas

by Ramanan on 18 July 2015

It’s remarkable how some economists were ahead of the time, while others such as Ben Bernanke seem to just catch up. In a recent post on his blog Ben Bernanke gives out some unorthodox ideas to resolve the Euro Area crisis.

Ben Bernanke says:

… Germany’s large trade surplus puts all the burden of adjustment on countries with trade deficits, who must undergo painful deflation of wages and other costs to become more competitive. Germany could help restore balance within the euro zone and raise the currency area’s overall pace of growth by increasing spending at home, through measures like increasing investment in infrastructure, pushing for wage increases for German workers (to raise domestic consumption), and engaging in structural reforms to encourage more domestic demand. Such measures would entail little or no short-run sacrifice for Germans, and they would serve the country’s longer-term interests by reducing the risks of eventual euro breakup.

Second, it’s time for the leaders of the euro zone to address the problem of large and sustained trade imbalances (either surpluses or deficits), which, in a fixed-exchange-rate system like the euro zone, impose significant costs and risks. For example, the Stability and Growth Pact, which imposes rules and penalties with the goal of limiting fiscal deficits, could be extended to reference trade imbalances as well. Simply recognizing officially that creditor as well as debtor countries have an obligation to adjust over time (through fiscal and structural measures, for example) would be an important step in the right direction.

That’s in 2015.

Compare that to the conclusion from a 2007 paper titled A Simple Model Of Three Economies With Two Currencies: The Eurozone And The USA written by Wynne Godley and Marc Lavoie for Cambridge Journal Of Economics (journal link):

… it should be noted that balanced fiscal and external positions for all could as well be reached if the euro country benefiting from a (quasi) twin surplus as a result of the negative external shock on the other euro country decided to increase its government expenditures, in an effort to get rid of its budget surplus. This case, where the surplus countries rather than the deficit countries adjust, as many authors have underlined, would eliminate the current downward bias in worldwide economic activity. Now this would require an entirely new attitude towards government deficits. One would need an anti-Maastricht approach, that would run against the Stability and Growth Pact and its neoliberal obsession with fiscal balance and government debt reduction. For instance, one would need a new Pact, that would discourage fiscal surpluses. National governments that ran budget surpluses would pay large proportional automatic levies to the European Union, who would be compelled to spend the sums thus collected in the deficit countries. In this manner, the ‘weak’ and the ‘strong’ members of the eurozone could converge towards a super-stationary state, with balanced budgets and current accounts, through an increase rather than a decrease in government expenditures and economic activity.

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. This raises the profound question as to whether in the long term it is possible to have a community of nations which have a single currency which does not have a federal budget of substantial size, and by implication a federal government to run it—a point that was made very early on in Godley (1992).

[italics in original]

Leave A Comment

Is A Fiscal Union Expensive For Its Rich Members?

10 July 2015

Josh Barro writing for The New York Times claims that a fiscal union for the Euro Area will be an enourmous expense for its rich members. Fiscal union would fix the euro permanently — but at enormous expense to its rich members. So it won't happen. http://t.co/naXIp75vIz — Josh Barro (@jbarro) July 10, 2015 He cites […]

READ MORE >>

Thomas Palley On Competing Stories On Inequality, The Financial Crisis And Stagnation

11 June 2015

Thomas Palley has a new paper Inequality, The Financial Crisis And Stagnation: Competing Stories And Why They Matter. Abstract: This paper examines several mainstream explanations of the financial crisis and stagnation and the role they attribute to income inequality. Those explanations are contrasted with a structural Keynesian explanation. The role of income inequality differs substantially, giving rise to […]

READ MORE >>

Kaldor’s Vision Of The Growth And Development Process According To Thirlwall

25 May 2015

Anthony Thirlwall’s new book Essays on Keynesian and Kaldorian Economics is out. It has a nice chapter (chapter 11) originally written by Thirlwall himself from 1991 titled Kaldor’s Vision Of The Growth And Development Process. The description from introduction (pdf from Palgrave’s website) is a good summary: Essay 11 outlines Kaldor’s vision of the growth and development process […]

READ MORE >>

On Matters Of Macroeconomics, Even A Beautiful Mind Can Go Astray

25 May 2015

John Nash died on Saturday in New Jersey. Via the blog Econospeak, I came across a 2005 talk titled Ideal Money and Asymptotically Ideal Money by John Nash about money and macroeconomics. pdf here and a news report here. Nash starts his lecture straightaway by dismissing Keynesian economics: The special commodity or medium that we […]

READ MORE >>

Krugman And Causality

17 May 2015

In a recent post titled Money, Inflation And Models for his NYT blog, Paul Krugman clearly states that “normal equilibrium macro models” say that the direction of causality is from money to prices. Krugman says: Consider the relationship between the monetary base — bank reserves plus currency in circulation — and the price level. Normal equilibrium macro models say […]

READ MORE >>

Fiscal Conservatism, Weak International Trade Performance And Income Inequality Not Good For The U.S. Economy

15 May 2015

The US economy is only 8.8 percent above the pre-crisis peak. The Levy Institute has a new Strategic Analysis publication titled Fiscal Austerity, Dollar Appreciation, And Maldistribution Will Derail The US Economy in which they identity three main structural characteristics of the economy of the United States that stand in the way of the recovery: (1) […]

READ MORE >>

More Jobs, Flat Wages: Trade And The Trade Deficit Continue To Hurt Us

12 May 2015

by Thomas Palley April’s Employment Report showed a gain of 223,000 jobs and a further one-tenth percent decline in the unemployment rate to 5.4 percent. The good news is the report shows the economy continues to nudge forward and create jobs for newcomers into the labor force. The bad news is the economy is not growing […]

READ MORE >>

Free Trade? Heterodox Dissent

25 April 2015

One of the most important message of this blog is that “free trade” is quite devastating to economies. In a recent article Economists Actually Agree on This: The Wisdom of Free Trade for The New York Times, Greg Mankiw once again pushes for free trade and also mentions that there is consensus in the profession. Many of […]

READ MORE >>