Monthly Archives: July 2015

Federal Government And Regional Balance Of Payments

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.

Ben Bernanke Embracing Heterodox Ideas

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]

Is A Fiscal Union Expensive For Its Rich Members?

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.

He cites the example of Connecticut:

But the American fiscal union is very expensive for rich states. According to calculations by The Economist, Connecticut paid out 5 percent of its gross domestic product in net fiscal transfers to other states between 1990 and 2009; that is, its tax payments exceeded its receipt of government services by that amount. This is typical for rich states: They pay a disproportionate share of income and payroll taxes, while government services are disproportionately collected in states where people are poor or old or infirm.

This is blatantly wrong. It assumes that output of individual regions and the whole of the the Euro Area will roughly be the same with or without a fiscal union. It ignores the notion that each region may be better off because a supranational fiscal authority will have powers to raise output via expenditure and taxes which individual regions cannot achieve.

In his 1997 article Curried EMU — The Meal That Fails To Nourish for Observer, Wynne Godley made this point well (link):

A useful comparison can be made with the US. Americans often point that if would make no sense if each US state had its own currency, so what is all the fuss about? But the question should be asked the other way round. How would the US make out with no President, no Congress, no federal budget, and no federal institutions apart from the ‘Fed’ itself, plus a powerful central bureaucracy?

The analogy is useful because the United States does so obviously need a federal budget as well as a federal bank, and the activities of the two authorities have to be co-ordinated.  If there is a recession, remedial (expansionary) fiscal policy at the federal level is the only proper response; it is inconceivable that corrective action could be left to component states, which have neither the perspective nor the co-ordinating machinery to do the job. If there is a federal budget there must obviously be a legislative and executive apparatus that executes it and is democratically accountable for it. Moreover, the need for federal institutions extends far beyond economic affairs.

[emphasis added]

So it is incorrect to claim that a fiscal union is highly expensive for rich states. If there is a fiscal union, while rich regions will receive less from the supranational fiscal authority than what they pay in taxes, there’ll be higher output and income than otherwise simply because there is a powerful institution which raises output of each region. Rich nations will be able to net export more than otherwise, for example, compensating for transfers in absolute terms.

Analysis such as by Josh Barro are erroneous usually because of implicit assumptions made such as an aggregate production function, which implies a neutral role for fiscal policy. This can easily be verified: his assumption is that output is determined by other factors, not fiscal policy (because he doesn’t say so) and hence the role of a central government is one which just transfers from rich regions to poor, instead of having any impact on the output of the whole region. Silly.