Financing Vs. Spending Unions: How To Remedy The Euro Zone’s Original Sin

by Thomas Palley

In economic policy, timing isn’t everything, it’s the only thing. The euro zone crisis has been evolving for over seven years, making it difficult to time policy proposals. Now, the shock of Brexit has created a definitive political opportunity for reforming rather than patching the euro. With that in mind, I would like to revive an earlier mistimed proposal for a euro zone “financing union” (English version, German version). The proposal contrasts with others that emphasize “spending unions”. But first some preliminaries.

The euro zone’s original sin

The original sin within the euro zone is the separation of money from the state via the creation of the European Central Bank (ECB) which displaced national central banks. Under the euro, countries no longer have their own currency for which they can set their own exchange rate and interest rate, and nor can they call on a national central bank to buy government bonds and finance government spending.


This article first appeared at Thomas Palley’s blog

The World Needs A Kaldorian Response

Dani Rodrik has a new article, The Abdication Of The Left written for Project Syndicate. He says:

The good news is that the intellectual vacuum on the left is being filled, and there is no longer any reason to believe in the tyranny of “no alternatives.” Politicians on the left have less and less reason not to draw on “respectable” academic firepower in economics.

Consider just a few examples: Anat Admati and Simon Johnson have advocated radical banking reforms; Thomas Piketty and Tony Atkinson have proposed a rich menu of policies to deal with inequality at the national level; Mariana Mazzucato and Ha-Joon Chang have written insightfully on how to deploy the public sector to foster inclusive innovation; Joseph Stiglitz and José Antonio Ocampo have proposed global reforms; Brad DeLong, Jeffrey Sachs, and Lawrence Summers (the very same!) have argued for long-term public investment in infrastructure and the green economy. There are enough elements here for building a programmatic economic response from the left.

This is fine, but it wouldn’t be enough to solve the world’s problems because the world as a whole is balance-of-payments constrained as most individual nations are. What is needed is a coordinated response at the international level – a concerted action.

In his 1984 book Causes Of Growth And Stagnation In The World Economy, Nicholas Kaldor wrote:

I should like to end this series of lectures by suggesting the outline of a world-wide agreement on the necessary policies for recovery. The programme could be summed up under four main heads:

  1. The first is coordinated fiscal action including a set of consistent balance of payments targets and “full employment” budgets.If this does not prove to be politically feasible, it is inevitable that the growth of unemployment will sooner or later force governments to take measures that would make it necessary for them to expand demand without being frustrated by the inevitable balance of payments consequence of expanding their economies relative to their trading partners. This means that there needs to be some form of restriction that would limit the increase in “competitive” imports to some target ratio in relation to exports. Trade liberalisation, which played such an important part in the rapid economic progress during the years of expansion, becomes a serious obstacle to economic recovery in the case of prolonged stagnation due to the inability of countries to achieve a coordinated set of policies. But, given a proper recognition of the problem, that under conditions of unrestricted free trade the actual volume of production and trade may in fact be considerably less than under some system of regulated trade – a system which relates the volume of imports in manufactures from a particular group of countries, such as the members of the EEC, to some mutually agreed ratio to the exports of individual members to the rest of the group – there is no reason why full employment should not be restored through policies of expansion, preferably directed by the expansion of State investment. This coordinated action by all countries, instead of isolated actions by each country, is the first and most important requirement of recovery.

At present all countries have fairly large deficits in the general government budget, but these are largely the consequence of the low level of activity. On a “full employment” basis they would show a highly restrictive picture – they would show surpluses and not deficits. Contrary to appearances, the requirement of stability is for expansionary budgets with lower taxes and higher expenditure, and not further fiscal restriction (as is advocated, for example, by M. de Larosiere of the International Monetary Fund).

Before the crisis, the economics profession believed in two orthodoxies:

  1. crude version of Monetarism, which treats the stock of money as exogenous and also claims that fiscal policy is impotent.
  2. free trade.

While policy response following the 2008 crisis have made economists realize that the first orthodoxy is wrong, they are yet to realize the orthodoxy of the second. As Joan Robinson said in her 1973 article, The Need For A Reconsideration Of The Theory Of International Trade, “there is no branch of economics in which there is a wider gap between orthodox doctrine and actual problems than in the theory of international trade”. The recent consensus of the economics profession on the debate about the UK EU referendum highlights it. Instead of the invisible hand, we need a visible hand, i.e., a coordination at the international level. The leftist response as highlighted by Dani Rodrik are welcome but still leave the problem open. So one needs both this and a world-wide fiscal expansion with balance-of-payments targets.


Circular Arguments

Recently, Paul Krugman reminded us of circular reasoning in his blog on Brexit. The same was said earlier by Mervyn King.

Economists use circular reasoning all the time but I’ll digress from economics in this post on something I came across recently involving Fermat’s Last Theorem.

There’s a proof of the irrationality of 21/n , where n is an integer for n > 2 (proof doesn’t work for n = 2) which goes something like this:

Suppose 21/n = p/q, where and are integers and n > 2 . Then:

pn = qn + qn

violating Fermat’s last theorem. So 21/n  is irrational by contradiction.

Sounds cool. But not so. It’s circular argument. A comment at mathoverflow by a person named JS Milne points that that Andrew Wiles’ proof of Fermat’s Last Theorem itself uses the irrationality of 21/.


Marc Lavoie On Absolute Advantage Vs. Comparative Advantage

Thanks, the blogger with pen name “Lord Keynes” for reminding us of Marc Lavoie’s fantastic description of free trade, comparative advantage vs. absolute advantage from his book, Post-Keynesian Economics: New Foundations. 

Google Books allows you to read pages 507-509 (if the embed doesn’t open, try another browser):

Marc Lavoie - Absolute Advantage Vs. Comparative Advantage

click picture to read on Google Books.

Krugman’s Envelope

Paul Krugman has an article each on his blog and for NYT Opinion on Donald Trump’s claim that he’ll take protectionist measures to improve U.S. manufacturing, especially on China.

The debate is around a paper Import Competition and the Great US Employment Sag of the 2000s by Daron Acemoglu, David Autor, David Dorn, Gordon H. Hanson and Brendan Price.

From the abstract of the paper:

Even before the Great Recession, US employment growth was unimpressive. Between 2000 and 2007, the economy gave back the considerable employment gains achieved during the 1990s, with a historic contraction in manufacturing employment being a prime contributor to the slump. We estimate that import competition from China, which surged after 2000, was a major force behind both recent reductions in US manufacturing employment and—through input-output linkages and other general equilibrium channels— weak overall US job growth. Our central estimates suggest job losses from rising Chinese import competition over 1999–2011 in the range of 2.0–2.4 million.

Now Paul Krugman explicitly agrees with this claim:

I basically agree with this conclusion, at least when we’re talking about manufacturing employment. But I’m troubled by some conceptual issues, which I think are important for interpreting the results.

As the second line of the quote shows, Krugman is reluctant to accept this. This shouldn’t be surprising. Krugman has been a champion of free trade and it will be difficult for him to accept that he has been wrong all around.

Krugman says:

… it all depends on offsetting policies. If monetary and fiscal policy are used to achieve a target level of employment – as they generally were prior to the 2008 crisis – then a first cut at the impact on overall employment is zero

First, the United States didn’t have full employment before the 2008 crisis. So fiscal policy wasn’t offsetting enough. Instead if the U.S. had taken measures to protect manufacturing, unemployment would have been lower for the same fiscal stance. But that is not enough. Even if fiscal policy had offset all loss of employment due to trade, such a policy would not have been sustainable as it would mean that U.S. public debt and the net international investment position keep deteriorating relative to gdp.

So the U.S. could have been better off taking some measures such as non-selective protectionism as recommended by Wynne Godley in 1999 in his article Seven Unsustainable Processes.

Second Krugman’s claim is that instead of purchasing manufactured imports, U.S. economic units would have non-manufactured imports. That is partly true, if the protectionism measure was selective. But even here, output would have been higher even if total imports were the same, non-manufactures instead of manufactures. In other words, what is more important is the import propensity, not imports itself.

In all, putting tariffs on trade can be highly expansionary for the U.S. economy and employment. China’s economy has expanded massively and has damaged the U.S. economy. China is in a position to expand output by boosting domestic demand rather than relying on exports because its international investment position is quite solid and it need not worry about balance of payments problems if it does so. Instead, China has a massively undervalued exchange rate and it gives unfair advantage to China. It is sometimes said that China should float its currency freely in the foreign exchange markets. Although this step would be great, it still relies on the market mechanism to solve problems and is not guaranteed to work. Who knows how much China’s currency would appreciate? Maybe it just appreciates 10% and not more. Moreover, it is not just China. U.S. faces competition from various other nations as well. So a non-market mechanism is needed such as non-selective protectionism. This will help the U.S. expand output without its debts rising in an unsustainable way.

Krugman’s back-of-the-envelope calculations are not really something which are obvious and the first cut to a right answer. The flawed ideology of free trade is behind Krugman’s numbers.

Needless to say, all this is not an endorsement of Trump. Strange times, when we defend politicians whose ideology we do not like. Even Bernie Sanders is not pro-free trade, although he hasn’t been as explicit as Trump.

Finally, on manufacturing versus services, Krugman says:

No matter what we do on trade, America is going to be mainly a service economy for the foreseeable future. If we want to be a middle-class nation, we need policies that give service-sector workers the essentials of a middle-class life.

I don’t understand what economists dislike so much about manufacturing. “Going to be” is different from whether it is correct to be and not do anything about manufacturing. It’s not a logical argument to say, “Oh! we are a service economy, manufacturing has lost its importance”. Because the U.S. manufacturing deficit was $831 bn in 2015.

Marc Lavoie Lectures On Post-Keynesian Economics And Stock-Flow Consistent Modeling

There are two wonderful lectures by Marc Lavoie given at the UMKC two years ago. I had seen them that time but forgot to post it on my blog.

Likely you might have seen it, but if not, here they are.

Lecture 1: Essentials of Heterodox And Post-Keynesian Economics


Marc Lavoie - Essentials Of Heterodox And Post-Keynesian Economics

Click picture to view the video on YouTube.

Lecture 2: Workshop on stock-flow consistent modeling


Marc Lavoie - Workshop On Stock-Flow Consistent Modeling

Click picture to view the video on YouTube.

Paul Krugman On Economists Gone Wrong

Now Britain finds itself in an alarming new landscape, where our very ways of feeding ourselves, like so much else, look uncertain.

– Bee Wilson, The New Yorker

Paul Krugman has a post The Macroeconomics of Brexit: Motivated Reasoning? on his blog The Conscience Of A Liberal about how “experts” exaggerated claims of the impact of a result to leave in the recent UK EU membership referendum (“Brexit”). Quite agree with Paul Krugman. When Michael Gove told Sky News that people in the UK have had enough of experts, he was laughed at. Video here.

Needless to say this is not an endorsement of Michael Gove’s other political position. Strange times, when you defend someone with different political ideology. The above is just meant to highlight a point that experts exaggerated and that people knew.

John Maynard Keynes also said this in the GT:

But although the doctrine itself has remained unquestioned by orthodox economists up to a late date, its signal failure for purposes of scientific prediction has greatly impaired, in the course of time, the prestige of its practitioners. For professional economists, after Malthus, were apparently unmoved by the lack of correspondence between the results of their theory and the facts of observation;— a discrepancy which the ordinary man has not failed to observe, with the result of his growing unwillingness to accord to economists that measure of respect which he gives to other groups of scientists whose theoretical results are confirmed by observation when they are applied to the facts.

Paul Krugman’s main point is that economists’ arguments were motivated reasoning, involved circular reasoning and assumed what they wanted their model to output.

But maybe Paul Krugman himself is doing so? Krugman claims:

I believe that Brexit is a tragic development, which will do substantial long-run economic harm. But what we’re hearing overwhelmingly from economists is the claim that it will also have severe short-run adverse impacts. And that claim seems dubious.

Okay, financial markets have improved after some initial panic caused by the fear of fear. and FTSE 100 is at year-to-day highs. But Krugman still wishes to claim that Brexit is bad long term:

OK, let’s start at the beginning. Brexit will almost certainly have an adverse effect on British trade; even if the UK ends up with a Norway-type agreement with the EU, the loss of guaranteed access to the EU market will affect firms’ decisions about investments, and inhibit trade flows.

This reduction in trade relative to what would otherwise happen will, in turn, make the British economy less productive and poorer than it would otherwise have been. It takes fairly heroic assumptions to make this into a specific number, but 2-3 percent lower income in perpetuity seems plausible.

So far, so good, or rather so bad: this is standard economics, basically Ricardo with a dash of new trade theory.

Firstly it claims that is takes heroic assumptions. Second, but more importantly, Ricardo’s theory? Seriously? Ricardo’s theory and new trade theory claim there is convergence of successful and unsuccessful economies under free trade but emperically what is observed is that because of the process of circular and cumulative causation, there is polarization, not convergence.

It should be possible for the United Kingdom to negotiate protective arrangements (especially in manufactures) in such a way that the EU does not impose punitive tariffs and its exports do not suffer. Trade won’t suffer because although the propensity to import reduces, the government can expand domestic demand since such policies might ease the balance of payments constraint and the volume of UK imports won’t fall.

More generally, the solution of the problems of the world can come about if there is a concerted action, in which fiscal policy is coordinated and there are set of rules for balance-of-payments targets. In this system of regulated trade, world trade can rise because of higher world income as compared to a world with free trade.

Brexit should make economists realize that their models do not conform to empirical data. Ricardo and new trade theory can be cast aside.


Why Negative Interest Rate Policy (NIRP) Is Ineffective And Dangerous

Abstract, new paper from Thomas Palley:

NIRP is quickly becoming a consensus policy within the economics establishment. This paper argues that consensus is dangerously wrong, resting on flawed theory and flawed policy assessment. Regarding theory, NIRP draws on fallacious pre-Keynesian economic logic that asserts interest rate adjustment can ensure full employment. That fallacious logic has been augmented by ZLB economics which claims times of severe demand shortage may require negative interest rates, which policy must deliver since the market cannot. Regarding policy assessment, NIRP turns a blind eye to the possibility that negative interest rates may reduce AD, cause financial fragility, create a macroeconomics of whiplash owing to contradictions between policy today and tomorrow, promote currency wars that undermine the international economy, and foster a political economy that spawns toxic politics. Worst of all, NIRP maintains and encourages the flawed model of growth, based on debt and asset price inflation, which has already done such harm.

Keywords: Negative interest rate policy, zero lower bound

(The post title is the link)

Bloomberg Interviews Mervyn King Post EU Referendum

Tom Keene and Francine Lacqua of Bloomberg interview Mervyn King post the Brexit vote. What I liked about the interview is that King says explicitly that the UK politicians exaggerated the impact of the leave vote. In another interview to BBC, he said explicitly that the UK Treasury exaggerated. He also criticizes the assumptions people made when putting out the numbers.


click picture to open the video on Bloomberg’s site

When Tom Keene asks him what he says as a “card carrying member of the UK elite” on what people think of common people, Mervyn King says that the UK political class has lost touch with them and has alienated them and were not allowed to discuss certain issues.

This is not a lefty or a socialist saying all this, this is Mervyn King. This goes on to prove that the UK left is clueless about economic impacts of their own ideas. There was hardly any noise against the remain camp.

Even heterodox economists supported remain!

He even says the fall in the pound is not a cause for concern as it can do good for UK trade. Which is a good point. What matters is expectations of the exchange rate more than the exchange rate itself for alarm and now expectations have stabilized.

Bank Lending Causes Growth?

Of course it does. If banks restrict their lending, it has an effect on aggregate expenditure as producers will postpone their plans and consumers might spend less. If banks increase their animal spirits, and lend more, producers and consumers borrow more with effect on aggregate demand and output.

But is growth only caused by bank lending?

In a recent article on Brexit, Richard Werner says:

I have been trained in international and monetary economics at the London School of Economics and have a doctorate from the University of Oxford in economics. I have studied such issues for several decades. I have also recently tested, using advanced quantitative techniques, the question of the size of impact on GDP from entry to or exit from the EU or the eurozone. The conclusion is that this makes no difference to economic growth, and everyone who claims the opposite is not guided by the facts. The reason is that economic growth and national income are almost entirely determined by a factor that is decided at home, namely the amount of bank credit created for productive purposes.

But this logic is carrying the logic in my first paragraph too much. Causality is a complicated issue. Banks don’t lend without thinking anything about its customer. Werner even claims that he has confirmed it with causality tests. But these tests have their own fallacies such as post hoc ergo propter hoc.

Let’s take a specific example. Suppose, I make a robot which does all household stuff for you, such as cooking food, washing your clothes and ironing them and keeping them back in your wardrobe. Basically any household stuff. Suppose I also make it difficult for anyone to replicate or copy it. My product – the robot – will sell like hot cakes all over the world, if the pricing works out cheap. The sales of my firm will benefit employees and stock holders and it will greatly benefit India, where I reside. Banks will lend me of course but it’s clear that the causality of the rise of output is more my innovation and not bank lending. More generally one can ask other questions: how was I successful in innovating? Perhaps my education was subsidized and I did most of my research was carried out in a university before I corporatized the idea.  Or maybe I paid employees a lot which made them productive.

There can be various other reasons, such as a fiscal expansion causing a rise in domestic demand and output, leading banks to lend more when they spot the trend and are confident of their lending. In that case, you could say that fiscal policy caused growth.

Post Brexit, two important things can be identified – which have already been talked about such as by the UK Treasury or NIESR. They are UK trade with the EU and migration. Migration is a complicated subject. If the UK regulates low skill migration, wages can rise and will contribute positively to aggregate demand. Allowing high skill migration to continue can keep UK firms competitive in international markets. Trade tariffs have to be renegotiated with the EU. UK politicians can ignore the message of the referendum result and reduce tariffs or, they can raise tariffs. A lot depends on how the political climate evolves. Just saying growth depends on bank lending implies that these trade and migration policies have no impact, which is completely wrong.

tl;dr summary: causality is a complicated subject.