Tag Archives: euro area


Thomas Palley — Fixing The Euro’s Original Sins: The Monetary – Fiscal Architecture And Monetary Policy Conduct

Thomas Palley’s new paper:

The euro zone (EZ) was created in January 1999. Its weak economic performance is significantly due to the euro’s neoliberal monetary architecture and the design of monetary policy. Those features undermine national political sovereignty and consign the EZ to severe economic under-performance, which in turn fosters political demands for exit from the euro. Escaping this dynamic requires restoring fiscal space to EZ countries, and also changing the design of EZ monetary policy. The paper shows how this can be done. It decomposes the challenge of reform into generic problems related to the neoliberal construction of monetary policy, and specific problems concerning the euro as a currency union. The currency union problems are further decomposed into “money – fiscal policy” architecture problems and specific monetary policy conduct problems.

[The title is the link]

Mario Draghi On Settlement Of Intra-Eurosystem Claims

Recently, Mario Draghi—in a letter responsing to questions about TARGET2 imbalances to two members of the European Parliament—says the following:

If a country were to leave the Eurosystem, its national central bank’s claims on or liabilities to the ECB would need to be settled in full.

Since many years many economists, led by Karl Whelan have refused to accept this. There has been a denial via various arguments. The main argument of this camp has been that TARGET2 assets of the ECB doesn’t really matter, presumably because central banks create money and can be capitalized using a bookkeeper’s pen. That is a strange argument because if a country were to leave the Eurosystem and cannot settle its claims to the ECB, the ECB will take a loss. It has less interest earning asset than otherwise and since the ECB’s profits ultimately get distributed to national treasuries, treasuries’ income doesn’t matter according to this argument.

Another way to see this argument is wrong is to think of the international investment position of the remaining region if a country leaves. It’s net international investment position falls. Does international investment position not matter?

Yet another argument. Suppose the day before a country leaves the Euro Area and the Eurosystem, the ECB were to buy that country’s government bonds. The leaving country’s NCBs’ liabilities to the rest of the Eurosystem will fall and its government’s liability will rise. This transaction is a purely financial account transaction in international accounts. How it is that one is debt and the other not debt? Those who claim that the intra-Eurosystem debts do not matter seem to believe that it’s not debt.

Of course, Mario Draghi’s position can be legally challenged. There’s hardly any mention in the legal documents of the Euro Area explicitly stating what happens. But since intra-Eurosystem claims (i.e., NCB TARGET2 balances) earn or pay interest, this makes the case for the settlement of the claims. In law, the reasons why they were created are sometimes used if something is not explicitly stated.

Euro Area NCBs’ TARGET2 Balance As Cumulative Accommodating Item In The Balance Of Payments

There’s a discussion on Nick Rowe’s blog about the interpretation of TARGET2 balances of the NCBs in the Euro Area’s Eurosystem. How do we interpret this? My answer is the headline.

TARGET2 balances arise because of cross-border payment flows within Euro Area countries. Instead of going through how these arise, I assume the reader knows them. I have covered it many times in my blog and many others have written it.

Let’s work here in the approximation that the Euro Area is the world and there’s no economic activity outside it. Since cross-border flows within the Euro Area banking system and the Eurosystem are transactions between resident economic units and non-resident units, these flows will give rise to entries in the balance of payments of each nation within the Euro Area.

In the new balance of payments terminology, such as as in the sixth edition of the Balance Of Payments And International Investment Position Manual, (BPM6), there’s an identity:

current account balance + capital account balance = net lending (financial account balance).

For terminologies see this table from the guide:


This is an identity but suggestive of some behaviour. The question is what is the residual in this. The current account consists of things such as exports, imports, interest payments between resident and non-resident units and so on. The capital account consists of acquisitions and disposals of non-produced non-financial assets and capital transfers. The financial account consists of things such as direct investment flows, portfolio investment flows and so on. Other than that, there’s also “reserve assets” and “other investment”.

There is a nice 1991 article by the BIS Capital flows in the 1980s: a survey of major trends. The author quotes James Meade who makes this distinction between autonomous flows and accommodative flows:

[accommodative capital flows] take place only because the other items in the balance of payments are such as to leave a gap of this size to be filled … [while] autonomous payments … take place regardless of other items in the balance of payments.

Strictly, this distinction makes sense in fixed exchange rate regimes. In floating exchange rate system, the two—accommodative and autonomous—can’t be clearly be separated.

Anyway, coming back to the Euro Area, before the crisis started, the banking system was working fine. So there would be flows in both the current account and the financial account. The goods and services balance in the current account depends on domestic demand and output at home and abroad and relative competitiveness. There’s no reason for this to be zero. Economic units engaged in the financial markets would buy and sell securities and these affect the financial account of the balance of payments of the two nations involved in the transaction. There’s no reason for balance of things such direct investment, portfolio investment (and financial derivative flows) to balance or to equal the current account balance. Since flows typically are via TARGET2, this affects banks’ balances at their NCBs. So it’s possible toward the end of the day for banks in Spain 🇪🇸 as a whole to find themselves in need for reserves (or settlement balances) and banks in say Germany 🇩🇪 to be in a situation where they have excess funds. So banks in Spain will likely contact banks in Germany to borrow funds, either for one day or more. This is because they will get a cheaper interest rate. If they borrowed from their NCB, the interest rate is slightly higher.

These borrowings and lendings give rise to other investment in balance of payments of the two nations. So in Meade’s language, this is an accomodative flow. Not all other investment items are accommodative flows and similarly, not all accommodative items are other investment items.

But as the financial crisis began in 2007, the interbank system froze. Banks didn’t lend each other much. Hence the residual was balances between the NCBs. This would arise automatically. So these flows can be said to be accommodating. The counterpart of this is banks borrowing from their NCBs.

There’s a technicality: somewhere around mid-2000s, the system was changed so that the bilateral balances of NCBs were assigned to the ECB on a daily basis.

Since the TARGET2 balance of NCBs is a stock and not a flow, they can be hence thought of as the cumulative accommodative item. Since the crisis, a lot of things have happened. The European Central Bank has taken various steps, so that banks have sufficient liquidity. Banks have been given facilities to borrow huge amounts from their NCBs for collateral at cheap rates. Later the ECB also started its asset purchase program in which it bought government bonds, ABS and covered bonds. Some of these were already in existence when the interbank markets froze. So even as interbank markets opened, they didn’t feel the need to borrow funds from banks abroad.

The IMF’s guide BPM6 says in Appendix 3 that these intra-Eurosystem claims (the TARGET2 balances) are to be recorded in Other Investment:

Intra-CUNCBs and CUCB balances

A3.46 Transactions and positions corresponding to claims and liabilities among CUNCBs and the CUCB (including those arising from settlement and clearing arrangements) are to be recorded for the central bank under other investment, currency and deposits or loans (depending on the nature of the claim) in the balance of payments and IIP of member economies. If changes in these intra-CU claims and liabilities do not arise from transactions, relevant entries are to be made under the “other adjustment” column of the IIP. Remuneration of these claims and liabilities is to be recorded in the balance of payments of CU member economies as income on a gross basis under investment income, other investment.

where CUCB and CUNCB are abbreviations for currency union central bank and currency union national central bank, respectively.

There is some similarity with “reserve assets” in the financial account of the balance of payments and the international investment position when comparing all this to a fix exchange rate regime. In the latter, when autonomous flows aren’t sufficient, the central bank may sell gold or foreign reserves in the markets. It may also engage in borrowing funds in foreign currency. These are also accommodative flows. In the Euro Area case however, the inter-NCB claims (and the assignment to the ECB) happens automatically. Also “reserve assets” don’t go below zero, while TARGET2 balances can be negative in the sense that they are in liabilities of some NCBs instead of being in assets.

The conclusion of all this is that TARGET2 is a sort of a residual finance to a whole nation which arises automatically. Some have interpreted this to conclude that this is unlimited. This is however not the case. Since the counterpart to these are banks’ borrowing from their NCBs, this is limited to how much collateral banks can provide the Eurosystem, with or without the help of their government.

The Treaty Of Rome And Balanced Trade

Policy Research in Macroeconomics (PRIME)’s blog Prime Economics reminds us of the Treaty of Rome, to establish a European Economic Community, first signed in 1957 which has a Chapter on Balance of Payments:




Each Member State shall pursue the economic policy needed to ensure the equilibrium of its overall balance of payments and to maintain confidence in its currency, while taking care to ensure a high level of employment and a stable level of prices.


  1. In order to facilitate attainment of the objectives set out in Article 104, Member States shall co-ordinate their economic policies. They shall for this purpose provide for co-operation between their appropriate administrative departments and between their central banks. The Commission shall submit to the Council recommendations on how to achieve such co-operation.
  2. In order to promote co-ordination of the policies of Member States in the monetary field to the full extent needed for the functioning of the common market, a Monetary Committee with advisory status is hereby set up. It shall have the following tasks:
    – to keep under review the monetary and financial situation of the Member States and of the Community and the general payments system of the Member States and to report regularly thereon to the Council and to the Commission;
    – to deliver opinions at the request of the Council or of the Commission or on its own initiative, for submission to these institutions.

The Member States and the Commission shall each appoint two members of the Monetary Committee.

I have emphasized many times in my blog that Euro Area balance of payments and international investment position imbalances are quite important for the Euro Area. Even before I started writing this blog, I had stressed before anyone else (on other Post-Keynesian blogs) that the imbalances are large and quite important in understanding the crisis.

Of course, imbalances can be corrected by deflating demand and output as has been the case in the Euro Area since the start of the crisis by policy makers. But it’s good to know that the founders of European integration thought of coordinating policies, which implies their policies would have been expansionary. Anyway, had the original ideas not been overthrown, the Euro Area would also have had a central government. Unfortunately neoliberalism became popular in the 1980s and this led to the Maastricht Treaty which forgot the original intentions of the founders.

The Treaty’s opening also has this important line:

RECOGNISING that the removal of existing obstacles calls for concerted action in order to guarantee steady expansion, balanced trade and fair competition

I should mention however that the Euro Area has this thing called the Macroeconomic Imbalance Procedure which tries to address the issue and even thinks of current account surpluses in the balance of payments as an imbalance, but it is still far away from doing anything about it, such as a coordinated fiscal policy expansion.

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.

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.

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?

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.

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 UK Should Leave The EU

It’s the United Kingdom European Union membership referendum tomorrow. In my opinion, the UK should leave the EU.

When discussing the Euro Area, it is emphasized frequently that Euro Area governments do not have the power to make expenditures by making drafts at the central bank as argued by Wynne Godley in 1992:

It needs to be emphasised at the start that the establishment of a single currency in the EC would indeed bring to an end the sovereignty of its component nations and their power to take independent action on major issues. As Mr Tim Congdon has argued very cogently, the power to issue its own money, to make drafts on its own central bank, is the main thing which defines national independence. If a country gives up or loses this power, it acquires the status of a local authority or colony. Local authorities and regions obviously cannot devalue. But they also lose the power to finance deficits through money creation while other methods of raising finance are subject to central regulation. Nor can they change interest rates.

The Euro Area was formed because Europeans wanted to come together and create a union which is big and powerful enough to be not affected by financial markets. The original intent was right but soon the whole idea came to be influenced by neoliberalism. The thing which was hugely missing (“the incredible lacuna” in Wynne Godley’s words in the above cited article) was the absence of central government of the Euro Area itself, which will have the power to collect taxes from Euro Area economic units and make expenditures. After some years of boom, the Euro Area found itself in crisis and could not deal with it well because there was no central government and fiscal policy to the rescue. The European Central Bank tried to save the monetary union but isn’t as powerful enough as a central government. More importantly, the Euro Area was brought into existence with the idea of free trade. Not only was power taken away from relatively economically weaker nations such as Greece but free trade was imposed by bringing their producers compete in the common market. In summary, there were two reasons why some Euro Area nations suffered.

  1. The monetary arrangement
  2. The common market.

Typically the former is emphasized more than the latter. Perhaps the reason is simple. It is easier to explain the former than the latter. In my experience, the latter is more difficult for people to understand and appreciate. Very few have emphasized it. Few exceptions are: Nicholas Kaldor, Wynne Godley.

Because economic growth is “balance of payments constrained”, free trade is devastating. The Euro Area could have had free trade if it had a central government which keeps imbalances in check because of fiscal transfers and regional policies.

Which brings us to the European Union itself and Britain’s membership. Although the UK government neither didn’t surrendered its sovereignty to make drafts at the central bank nor irrevocably fix the exchange rate in 1999, the nations’ producers still compete in the common market. It is better off leaving the European Union and have powers to impose tariffs on imports. Free trade is destructive to trade and one needs a lot of protection – at least the power of the optionality to impose such things any time a nation needs.

It was surpising to see less heterodox noise on this.

Nicholas Kaldor wrote a lot on this in the 1970s before the United Kingdom European Communities membership referendum in 1975. In his Collected Economics Essays, Volume 7, Nicky wrote (Introduction, page xxvi, October 1977) :

The final section of this volume, Part III, reproduces papers written in the course of the “Great Debate” on the question of British Membership of the Common Market in 1970 and 1971, and includes as a postscript a lecture on Free Trade written in 1977. As this debate came to an end when Britain entered the market, a decision which was later confirmed in popular referendum with a 2:1 majority, the reproduction of these papers may strike as otiose and serving little purpose other than somewhat ignoble one of self-vindication in the eyes of future historians. However, if the long-run effects of our membership turn out to be as disastrous as I feared they would be in 1971—and nothing that has happened has caused me to change my views—I think it is of the utmost importance that the true arguments against membership should be accessible to successive generations of students, the more so since the political debate continues to be dominated by issues (such as our effects of membership on the cost of food, on our agriculture, or the net budgetary cost of membership) which I regard as secondary and which could be brushed aside if the long-run effects on Britain’s manufacturing industry and on our capacity to provide employment were favourable.

[page xxviii] … the last essay of this volume, “The Nemesis of Free Trade”, which recounts the arguments in the great debate on Free Trade and Protection conducted at the beginning of this century between Herbert Asquith and Joseph Chamberlain. The points made on both sides seem to have lost none of their freshness or relevance in the intervening years. What has changed is our freedom to act. In 1905 we were free to decide whether to continue with the policy of free imports or to protect our industries. In 1977 the choice is no longer open to us, except at a political cost of withdrawing from the Common Market, an act which few people would contemplate seriously so soon after accession.

But after so many years, here is the chance to undo all this and withdraw from the EU. The UK should leave the EU.