Impeccably running a sinking ship

Today I am writing from Austerity Land a.k.a Europe. I know Britain is also austerity land but it has its own currency and will be able to reverse direction more easily as the political sentiment moves against them. I know the US is also trying to emulate the austerity lands but so far the deficit is sufficient to maintain some vague sense of growth there and the politicians haven’t really been able to agree on anything. But in Europe the politicians and central bankers are systematically demolishing their economies – one step at at time – and pushing the system ever more closer to collapse. It is only the extraordinary “outside the rules” intervention of the European Central Bank that is keeping the EMU from collapsing virtually immediately. The Australian ABC News is carrying a story (September 13, 2011) – Shares hit 2-year low as Eurozone crisis deepens. The message of that article is being repeated in various languages over here in Europe across the mainstream media. There is an advanced state of denial over here – a denial that the problem is the Euro itself. How could a currency be a problem? Answer: when it is foreign to every government that uses it. Whatever we conclude about who pays taxes in Greece or who doesn’t; about whether certain public servants have excessively generous pay and conditions or not; about whether workers in one nation are lazier than workers in another; none of these mini-debates focuses on the issue. The problem is that when a nation surrenders its currency-issuing capacity and starts borrowing in a foreign-currency then it is open to solvency risk and cannot respond easily to a negative demand shock of the proportions that we say hit the world in 2007-08. Setting up a monetary system with those intrinsic features ensured that the EMU would enter crisis when the first significant negative demand shock arrived. It was not if but when. Now the same logic that got the EMU into this mess is also prolonging the crisis and denying the region of much-needed growth.

As an anecdotal (non-scientific) research observation I noticed yesterday and today that in Belgium (near Liege) and in Maastricht that there were many more For Sale and To Rent signs on building in the urban areas than I have ever seen previously. I know these areas very well and have been coming here for more than 20 years on an annual basis. The locals are telling me that things are not selling and vacancy rates are rising in business districts and more small businesses go to the wall. I also noticed yesterday that the quality of shops in the main shopping area of Maastricht, near to where I stay when I am over here, has declined. Soon the “pawnbrokers” and “tattoo shops” will move in and then you know that urban decay has set in.

While share markets generally fell yesterday and already today, the banking sector was hit particularly hard. In March, the Stoxx Index was around 210 and yesterday (Monday) it closed at 120.26, down around 4.5 per cent on the day.

The following graph is what happened to the STOXX Europe 600 banking sector index today (I am writing this on Monday evening/Tuesday morning Maastricht time). The data is from March 2011 to yesterday.

The G-7 meeting in Marseilles last Friday was a total flop if the aim had been to provide leadership in the current crisis. The reports carried all the usual motherhood statements such as a “coordinated response” was needed to the deepening crisis but also statements such as “a lack of room to manoeuvre in the face of the worst loss of confidence since the credit crisis” ((Source).

The US apparently wanted the big Eurozone nations to spend more to prevent the southern EMU states from defaulting yet the German contribution was that budget deficits have to be cut further.

They apparently even disputed whether they should put out an official Communique but relented – well, sort of – they released a “terms of reference” which apparently is less binding than a Communiqué.

Among the classic lines in that statement we read:

We must all set out and implement ambitious and growth-friendly fiscal consolidation plans rooted within credible fiscal frameworks.

The “growth-friendly” austerity is a lovely turn of phrase. Who invents this sort of stuff?

They also claimed they supported “market-determined exchange rates” but that of-course doesn’t apply to the EMU nations – which are denied that right.

They also said there was a need to “rebalance demand and strengthen global growth” which is code for blaming China for the crisis and its extended nature.

But with a renewed economic crisis now impinging on the advanced world that was about as much leadership as they were prepared to offer – read nothing coherent and more of the same. The same stance, that is, which is pushing the world economy back into recession.

A Reuters Report I read today quoted the Canadian finance minister (who attended the meeting) as saying that the “lack of confidence globally is the same” as in 2008. He also claimed that:

Most importantly, both in the United States and the EU, we need to see credible medium-term fiscal plans to support confidence-building in their economies — confidence by consumers and confidence by business … There is a need for political will to maintain sound fiscal policy. That sounds like an obvious thing…but the pressures are always there to spend more money. And it’s easy for politicians to say, ‘I will spend less money,’ but then of course they actually have to do it … [on Greece] … They have a plan to control deficits and debt. They have to implement it and as I said earlier, that’s not always popular with the people.

What an extraordinary thing to say. He is another of these characters who think that if you attack the viability of consumers and business firms by eroding aggregate demand that they will become more confident and spend more even though more would be unemployed and going bankrupt as a result of the fiscal austerity.

It is the extraordinary argument that cutting spending begets more spending. The same arguments have been used to justify harsh austerity measures in Ireland (result – things have become worse) and now Britain (result – things are getting worse).

Think about Greece – they surely have demonstrated the “political” will to make the cuts demanded of them by their masters – the EU and the ECB. Result? The situation is getting worse.

The European edition of Monday’s Wall Street Journal is carrying the story (September 12, 2011) – Greece Acts to Avoid Debt Default – which details how:

The Greek government …will impose a new property tax to cover a €2 billion ($2.7 billion) shortfall in budget targets this year, which it has promised its international creditors in exchange for receiving fresh aid.

They are also cutting wages of public officials but that is largely symbolic.

In last week’s GDP estimates for the June 2011 quarter (September 6, 2011), Eurostat data for Greece was not provided. The forward estimates suggested that the economy would shrink by 3.9 per cent over the year to June 2011.

On September 6, 201, the Greece Statistical Office released their own – Quarterly National Accounts – estimates for the June quarter 2011. They showed that real GDP contracted again in the June quarter 2011 by a staggering 7.3 per cent (on an annualised basis).

The Greek Finance Minister was boasting at the weekend (when announcing the new tax) that they would “step up” the fiscal austerity and the coming two months would be ”hellish”. As if the last few years haven’t already been that.

But what they are now observing is the obvious.

The WSJ report notes that:

Greece’s government has been reluctant to take new austerity measures that would deepen the recession, which it blames for its inability to meet this year’s deficit target of 7.6% of gross domestic product.

So why would they agree to the demands of the EU/ECB/IMF for even greater fiscal austerity when private consumption is collapsing, business investment fell by a staggering 13 per cent (real terms) last year and the pace of decline is accelerating. The June quarter 2011 National Accounts shows that private capital formation fell by -21.8 per cent on an annualised basis. This component of expenditure is always the most volatile but drops of that magnitude – which have been systematic over the last three years are extraordinary.

Net exports are narrowing but not because exports are rising – the reason is that imports are shrinking faster than exports because domestic incomes are being savaged.

When will the Euro bosses and their complicit Greek (socialist) politicians admit that their austerity plans are pushing their goals (lower budget deficit) further away from their targets? You cannot reduce a budget deficit easily when every other nation is doing the same by cutting growth.

What they are also doing to countries like Greece is reducing their long-run growth potential. By destroying the confidence of private investors the growth in potential output (productive capacity) is being undermined. Once aggregate demand resumes, the non-inflation growth potential of the economy will be lower. The mandarins will just rationalise this by saying the NAIRU has risen and this will prompt some klutz from the OECD or IMF to demand even more structural reforms – read: wage and condition cuts for workers.

The evil cycle of neo-liberalism is circular – the ideology inflicts damage which is then explained by there not being enough damage which then leads to policies which cause further damage which then is rationalised …. and so it goes. Meanwhile the underlying imbalances in factor shares, bank regulations and the rest of the true causes of the GFC are ignored.

One look at the National Accounts data tells me that the only viable growth solution at present is for public net spending to grow. The Euro ideologues (those with safe jobs) have vetoed that obvious option. In denying Greece the only option to grow these characters are in denial of basic economics.

Which brings me to the extraordinary press conference last week by Jean-Claude Trichet – the second last one he will hold as boss of the ECB.

In his Introductory Statement to the press conference which also involved questions and answers, the ECB boss became very emphatic. In response to the question which quoted the German leader of the opposition as saying that the ECB was socialising debt and that Trichet had “transformed the ECB from an anchor of stability into a European bad bank” and that it was causing inflation and that Germans should go “back to the Deutsche Mark”, Tichet said:

I will say the following: first, we were called to deliver price stability! We were called on by all the democracies of Europe to deliver price stability and, in particular, of course by the 17 democracies that asked us to issue the currency in their 17 countries. We have delivered price stability over the first 12-13 years of the euro! Impeccably! I would like very much to hear some congratulations for this institution, which has delivered price stability in Germany over almost 13 years at approximately 1.55% – as the yearly average of inflation – we will recalculate the figure to the second decimal. This figure is better than any ever obtained in this country over a period of 13 years in the past 50 years. So, my first remark is this: we have a mandate and we deliver on our mandate! And we deliver in a way that is not only numerically convincing, but which is better than anything achieved in the past.

In the actual presentation Trichet said “Impeccably, Impecabbly” although the ECB transcript only notes a single instance.

He went on to note that prior to the crisis several governments wanted to relax the Stability and Growth Pact restrictions on fiscal aggregates (notably France, Germany and Italy) and the ECB opposed that. He also noted that the secondary bond market purchasing program that the ECB is currently engaged in which is the only thing holding the EMU together is an interest maintenance operation (which by implication he wants you to avoid thinking it is bailing out governments). The logic is obvious they want to ensure there is enough liquidity in the system to ensure that their interest rate target is met each day. But they could do that in a number of ways and the secondary bond market purchases are in effect a fiscal operation.

I agree, though, with his detailed response. While the ECB inherited the steel hand of the Bundesbank, the point is true – they were charged with delivering price stability and they narrowed the perception of monetary policy to do that. They are not alone though – most central banks inherited this neo-liberal logic – that the main macroeconomic stabilisation tool should be monetary policy with fiscal policy passive and supportive of the interest rate regime.

The 1991 recession really delivered price stability because it wiped out the pent-up inflationary expectations inherited from the OPEC oil price shocks of the 1970s. There is no evidence that inflation targetting central banks did any better than non-targetting central banks. Please read my blog – Inflation targeting spells bad fiscal policy – for more discussion on this point.

The belief was that price stability would deliver optimal real growth and full employment. The economic theory models that supported that assertion were deeply flawed – but remain dominant today. It was just claimed that price stability in some way generated full employment even though the former required disciplined monetary and fiscal policy to achieve it. In a stagflation environment if price spirals reflect cost-push and distributional conflict factors, such an approach could never work. That was overlooked.

Central banks effectively controlled inflation by imposing unemployment. The latter ceased being a policy target (to be minimised) and instead, in this new era, became a policy tool. They rationalised this by inventing a new concept of full employment – the NAIRU. Please read my blog – The dreaded NAIRU is still about! – for more discussion on this point. So full employment became anything they wanted it to be and at times during this period it was defined as 8 per cent unemployment, then 7, then 5 etc – all ad hoc and all “bollocks”.

Central bankers mouthed the rhetoric coming out of mainstream macroeconomics textbooks that the growth performance of the economy is determined by the economy’s innate productive capacity, – that is, it is supply-determined and this cannot, ultimately, respond to changes in aggregate demand policy. Any attempts by the government to reduce the unemployment using expansionary fiscal policy would be inflationary.

Many even denied that in the short-run, contractionary monetary policy (hiking interest rates) would result in any lost output or higher unemployment. In the blogs I link to above you will see these claims defy the empirical experience.

Central banks effectively forced the unemployed to engage in an involuntary fight against inflation and the fiscal authorities further worsened the situation with complementary austerity. Disinflationary monetary policy and tight fiscal policy can bring inflation down and stabilise it but it does so at the expense of creating and maintaining a buffer stock of unemployment. The policy approach is seemingly incapable of achieving both price stability and full employment.

But the empirical evidence is clear – inflation targeting countries failed to achieve superior outcomes in terms of output growth, inflation variability and output variability. Other factors have been more important than targeting per se in reducing inflation. Most governments adopted fiscal austerity in the 1990s in the mistaken belief that budget surpluses were the exemplar of prudent economic management and provided the supportive environment for monetary policy.

The fiscal cutbacks had adverse consequences for unemployment and generally created conditions of labour market slackness even though in many countries the official unemployment fell. However labour underutilisation defined more broadly to include, among other things, underemployment, rose in the same countries.

Further, the comprehensive shift to active labour market programs, welfare-to-work reform, dismantling of unions and privatisation of public enterprises also helped to keep wage pressures down. It is clear from statements made by various central bankers that a belief in the long run trade off between inflation and employment embodied in the NAIRU has led them to pursue an inflation-first strategy at the expense of unemployment, even though the existence of long term unemployment itself, beyond the cycle, cannot be explained in this context.

Disinflations are not costless irrespective of whether targeting is used or not and sacrifice ratios have risen over the last 15 years. The point is clear. The real costs of inflation targeting lie in the ideology that accompanies it such that fiscal policy has to be passive (that is, the pursuit of surpluses given the logic adhered to).

The failure of economies to eliminate persistently high rates of labour underutilisation despite having achieved low inflation is directly a consequence of this fiscal passivity. We thus need to move towards a new paradigm where inflation control can coincide with full employment.

So in that sense Trichet’s comments are accurate. They were ideological warriors in the service of neo-liberalism and in terms of their narrow charter they were successful.

Which then calls into question (a) the charter and (b) the context.

The context relates to the way the charter was pursued within the EMU. By design, fiscal freedom was sacrificed by the member states.

I agree with Paul Krugman in his recent Op Ed (September 11, 2011) – An Impeccable Disaster where he says that in relation to Trichet’s assessment that the ECB has performed impeccably:

Indeed it has. And that’s why the euro is now at risk of collapse … What Mr. Trichet and his colleagues should be doing right now is buying up Spanish and Italian debt – that is, doing what these countries would be doing for themselves if they still had their own currencies. In fact, the E.C.B. started doing just that a few weeks ago, and produced a temporary respite for those nations. But the E.C.B. immediately found itself under severe pressure from the moralizers, who hate the idea of letting countries off the hook for their alleged fiscal sins. And the perception that the moralizers will block any further rescue actions has set off a renewed market panic.

The problem is that the design of the EMU is the problem. The Euro itself is the problem. The inflation targetting central bank is part of the ideological array that has led to a hostility towards fiscal policy and in the EMU context extreme measures to contain fiscal policy freedoms. By excluding the capacity of nations (or supra-nations) to use fiscal policy to respond to asymmetric aggregate demand shocks the designers of the EMU set the nations up for failure. As soon as the shock came (around 2007) those design flaws became evident.

It is only the ECB’s stealthy interventions into secondary bond markets that is keeping the ship afloat. Eventually, the political pressure will curtail that activity (probably) and Greece will go under.

Please read the blogs in my Eurozon ecategory for more discussion about the Eurozone design flaws.

Paul Krugman also likens what is happening in Europe at the moment to a “bank run except that the run is on their governments rather than, or more accurately as well as, their financial institutions”. This is accurate because the governments of the member states surrendered their currency sovereignty to the ECB and can go broke if investors lose confidence just as a private bank can go broke. Moreover, a national government in a fiat monetary system always has sovereignty over currency issue and can bail out its banking system should that be deemed appropriate. The EMU nations cannot, ultimately defends their financial institutions because they surrendered their fiscal sovereignty. Only the ECB has that capacity by design.


The blog is a bit later than usual but for me it is much earlier – sitting here in the centre of Europe.

But the situation is worsening over here – the physical evidence is patent and the policy options being discussed are all missing the point. The latest news is that Germany is trying to engineer a situation where Greece is allowed to undertake some sort of “orderly” default – given that the French and German banks have mostly written their exposure to Greek government debt down.

But if it defaults in some way it may as well go the whole way and just leave the Eurozone altogether and re-establish their own currency. In other words take the Argentinean route (2001). It is not perfect but it is a whole lot better than what is happening to them now.

I remain firmly of the view that the Eurozone cannot provide prosperity to its citizens unless it has a radical change in design. The best option remains – as I concluded a few years ago – for the member nations to go it alone and leave Germany trying to export to them at vastly better competitive rates (for the smaller nations) once their currencies depreciated.

That is enough for today!

This Post Has 13 Comments

  1. In Britain though we’re still suffering from increasing CPI and RPI price rises. Today’s figures were high again with price rises in a lot of categories.

    Input prices are high, but even so I would have thought that the lack of demand would have made retail stores more circumspect – yet there are huge mark-ups on clothing. They seem to be chasing falling volumes with higher prices to maintain turnover. It’s all very bizarre.

    This is going to break at some point. What is going to fail first I wonder?

  2. Neil. House prices are drifting down nominally let alone in real terms. Once the austerity cost inflation drops out of the stats in spring 2012 it’s likely the underlying deflation of government under-net spending and undermining/sabotaging private sector net saving desires will hold the economy down.

    Tax year 2012/13 ConDems plan to tax public servants via higher pension ‘contributions’ is just one example of greater leakages at the national economic level.

    Graduate Engineers are unemployed yet corporations claim they can’t find enough skilled (experienced?) workers, why don’t they take on the unemployed engineering graduates and train them up?

    Meanwhile the bully boy vandals Osbo and Cambo with the arsonist Cleggo, continue trashing our economy and expecting us to pay the bill to their plutocrat chumps!

  3. If a country would get out from a currency union, it is predicted that its “new” currency will revalue or devalue with respect to the union currency, according to history and situation of the current account.

    If the above is true then:
    – it is a fact that in a currency union, the countries with current account deficits have their “own currency” overvalued, while countries with current account surpluses have their “own currency” undervalued.

    The concept of a country maintaining its “own currency” comes from:
    – the always existing possibility of “getting it back”;
    – a currency union being described as an arrangement where countries decided:
    i) to fix the exchange of their currencies
    ii) to give a common denomination to all currencies
    iii) to render management of all the currencies (now indistinguishable by denomintion) to a supra national body.

    I wonder if there is economic analysis of the above phenomenon that, clearly, gives wrong informations and wrong incentives to national economies.

  4. Bill,

    I just wonder how you imagine Greece seperation from EMU? People in Greece have their savings denominated in euros and if drachma was to be presented, they definitely wouldn’t want to exchange those euro savings in drachmas. Why? Because they would know that drachma would be going to be devalued. Therefore, much of the savings might leave the country and therefore it might result in a collapse of Greece banking system.

    So what’s about the whole process of Greece leaving the eurozone? Having in mind the current situation in the EMU, this question begs for a seperate blog entry. 🙂 But I would be fine even with a short answer to this question.

  5. Has Krugman talked about monetary sovereignty before or is this something new out of him? Either way, it’s very MMT altogether…

  6. What’s the problem with the Greek banks collapsing?

    If they collapse and Greece has its own currency then they can be nationalised, the depositors reimbursed with Drachma, and the investors take a bath.

    All the state cares about is the clearing system and the lending system. That can be put back on its feet very quickly once you use the full power of the currency issuer to do so.

    That is after all how Iceland recovered.

  7. I am fascinated by the mechanism a country would use to exit the Euro. I’ve often heard the argument depositors would immediately shift all their money out of the country. Surely they would announce succession on Friday after the banks have closed making that more of a challenge. It would have to be the worlds worst kept secret though, by that stage most of the money that could would have long flown the coop. Someone suggested operating parallel currencies for a while, I think Argentina did that for a period. How does that work? You can keep your euros in the bank. You get paid in new drachma and taxes are payable in new drachma at a fixed rate? Both are legal tender for several years.

    I don’t think the consequences are as dire as the mainstream portray. There are some clues they are exaggerating.

    1) Claims the country will not be able to fund itself in new drachma in the “markets”. (MMTers are allowed to snicker).

    2) The other suspect comment is that external investment dries up completely. Like that is not happening now! Once the initial fear subsides and they see the Greek Government has the authority for fiscal stimulus, the hyaenas will come a shuffling back quick time looking for carrion.

  8. You’ve nailed it, at some length, with regard to the confused idiots who think contracting an economy will expand it. That cutting spending, as you say, will create more spending. That removing jobs will increase employment. It’s so hilarious to see “serious people” gone stark raving mad. I like the remark of a 17th Swedish advisor to the ruler who said “You have no idea, my son, with what little intelligence the world is run.”

  9. Why is everybody suggesting Greece should leave the Euro, but nobody is ever suggesting that California should leave the Dollar? California could like Greece have it’s own much weaker currency, lower it’s debt and go the successful Argentina way of consolidating it’s finances!

  10. Reports in the UK suggest the Greek Government will in part collect new taxes via electricity bills! I think that says it all.

  11. Andreas, for the simple reason that Greece is a sovereign country and it can quit the EMU if it wishes. The Civil War in the US decided the issue in the US. The states are not free to secede from the Union.

  12. When Euro was introduced in 2001 it was circulated along with the national currencies. Somehow nobody was worried about run from euro into drachma. I am not sure about Greece but in Germany if you still have DM left you can easily exchange them into Euro.
    Same protocol can be applied in Greece. Prices can be denominated in euro and drachmas end of story. The need for drachma will be governed through taxation. I perfectly understand the risk that if the Greeks will decide manically to run all over into euro but there will be enough people willing to exchange their saved euro into drachmas. Taxation is inevitable. The longer Greece stays in euro the more likely the taxation system will erode.
    The only problem for Greece exiting Euro is the EU and specifically, Maastricht Treaty: 3% deficit and 60% Debt. That means Greece will turn into Romania which imposed the austerity as bad as in Greece and additionally pegged the currency to euro to make the matter worse. You could be pretty sure after exiting the EMU the eurobureaucrats will keep on bulling Greece. It is pretty sad.


    California is a part of USA inhabited by USA citizens if Californians decide to change the government they go to the poll station. Greek currently can’t do this even if they appoint Bill and readers of this blog as their next parliament because decisions are made in Brussel by unelected bureaucrats.
    Furthermore, Californians can go to any US state and take jobs. It would be a non-sense even in such crazy world to see headlines “Californian emigration impoverishing the State of New York”, etc.
    Even USSR died at the end although the system was 100times more stable than eurozone. Everyone in former republics was forced to speak Russian and there was direct fiscal support for former republics.

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