I have been travelling for most of today so I have to keep this post…
Yesterday’s Statement from the US Federal Reserve Open Market Committee (FOMC) stated that the US economy is slowing and the “housing sector remaining depressed” and employment growth slow. The US central bank indicated that moderate growth would persist for the immediate future but that it was threatened by events overseas (read Europe). And over in Europe – the pressure is mounting on the ECB, which knows it must continue to work out ways to fund member states but is being constantly pummelled by the inflation-phobes in Germany (and elsewhere). The problem in Europe is not sovereign debt but a lack of spending. Even within the flawed European monetary system design, the ECB has the capacity to fund increased spending. Those who claim this would be disastrous have a strange view of the consequences of not doing that. This debate resonates with that between Keynes and the Classics in the 1930s. The former demonstrated categorically that without external policy intervention (for example, fiscal stimulus) economies tend to states of chronic mass unemployment with massive income losses (and other pathologies) being the result. Do the Euro leaders really want that state to evolve? They are at present doing everything they can to ensure it does.
The FOMC decided to:
… keep the target range for the federal funds rate at 0 to 1/4 percent … at least through late 2014 … [The Committee also decided to]and] … to continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June …
So as expansionary monetary policy that the central bank can maintain and extended for at least 2 years.
Back in Europe – the former Greek finance minister (Mr Venizelos) had apparently made it clear to the Troika representatives who are in Greece this week to check whether that nation is cutting their budget hard enough “that the measures that Greece’s institutional partners were demanding were not possible to take.” (Source).
I love the terminology – the ECB, EC and IMF are now termed “Greece’s institutional partners”. They are more like concentration camp wardens.
But the resistance didn’t last long and the latest news reports that PASOK and the Democratic Left members of the coalition government have backed down (Source):
… over their opposition to the way Greece will implement 11.5 billion euros of spending cuts demanded by the troika …
The Greek economy has been in recession for five years and things are getting worse.
The EC boss (Jose Manuel Barroso) was adamant. He was reported as saying (Source) that:
To maintain the trust of European and international partners, the delays must end. Words are not enough. Actions are much more important … The key word here is: deliver. Deliver, deliver, deliver.
Deliver what exactly? More about that in a moment.
Meanwhile, there has been mounting pressure from the German media on the ECB to coincide with the major meeting that was held yesterday where presumably Mr Draghi (the ECB boss) had to explain to his Governing Board colleagues the comments he made in his Speech in London last week (July 26, 2012) where he said:
Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.
That has sent the Germans into paralexia and all the inflation phobias have been rehearsed in recent days in a variety of press outlets.
For example, the German media site Welt Online carried an Op Ed yesterday (August 1, 2012)- Verklagt die EZB! Rechtsstaat kann Europa retten – (Sue the ECB! State Law must save Europe) – written by German economist and lawyer Hans-Walter Forkel.
Die Welt is a conservative national newspaper published daily in Germany with links to the UK Telegraph, Le Figaro in France and ABC Spain – to give you some reference points on its position in the market.
The article said that the Euro crisis had torn up all the rules that were agreed when the monetary union was established. He argues that the German government is complicit in this disregard for the agreed rules and the only recourse is for the citizens of Germany to sue the ECB in the European Court of Justice for violating the rights of holders and depositors of money (“Sie verletzt die Rechte der Geldeigentümer und Sparer”).
The implicit argument is that the ECB’s SMP and LTRO programs (with what he considers to be inflationary consequences of expanding the money supply) and the low interest rates penalising depositors have undermined the rights of citizens in Europe.
He considers that to be a violation of tax equity (“Über Inflation und bewusst niedrig festgelegte Zinsen finanziert die EZB die Staaten und deren Schulden mit. Staatsfinanzierung über Inflation und Niedrigzins ist ungleich, willkürlich und verstößt so gegen die Besteuerungsgleichheit.”)
He considers that critics of the Euro focus on the problem with the legal structure of the monetary union which impedes the functioning of the system. He believes that if the laws had have been enforced then there would not be a problem now:
Der Rechtsstaat ist bei der Euro-Krise nicht das Problem, sondern die Lösung. Die Politik tut so, als ob das Recht der Lösung der Krise im Wege stünde. Dies ist grundfalsch. Die europäische Staatsschuldenkrise gäbe es nicht, wenn das Recht durchgesetzt worden wäre.
I do not agree with this for reasons to be explained. If the ECB had not breached the spirit of its charter then the Eurozone would be dead already.
But I do agree with this accompanying argument that the “Rule of Law” is an essential device to preserve modern democracies. However, he claims that the trend towards governments running budget deficits is a violation of the rights of citizens within a democracy and thus compromises the viability of the state.
Why? Because he claims there should be equality of taxation and receipt of benefit. Which stretches the concept of a democratic state to the extreme.
I agree with him that governments should disclose the true cost of their policies (“Nur über den Rechtsstaat werden die Herrschenden gezwungen, die wirklichen Kosten ihrer Politik offenzulegen.”) although he is referring to the state stealing from the people via inflation and low interest rates.
I consider the state lies about the true cost of persistent unemployment and underemployment. If the citizens really knew what these costs were – they dwarf any costs associated, for example, with inflation and “microeconomic inefficiency” – then the public debate would be different.
Meanwhile, the German press reported in this article (August 1, 2012) – Deutschland muss über Euro-Austritt nachdenken – (Germany must think about exiting the Euro) – we read that
Tagesschau.de is no minor media group or extremist think tank in Germany. It is a “German national and international television news service produced by Norddeutscher Rundfunk (NDR) on behalf of the German public-service television network ARD”. It is watched by around 10 million viewers in Germany each night which is reported to be about a 33 per cent audeince reach.
The article rails against the ECB for being incompetent and untrustworthy. The two obvious policy directions for the ECB – buying government bonds from Spain and Italy and/or giving the ESM a banking licence so it can borrow cheaply from the ECB and, in turn, buy bonds from the ailing governments – are eschewed by the article.
They say either plan violates the Maastricht Treaty and the ECB is not to fund states (“Der Plan verstößt eindeutig gegen den Maastrichter Vertrag. Die EZB ist nicht dafür da, Staaten zu finanzieren”).
There main complaint – a rehearsal of the constant German refrain (or obsession) – is that the injection of cheap money (“dass die Politik des billigen Geldes grenzenlos fortgesetzt wird”) will result in a disastrous inflation (“Die Folgen werden fatal sein”) and the population will lose their savings (“Dadurch verlor die Bevölkerung endgültig den Wert ihrer Ersparniss”)
With the German government spending billions in bailouts and the German taxpayer continually being required to support failed states elsewhere in Europe, the article asks the question – is it worth it? (“Ist der Euro den hohen Preis seiner Rettung wert?”).
The fact that this sort of argument is appearing in the public broadcasting service is quite a change.
It is also no surprise that there are allegations of impropriety being made against the ECB boss. Apparently he is being investigated by the EU Ombudsman over “an alleged conflict of interest” (Source).
And the UK Guardian article (August 1, 2012) – Bundesbank warns over eurozone crisis as ECB prepares to meet – reported that the boss of the Bundesbank, Jens Weidmann said that the BuBa is opposed to the ESM being granted a bank licence and that the ECB should “not overstep its own mandate” and that the ECB was being abused by European politicians for:
… fiscal policy objectives.
Which goes to the heart of the problem. In a monetary system the central bank and the treasury functions of government work closely together.
The two arms of government (treasury and central bank) have an impact on the stock of accumulated financial assets in the non-government sector and the composition of the assets.
The government deficit (treasury operation) determines the cumulative stock of financial assets in the private sector. Central bank decisions then determine the composition of this stock in terms of notes and coins (cash), bank reserves (clearing balances) and government bonds with one exception (foreign exchange transactions).
Please read my blog – The consolidated government – treasury and central bank – for more discussion on this point.
The Eurozone deliberately deleted the treasury function and took the central bank function out of the control of the member states. The fiscal function remained at the member state level with some EC redistributive capacity and then imposed rules on the member states (the Stability and Growth Pact) which were designed to limit the freedom of the states to use that fiscal capacity.
The problems were many:
1. The member states abandoned their currency sovereignty so became dependent on their tax bases and their capacity to borrow (outside of the redistribution that occurred under the EC’s regional strategies). At that point, the member states took on default risk on their debt and bond markets clearly knew that and have acted accordingly.
2. The fiscal rules (SGP) were unrealistic in the context of a major negative shock in aggregate demand which undermined the member states’ tax bases and drove up welfare-oriented spending. The 3 per cent rule barely contained the cyclical swings in the budget outcome much less any structural net spending that was required to offset losses in non-government spending arising from the crisis.
3. There was no federal fiscal capacity created to work with the ECB to ensure that asymmetric negative demand shocks could be quickly dealt. The avoidance of that fiscal capacity was deliberate because the Euro leaders were intent on pushing neo-liberal limits on the fiscal capacity of the member states.
4. Any functioning monetary system requires both the treasury and the central bank capacities to be working together to maintain prosperity. The absence of the federal fiscal capacity in the Eurozone meant that, by default, the ECB had to play both roles.
Within the highly constrained (arcane) rules within which is has to act, the ECB has been able to keep the bond markets at bay, although its ideological partnership with the EC and the IMF has meant these interventions have only been of temporary benefit.
The fact is that the problem in Europe is not a sovereign debt problem. It is a growth problem. The ECB can take care of any perception that member states will default on their outstanding debt – with a stroke of a pen (computer keyboard). But by imposing austerity on the member states most in need of growth, it has become partner to an evolving and downward spiral in the Eurozone’s viability.
Instead of using its capacities to engender growth and quickly short-circuit the crisis, the ECB has on the one hand wielded the axe which has undermined growth and on the other hand, done just enough by way of administering band-aids, to stop the Eurozone collapsing (in its current form).
The Germans are not very clear on what they expect will happen if the ECB abandons this role. Consistent with their free market leanings (although the Germans could hardly be called free marketeers), there is some abstract notion that the market will sort this all out and nations have to rebalance their costs and productivity to restore growth through trade.
Further, the solution for what they consider to be bloated states (for example, Greece) is widespread privatisation and job and salary cuts. They also think that welfare entitlements have to be cut to provide incentives to the unemployed to work.
All of this debate is – of-course – a rerun of the 1930s. This is the sort of logic that John Maynard Keynes came up against when confronted with the views of the British Treasury who would have been touting the German line in the current situation.
You can understand this debate, in part, by considering the different views of unemployment. The Classics considered unemployment to be a transitory phenomenon – a disequilibrium state – which would be quickly resolved if market prices were allowed to adjust to reflect underlying productivity.
Keynes was adamant that this was not the case. For him, mass unemployment was an equilibrium state, which meant that it could persist indefinitely unless there was some “exogenous” intervention (from government policy).
The Classics allowed for some transitory unemployment when the composition of aggregate output was disrupted. So if there was a shift in demand from product A to product B, workers employed to make product A might find themselves unemployed until they accepted jobs from firms making product B.
The Classics believed that wage movements would ensure these resource transitions occurred.
They denied the possibility of a deficiency in effective (aggregate) demand.
Keynes showed that involuntary unemployment was an equilibrium state – in the sense that there are no dynamics present that will change the situation.
Firms are producing and hiring at levels that are consistent with their sales expectations and so have no desire to change output levels. The unemployed clearly desire higher consumption and would buy more goods and services if they were working but that latent demand is “notional” and not effective (backed by cash).
Accordingly, the market fails to receive any signal from the unemployed and so firms cannot respond with higher production.
This distinction between notional and effective demand was at the heart of the “Keynes and Classics” debate during the Great Depression, which pitted the UK Treasury view in the 1930s with the emerging views that became identified with Keynes but were also developed by several others (Kalecki, Marx etc).
A major flaw in the mainstream reasoning in the 1930s (and still today) surrounds the so-called “Say’s law” which claims that “supply creates its own demand”. Say’s law denies there can ever be over-production and unemployment. If consumers decide to save more then the firms react to this and produce more investment goods to absorb the saving. There is total fluidity of resources between sectors and workers are simply shifted from making iPods to making investment goods.
Keynes showed that when people save – they do not spend. They give no signal to firms about when they will spend in the future and what they will buy then. So there is a market failure. Firms react to the rising inventories and cut back output – unable to deal with the uncertainty.
The break with neoclassical thinking came with the failure of markets to resolve the persistently high unemployment during the 1930s. The debate in the ensuing years were largely about the existence of involuntary unemployment. The 1930s experience suggested that Say’s Law, which was the macroeconomic component and closure of the neoclassical system based on the optimising behaviour of individuals, did not hold.
The neoclassical economists of the day who were opposed to Keynesian thinking continued to assert that unemployment was voluntary and optimal but that some factors not previously included in the model prevented Say’s Law from working. These factors included the imposition of minimum wages by government legislation. Keynes, following Marx and Kalecki, adopted the distinctly anti-orthodox approach and refuted the basis of Say’s Law entirely.
The theoretical push to reassert Say’s Law by neoclassical economists was severely dented by the work of Clower (1965) and Axel Leijonhufvud (1968). They demonstrated, in different ways, how neoclassical models of optimising behaviour were flawed when applied to macroeconomic issues like mass unemployment.
Clower (1965) showed that an excess supply in the labour market (unemployment) was not usually accompanied by an excess demand elsewhere in the economy, especially in the product market. Excess demands are expressed in money terms. How could an unemployed worker (who had notional or latent product demands) signal to an employer (a seller in the product market) their demand intentions?
Leijonhufvud (1968) added the idea that in disequilibrium price adjustment is sluggish relative to quantity adjustment. Leijonhufvud interpreted Keynes’s concept of equilibrium as being actually better considered to be a persistent disequilibrium. Accordingly, involuntary unemployment arises because there id no way that the unemployed workers can signal that they would buy more goods and services if they were employed.
Any particular firm cannot assume their revenue will rise if they put a worker on even though revenue in general will clearly rise (because there will be higher incomes and higher demand). The market signalling process thus breaks down and the economy stagnates.
Please read my blog – Fiscal austerity – the newest fallacy of composition – for more discussion on this point.
We read in Keynes’ General Theory (Chapter 3) that:
When employment increases aggregate real income is increased. The psychology of the community is such that when aggregate real income is increased aggregate consumption is increased, but not by so much as income. Hence employers would make a loss if the whole of the increased employment were to be devoted to satisfying the increased demand for immediate consumption. Thus, to justify any given amount of employment there must be an amount of current investment sufficient to absorb the excess of total output over what the community chooses to consume when employment is at the given level. For unless there is this amount of investment, the receipts of the entrepreneurs will be less than is required to induce them to offer the given amount of employment. It follows, therefore, that, given what we shall call the community’s propensity to consume, the equilibrium level of employment, i.e. the level at which there is no inducement to employers as a whole either to expand or to contract employment, will depend on the amount of current investment. The amount of current investment will depend, in turn, on what we shall call the inducement to invest; and the inducement to invest will be found to depend on the relation between the schedule of the marginal efficiency of capital and the complex of rates of interest on loans of various maturities and risks.
Thus, given the propensity to consume and the rate of new investment, there will be only one level of employment consistent with equilibrium; since any other level will lead to inequality between the aggregate supply price of output as a whole and its aggregate demand price. This level cannot be greater than full employment, i.e. the real wage cannot be less than the marginal disutility of labour. But there is no reason in general for expecting it to be equal to full employment. The effective demand associated with full employment is a special case, only realised when the propensity to consume and the inducement to invest stand in a particular relationship to one another. This particular relationship, which corresponds to the assumptions of the classical theory, is in a sense an optimum relationship. But it can only exist when, by accident or design, current investment provides an amount of demand just equal to the excess of the aggregate supply price of the output resulting from full employment over what the community will choose to spend on consumption when it is fully employed.
The concept of an under-full employment equilibrium is thus clear. Rising unemployment means falling incomes, which, in turn, means falling spending, which, in turn, means rising unemployment.
The situation stabilises when firms revise their expectations of aggregate demand downwards and start to meet the actual spending that is forthcoming. Then employment stabilises at the lower level.
The existence of such a chronically depressed state was the reason Keynes advocated external policy intervention to break into the malaise. That rationale became the justification for counter-cyclical fiscal policy and it remains as valid today as it did then.
In the context of the current situation, the outstanding budget deficits will continue to provide some demand support around which the real economy will stabilise at horrifically high unemployment rates.
The equilibrium has not yet been achieved though because of the continuing call for further cuts in public spending and the attack on workers’ pay and conditions and welfare entitlements. Fiscal austerity will continue to undermine total spending and so firms will continue to lay off workers.
Presumably, once the fiscal austerity gets the budget deficits down to some level the state of demand will stabilise – but the consequences will be profound in terms of the resulting poverty and despair.
At that point the Euro leaders will probably hail the exercise a success because they will produce graphs showing the hideous rise in unemployment has stabilised.
Of-course, within the official numbers are inter-generational dysfunction (the massive youth unemployment) – and the costs of this policy folly will reverberate for the next 50 odd years at least.
The Rule of Law does demand that governments be accountable and provide their citizens with information about the costs and benefits of policy choices.
I wonder whether Dr Weidmann has done those calculations. I wonder whether Mr Barosso has a spreadsheet calculating the costs of persistent mass unemployment for a decade or more in nations throughout Europe. It is fine for him to tell the Greeks to “deliver” but all they will be delivering is decades of disadvantage arising from mass unemployment.
The solution is obvious – the member states have to spend more in their domestic economies to break into the downward spiral in aggregate demand and avoid a chronic underemployment equilibrium from occurring.
At present, the only real option open to them is for the ECB to fund that spending.
In that context, I urge the German government to provide free psychological counselling to all of its citizens (including BuBa officials) to help them work through their inflation phobias and see the damage that the current policy framework is actually causing.
Alternative Olympic Games Medal Tally
My Alternative Olympic Games Medal Tally is now active.
I update it early in the day and again around lunchtime when all the sports are concluded for the day.
That is enough for today!
(c) Copyright 2012 Bill Mitchell. All Rights Reserved.