Options for Europe – Part 53

The title is my current working title for a book I am finalising over the next few months on the Eurozone. If all goes well (and it should) it will be published in both Italian and English by very well-known publishers. The publication date for the Italian edition is tentatively late April to early May 2014.

You can access the entire sequence of blogs in this series through the – Euro book Category.

I cannot guarantee the sequence of daily additions will make sense overall because at times I will go back and fill in bits (that I needed library access or whatever for). But you should be able to pick up the thread over time although the full edited version will only be available in the final book (obviously).


1992 – The backfilling begins


The design of the EMU agreed on in Maastricht reflected a range of factors, none of which made any real macroeconomic sense. Charles Wypolosz wrote in 2006 that “With little experience to rely upon and limited theoretical backing, economists and policy-makers had to invent practically everything in little time. Policy-makers rushed to negotiate a detailed agreement, having no time for detailed economic analysis” (Wyplosz, 2006).

The French were obsessively motivated by its desire to end the threat of German militarism within Europe forever. The Germans, suffering an unspoken shame for their past militarism and associated deeds, had only their economic success including the ‘discipline’ of the Bundesbank as a source of national pride. They wanted to be part of the ‘European Plan’ to demonstrate a rejection of their past history but their obsessive fear of inflation meant that this had to be on their own terms, which meant that the new Europe had to accept the Bundesbank culture. Within the German ‘stability’ environment, it was seemingly overlooked that the nation relied on robust import growth from other European nations. The fact that not all nations can have balance of trade surpluses was ignored. They also wanted political integration via a strengthened European Parliament but that fell by the wayside as the Maastricht negotiations concentrated on the economic and monetary goals.

Overlaying this political play-off between France and German, which had dominated European affairs since the end of the Second World War, came an even more destructive force – the surge in Monetarist thought within macroeconomics, first within the academy, then into policy making and central banking domains. Unemployment became a policy tool to allegedly maintain price stability rather than a policy target as it had been up until the mid-1970s. National governments deliberately created persistently high levels of unemployment by suppressing spending as they thought this was the only path to price stability. The importance of this new ‘paradigm’ in economic thinking for the design of the EMU was two-fold. First, there was a rejection of any need to develop a European-level fiscal function to work in tandem with the proposed European Central Bank. All sorts of sophistry was used to justify this decision, including a specious appeal to the principle of subsidiarity. The reality was that the politicians, infested with Monetarist thought, wanted tight fiscal limits to be built-in to the design of the EMU. Second, once it was clear that the fiscal and social policy functions would continue to be the responsibility of the national governments, the politicians had to ensure the fiscal straitjacket could be applied down to that level. They thought that the proposed imposition of tight fiscal rules – deficits no greater than 3 per cent of GDP and public debt no greater than 60 per cent of GDP – would accomplish that goal. As we have learned earlier, these rules had no economic motivation. They were arbitrarily conceived. But they were considered to be restrictive enough to support the priority for price stability even though no coherent research had been published, which robustly demonstrated how these sort of fiscal rules would be necessary or sufficient to maintain a stable and low inflation environment.

The whole process had a surrealistic air about it at the time.


There was one major piece of analysis published by the European Commission in 1990 – One Money, One Market – that sought to provide some analytical backing to the Delors Plan. The analysis used deeply flawed economic models (including the notoriously poorly performed IMF Multimod model), which generated sympathetic results that were predicated by the assumptions made. These type of models are held out as ‘neutral’ tests of policy propositions but are, in fact, so laden with theoretical biases that they are incapable of providing an ‘independent umpire’ role. Economists have coined an expression – GIGO (Garbage In, Garbage Out) – which is apposite.

Further, the construction of ‘macroeconomic stability’ in the One Money, One Market analysis was solely in terms of “better overall price stability” (European Commission, 1990: 9). The authors admitted that while stability (low inflation) and growth would be part of the overall macroeconomic performance of the proposed EMU, a “quantified estimate of the potential impact of EMU is not feasible” (p. 9). Even their modelling could only predict lower output variability rather than stronger growth. In other words, the EMU could just produce an entrenched stagnant state where growth was consistently negative or low with little variation – more or less what has happened over the last 6-7 years with little end in sight.

The analysis also claimed that while an independent central bank should operate at the central level, “the case for centralized powers over budgetary policy is much weaker” (p. 13), but recognised that if tight fiscal rules were used to coordinate national-level fiscal policy positions then the ability of nations to absorb ‘shocks’ in economic activity would be reduced, especially given that the capacity for exchange rate adjustment would be eliminated. Yet, they still advocated tight fiscal restrictions.

The report recognised that “national level stabilization and adjustment in the case of country-specific disturbances” (for example, a collapse in private spending as occurred in many nations in 2008) “requires flexibility and autonomy, at least within a normal range of sustainable public deficit and debt levels” (p. 23). Fiscal policy has two components: (a) the taxation and spending settings chosen on a discretionary basis by government and deemed suitable to achieve its socio-economic goals in normal times; and (b) the cyclical or automatic stabiliser component, which refers to the impact of economic activity on the fiscal settings. Thus, when economic activity is slow and employment falls, taxation revenue gained by the government slumps and welfare payments associated with unemployment tend to rise, the net result being that the fiscal balance (the difference between spending and revenue) rises, usually into deficit if the downturn in activity is serious enough. The stabiliser component puts a ‘floor’ into the slump in total spending because the net contribution of government to spending thus rises. Imposing rules on the total fiscal outcome constrains the capacity of fiscal policy to make these adjustments and ensures, in most cases, that an economic downturn will cause higher unemployment than is otherwise the case, if fiscal policy retained its flexibility and was allowed to work in the way it is designed to.

The ‘One Money, One Market’ report recognised that but then concluded, consistent with the Monetarist bias towards promoting inflation control as the dominant and prioritised policy goal, that “Budgetary discipline, in order to avoid excessively high deficits, will need to be intensified …” (p. 23). In other words, they knew that if the system was to face a major reduction in total spending (from whatever source), the stabilisers built into the national government fiscal policy would be prevented from working in a normal and flexible fashion by the uniform and tight fiscal rules from working and absorbing the costs. In that context, they knew that unemployment would rise sharply and persist and fiscal deficits would rise, and the only remaining front-line that nations had to ensure they obeyed the fiscal strictures would be to attack domestic wages, pension entitlements and public services and infrastructure provision. The economists advising the European Commission knew all that but left it unstated and did not take that to the ‘people’ as a major implication of what they were doing in their name.

It is also worth noting that there is no credible empirical research which shows that a more politically independent central bank can engineer ‘disinflations’ (central banks increasing interest rates to reduce inflation) with attenuated real output losses (see, for example, Ball and Sheridan, 2003; Mitchell and Muysken, 2008). The evidence is that when the central bank prioritises inflation over other macroeconomic goals (such as high output and income growth, and lower unemployment) the real losses are substantial with lower real output growth and higher unemployment (Ball and Sheridan, 2003, provides the most comprehensive and rigorous work in this area of research to date). Mitchell and Muysken (2008) argue that this is not due to the way the central bank is organised (‘independent’ or otherwise). Rather, it is the ideology that accompanies the ‘inflation first’ monetary policy obsession that damages the real economy because it embraces a bias towards passive fiscal policy (explicit or implicit fiscal rules which restrict the capacity of fiscal policy to maintain adequate levels of spending in the economy). This bias locks in persistently high levels of labour underutilisation. 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 mass unemployment. In other words, it deliberately undermines the capacity of the government to achieve full employment (Mitchell and Muysken, 2008).

Further, workers and firms build expectations of future inflation into wage negotiations and price setting decisions, which means that an inflationary process can become self-fulfilling if all parties think high inflation will persist. This suggests that the fight against inflation has to not only curb cost increases above the capacity of the economy to absorb them but also break the expectation that inflation would persist no matter what. In this context, one of the claims made my Monetarists, which was asserted by the economists in favour of the EMU, was that central bank independence and the ‘credibility bonus’ that this allegedly brought (meaning investors trust that the central bank will not succumb to political popularism and abandon a tough fight against inflation) would encourage faster adjustment of inflationary expectations to policy announcements. Ball and Sheridan found that there is no evidence to justify this claim. A related perceived benefit of the ‘inflation first’ strategy outlined by proponents of ‘independent’ central banks was that it would expunge inflationary expectations from the economy. While there is limited research in this area, which uses actual survey data on expectations, the evidence appears to be that the major reductions in both inflation and measured inflationary expectations occur during large recessions (such as the 1991-2) and are unrelated to do with legislative changes that establish central bank independence and the introduction of formal inflation targeting. The decline in the inflation juggernaut occurred around the 1991 recession in most countries.

There appears to be no hard evidence available at this point in time that supports the central claims made by those who prioritise central bank independence and the pursuit of formal ‘inflation first’ monetary policy. The credible evidence is fairly clear. When central bankers prioritise ‘price stability’ as their sole focus, they use the persistent pool of unemployed (and other forms of labour underutilisation, for example, underemployment) as a buffer stock to achieve their ‘desirable’ price level outcome. For example, if the central bank thinks that inflation will likely rise against their policy their target rate they will induce higher rates of unemployment by increasing in interest rates until they are satisfied their inflation target is being met. The higher unemployment causes income losses and workers are more reluctant to seek wage rises.

While some extreme elements of the profession still deny that this type of monetary policy conduct will be detrimental to GDP, most economists acknowledge that any disinflation engendered by this approach will be accompanied by a period of reduced output and increased unemployment (and related social costs) because a period of (temporary) slack is required to break inflationary expectations.

The real question then is how large are the output losses following discretionary disinflation? There is overwhelming evidence to suggest that the cumulative costs of this strategy in real terms have been substantial. Economists measure these real costs in terms of a quantitative measure known as the ‘sacrifice ratio’, which is the accumulated loss of output during a defined disinflation episode, calculated as a percentage of initial output expressed as ratio of the accumulated reduction in the inflation rate. While it sounds complex, it is in fact a very easy number to calculate. For example, if the sacrifice ratio was two it would mean that a one-point reduction in the trend inflation rate will be associated with a GDP loss equivalent to 2 per cent of the initial output level before the central bank increased interest rates.

Two major impacts occur when the economy goes into a monetary-policy induced slump. First, actual economic activity (GDP growth) declines and what is known as an ‘output gap’ increases. This is measured as the percentage deviation from potential (or maximum) output achievable. These income losses may be substantial. Second, when an economy goes into recession and sales dry up, firms are reluctant to invest in new capacity. As a result, the potential real GDP growth path also declines as the collateral damage of low confidence among firms curtails investment (which slows down the growth in productive capacity). As a result, the long-term capacity of the economy to grow is reduced.

These effects, taken together, typically ensure the ‘sacrifice’ of an inflation-first strategy (which ignores the initial real output losses and rising unemployment) will be substantial and endure for decades. Monetarist doctrine predicted that as central banks became more independent and concentrated solely on price stability objectives, sacrifice ratios would decline. There is a vast literature that examines the estimation of sacrifice ratios and the findings typically show that disinflations are not costless and, are in fact, significant. Estimates of sacrifice ratios have increased over several decades contrary to the predictions of the Monetarists, which were driving the development and design of the EMU.

The average sacrifice ratio for all countries over the 1970s and 1980s was around 1.3 to 1.4. European economies produced varied results but were not an outlier. Significantly, the average estimated GDP sacrifice ratios have increased over time, from 0.6 in the 1970s to 1.9 in the 1980s and to 3.4 in the 1990’s. That is, on average, reducing trend inflation by one percentage point results in a 3.4 per cent cumulative loss in real GDP in the 1990s. In terms of unemployment the latter can be interpreted roughly speaking as a cumulative increase by 7 per cent (see Mitchell and Muysken, 2008).

These macroeconomic costs were largely ignored by the economists advising the European Commission on the design of the proposed EMU. They were content to recite the Monetarist religious faith that prioritising a low inflation regime would have little or no negative real output consequences, and would, instead, maximise the growth potential of the economies in question. That was a denial of the evidence base available then and since. But they also knew that these issues were too complex for even the popular press to pick up on and so the evidence could remain ‘buried’ in the arcane world of academic journals and books and the public would be none the wiser. Never the twain shall meet!

It is also interesting to note, that consistent with this era of thinking in macroeconomic policy, flexibility was lauded as essential at the so-called microeconomic level, which meant that governments should deregulate markets and remove all the protections that had helped to level the playing field, somewhat, between workers and capital in the post World War II period such that workers were able to enjoy some semblance of security and real wages growth consistent with productivity growth. But, at the macroeconomic level, flexibility was eschewed, despite the fact that all reasonable research studies to that date and since have demonstrated that the losses that are associated with mass unemployment dwarf any losses that can be identified with ‘microeconomic’ inefficiency. The greatest inefficiency is mass unemployment.

Yet the first major attempt at evaluating the costs and benefits of the proposed EMU concentrated on these lesser costs and benefits and ignored the ‘elephant’ that the system they were designing would inevitably create at some point – a major recession with entrenched mass unemployment.



Once the Treaty was signed in March 1992, the European Commission and a phalanx of sympathetic economists set about ‘backfilling’ – producing research papers, which apparently provided intellectual and evidential authority to justify the decisions that had been made and to ‘prove’ how sound the Treaty parameters were. It was theatre, of the high farce variety.



Chapter X The EMU and Optimal Currency Areas (OCA)

Wyplosz (2006: 21) argued that the Commission’s publication ‘One Money, One Market’ “came to late” to influence the deliberations at Maastricht, but it did serve to “draw researchers into the issue” of monetary integration. As a result the economic researchers were left “with the task of assessing the treaty” (p. 211). There was a clear divide among the US-based studies which rejected the viability of the proposed design and thought it unlikely that it would proceed to fruition, on the one hand; and the European-based studies that were generally positive overall (Wyplosz, 2006).

While playing “no serious role in the drafting of the Maastricht Treaty” (Wyplosz, 2006: 211), the long-standing concept of an Optimal Currency Area (OCA), which emerged from the work of three economists, Canadians Robert Mundell (1961) and Ronald McKinnon (1963) and American Peter Kenen (1969), became an organising framework for the debate over the viability of the proposed EMU.

OCA theory purports to define the conditions under which several independent countries will be better off by forming a monetary union (sharing a currency) or, alternatively, fixing their exchange rates. Optimal is a term economists use with regularity and it often refers to some arcane mathematical exercise which is equivalent to counting the ‘number of angels on a pinhead’. In the case of monetary integration it refers to the collection of geographic units (in the case of the EMU, Member States) that would most effectively enter a monetary union. To few ‘geographical areas’ or too many will deliver a sub- or non-optimal arrangement.

Wyplosz (2006: 212) said that the European Commission “officials did not waste much time on the issue, which they saw as mainly political” The Maastricht Treaty was more about process towards the adoption of the single currency and the requisite institutional changes that would be required to accommodate this process. The question then arises as to why this existing and seemingly relevant economic framework (OCA) was ignored? Merely claiming that the policy makers constructed the EMU as a political issue is not sufficient. In fact, it goes much deeper than that.

The existing OCA literature at the time of the Maastricht negotiations was associated with the Keynesian approach to macroeconomic policy and thus rejected out of hand by the Monetarists, who saw no major fiscal role for governments beyond maintaining tight fiscal positions to support the emphasis on price stability.



Additional references

This list will be progressively compiled.

Ball, L. and Sheridan, N. (2003) ‘Does Inflation Targeting Matter?’, NBER Working Paper No. w9577, March.

European Commission (1990) ‘One Money, One Market’, European Economy, 44. http://ec.europa.eu/economy_finance/publications/publication7454_en.pdf

Kenen, P.B. (1969) ‘The Optimum Currency Area: An Eclectic View’, in Mundell, R.A. and Swoboda, A.K. (eds.) Monetary Problems of the International Economy, Chicago, University of Chicago Press, 41-60.

McKinnon, R.I. (1963) ‘Optimum Currency Areas’, American Economic Review, 53, 717-725.

Mitchell, W.F. and Muysken, J. (2008) Full employment abandoned: shifting sands and policy failures, Aldershot, Edward Elgar.

Mundell, R.A. (1961) ‘A Theory of Optimum Currency Areas’, American Economic Review, 51, 657-665.

Wyplosz C. (2006) ‘European Monetary Union: The Dark Sides of a Major Success’, Economic Policy, 46, 207-247.

(c) Copyright 2014 Bill Mitchell. All Rights Reserved.

This Post Has One Comment

  1. “It is also worth noting that there is no credible empirical research which shows that a more politically independent central bank can engineer ‘disinflations’ (central banks increasing interest rates to reduce inflation) with attenuated real output losses (see, for example, Ball and Sheridan, 2003; Mitchell and Muysken, 2008).”



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