I wanted to
start this blog with a short note on Europe. I too often read in financial
and general media different explanations on why "Europe is great" or "why Greece
or Portugal has to exit" etc…. To my opinion all these views miss the big picture. To better understand the issue,
one needs to understand the roots of the current recession, its nature and more
importantly the difference between a modern fiat monetary system such as the US
and a fixed-exchanged rate system (or countries financing themselves in a foreign
currency) such as the EMU.
The developed
world is experiencing a very specific and rare type of recession: a balance sheet recession. The
Japan has been going through such a recession since the collapse of the real
estate bubble in the early 90s. A balance sheet recession is created when the
private sector is bearing excessive level of debt and starts saving to pay down
debt, usually following an economic shock triggering waves of defaults. As a
result, aggregate demand decreases sharply as the private sector save instead
of spending and if the government does not offset the loss of spending from the
private sector – i. increase the public deficit - the economy shrinks for years and can
even fall into a deflation spiral (like in Japan in the 90s). The economy will
not exit recession until the private sector desires to save is satiated (usually last several years). Current
austerity measures aiming at reducing deficits in Europe are ill-timed and illustrate
perfectly the reduced flexibility – by design - of the EMU.
During the
60-80s the G7 economies where roaring. The focus of economists shifted from full
employment (Keynes in the 30s) to controlling inflation exclusively with
monetary policies (Friedman). Fiscal policies where forgotten to the benefit of
monetary policies that became the new paradigm. Theories such as NAIRU,
advocated that an unemployment buffer is necessary to control inflation… Politicians
(Clinton for ex), helped by strong economic backdrop focused on running budget surplus
to follow their ideological views. Ultimately it pushed the private sector into
debt. A fiscal surplus means that the government is spending less than it is taxing
and as a result puts a drag on aggregate demand limiting the ability of the
economy to grow. As the US private sector financial balance was low, for income
to be stable, the private domestic sector had to spend more than they earned. Remember
the basic equivalence: (S-I)+(X-M)
= (G-T) where (S-I) private sector financial balance (spending-saving) + (X-M) net
export = government balance (spending-tax). If the external sector is flat like
in most EU countries and the private sector is spending less than it saves, the government has to spend the”spending gap” to keep the GDP
stable.
Moreover, in
the late 90s neo-liberalism pushed politicians to deregulate the financial
sector with the idea that the market will self regulated itself. The financial
sector had the liberty to invent and distribute whatever product they wanted
and to invest in all sorts of products without close scrutiny of their balance
sheet exposures. The private sector looking to keep their income stable bought
into debt-structured products to compensate the loss in government spending
while banks where leveraging themselves like never before. This created the
roots for the next decade’s debt driven recession.
The wide
adoption of neo-liberal economic theories and misunderstanding of the mechanism
of a modern fiat monetary system lead the consensus to continue to believe that
a government is like a household: its debt must be managed in order not to be
“over indebted”. This absurd myth is also probably a heritage of the “gold
standard”monetary system where the issuance of money was controlled by the
amount of gold held by the Central Bank.
To debunk
this myth, we have to discern between two types of monetary systems:
1. Fixed-exchange
rates countries or countries that have debt issued in foreign currency, does
not have “real” full monetary and fiscal sovereignty. Their peg or their obligation in foreign
currencies limits the amount of money they can spend (otherwise their funding
will be cut or currency devaluated). This is the case of Europe where member
countries effectively finance themselves in a “foreign currency “! Indeed, the ECB is managing the interest rate focusing on inflation and does not have any fiscal role - moreover, EMU members does not have any fiscal (nor monetary obviously) flexibility as they have to respect the treaty limits of debt/gdp, inflation etc.. Which means that even if EMU members have different business cycle or different private sector financial balances they have to live with the same monetary and fiscal (non-existent) policy!
2. Modern
fiat currency systems: governments
can never run out of money, do not need to finance themselves as they have the
monopole of money issuance. This is the case in Japan for example. While much
criticized by economics observers in the 90s ( “the lost decade”) Japan Gov actually understood the power of fiat money system and used it to
fight against their balance sheet recession – that is why they have 230% debt/gdp ratio
(and no inflation). Should they have followed an European route for example,
their economy would be in a much worse state. Despite the huge fiscal and
monetary stimulus they are barely out of recession (stimulus amounts where not enough to offset the spending gap). The US or UK are also perfect examples of modern fiat monetary system. Debates about public debt are
made to limit public fear of high government debt which is ideologically linked
to additional tax burden in the future that leads household to spend less. In
reality, the US or UK debt does not exist per se – debt issuance is a system created to
regulate the short term rates via the management of commercial bank reserves –
I ll come back in details on this points in later blogs.
Think about
it minute, if the government does not spend, how would we spend money to create
a company, buy a car etc..? This is because the government “raise debt” that we
are able to spend. Spending create income, that create output that create
employment. In a modern fiat currency system, the government (and the central
bank) role is to control the flow of money in the economy and optimize it in function
of aggregated demand and output to create the maximum employment/growth while
limiting inflation.
Obviously there
is a limit to the amount of money that can be spent by the government in order
not to create inflation. Inflation arises when the aggregate demand outpaces available
output. In developed economies operating well below potential level of output
(with 11% (France) or 25% (Spain) unemployment rate) how can politics fear inflation??
(keeping limit at 2.5% at Maastricht arbitrary level).
In Europe, as government spending is
expected to shrink (!), the external sector is the only option to revive growth –
as it was the case for Latin American countries in the 90s that were borrowing
money to the IMF…But this is actually worse in EU than it was for these
emerging countries at that time because the EMU countries cannot improve their
international competitiveness by exchange rate depreciation and as a result they
have to engage in “internal devaluation” to improve their international
competitiveness, which means they have to cut real unit labor costs. In a
nutshell, the EMU system is in a worst position than for example Argentina in
2001…
So, I hope
you understand by now the powerful economic (and social) tools of a modern
fiat monetary system and the fact that the EMU - by structure and treaty - does not have them. This weak and obsolete structure coupled with the general misunderstanding
of modern monetary system and different political agenda is driving the EMU
into economical abysses. Without
EU governments increasing aggressively deficits for years via fiscal stimulus
to support the economy while the private sector fixes its balance sheet – there will
not be any economic recovery and deflation specter will continue to hang around.
Apart from an
obvious break up of the EMU, what are the solutions? The creation of a fully federal system (with money transfer)
would be the ultimate solution for the construction of a more modern fiat monetary
system. But with large and growing difference in economic growth and structure such a
system would need significant time and resources. Eurobonds would be a good
first step, as they would represent a “joint-increase” in government deficit to
create growth (a sort of EU New Deal). A simple short-term fix option would be the ECB saying “ we guarantee all
EMU sovereign bonds” – it would reduce significantly borrowing rates for EMU
members and provides with time to think about the future while limiting or canceling austerity measures. The ECB will be forced at one point to use - at least in a statement - the unlimited financial surface provided by its money printing ability.
In the short
term, social unrest will continue to develop until the economic and social deterioration will be such that it will force EU political elite to propose reduction in austerity measures (like recently in Spain, Italy, Greece and most
recently with the election of France). Germany's economic performance is to be
followed closely if one wants to anticipate Merkel's move to join the “growth
coalition”. It will probably be the first step toward a “conjectural pause” in
this structural crisis.
