Jan Kregel: Europe at the Crossroads. Financial Fragility and the Survival of the Single Currency. Levy Economics Institute of Bard College (Policy Note, 2015,02).
[This policy note is adapted from remarks presented at the Levy Institute conference “Europe at the Crossroads: A Union of Austerity or Growth Convergence?,” Athens, Greece, November 22, 2014.] [...] There have always been two different approaches to European unification. These can be roughly divided into the “economists” and the “structuralists.” For the latter, unification was a process of creating the appropriate institutions on the presumption that the comportment of the member-states would eventually adapt to the desired structure. An example of this strategy is the common agricultural policy, which incorporated an implicit fixed exchange rate structure that was supposed to eventually produce the kind of market exchange rate stability that would allow the introduction of the common currency. On the other hand, “economists” argued that the operation of market processes would produce real economic convergence, which would eventually create the conditions to allow the introduction of institutions such as a common currency as the “crowning” achievement of the European project. But whatever the approach, it was always accepted that the end result would be something on the pattern of a United States of Europe, with a common currency similar to the dollar in the United States. The diversity that has prevailed in individual US states operating under a single currency seemed to support the structuralist view, while the existence of a strong federal government to offset regional diversity supported the economists’ view that Europe should first move to more integrated political structures before the introduction of the single currency. [...] As noted, the basis of the German approach is that the euro is equivalent to a fixed exchange rate system with no possibility for change of parity. But, in contrast to the original Bretton Woods system, there is no government that issues the reserve currency. This means that the sovereign debt of national governments is no different than the debts of the private sector. Repayment of private debt requires firms (households) to earn profits (wages), roll over the debt via additional borrowing, or sell assets, while repayment of sovereign debt requires taxes greater than expenditures, borrowing (rolling over), or asset sales. Just as different private borrowers have different credit risks, “sovereigns” have different credit risks, but the fact that they are incurred in a common currency issued by a single central bank led financial markets to completely overlook these risk differentials in the first 10 years of the euro’s existence. The concern to ensure ironclad conditions on fiscal balance is thus understandable, for it is the only way to avoid government default and maintain the integrity of the euro. The failure of the rest of the EU to follow these policies has produced precisely the kind of political pressure that German experts had foreseen in 1996, with Germany called upon to bail out the indebted Greeks, Italians, Portuguese, and Spanish, and possibly the French workers who were successful in introducing a 35-hour workweek when German workers were facing restrictions on wage increases and reductions in social safety nets. It should thus be no surprise that Germany now refuses to grant debt reduction and is calling upon Greece to implement similar policies and upon the rest of the EU to accept deeper political integration in order to preserve the euro and solve the sovereign debt crisis. It is a return to the policies that Germany has always advocated as necessary for the successful creation of the single currency. Greece thus becomes the poster child for the German argument about the need for its own policies and provides the picture postcard of the kind of policies that have to be implemented. As long as Greece threatens to disobey and to leave the euro, Germany’s position in favor of increased political integration and centralized control based on its own proposals for the euro’s success grows stronger. But while for Germany these are the necessary conditions for the stability and success of the euro, from a Minskyan point of view they are the source of the financial instability in the euro area. We can use Minsky’s analysis of financial fragility - in terms of hedge, speculative, and Ponzi financing profiles - to see the paradox of the German position. For Germany, governments should always have hedge financing profiles (that is, generate fiscal surpluses sufficient to meet debt service), since they do not have access to financing from the ECB that would allow for speculative finance (i.e., occasionally rolling over to refinance), while the current conditions facing Greece and the other peripheral countries are those of Ponzi finance - they have to borrow in order to meet debt service. To this end, Germany has introduced balanced budget legislation and strengthened the SGP [Stability and Growth Pact] to pledge EU members to the same objectives through the “six-pack” and “two-pack” amendments. However, a policy of imposing hedge financing as a common EU policy contains a paradox, and a virtual impossibility theorem for countries that currently have debt and deficit ratios above the SGP limits, as this requires a rising fiscal surplus that can only be achieved through a combination of higher growth and taxation. Since governments cannot produce this growth through deficit spending, it must come from either domestic consumption and investment or foreign demand. But increased domestic expenditures cannot be generated by reducing government expenditures or raising taxes to generate the required fiscal surplus, since this only reduces domestic demand. Further, these objectives have been made more difficult by the misdirection of investment, which has tended to reinforce real divergence across countries. This is seen in the differential impact of capital flows in the euro area. The northern tier economies have attracted foreign investment flows into “productive” sectors, increasing productivity relative to wages, while the southern tier economies have attracted investment in real estate and other non-productivity-increasing activities - all while wages have tended to grow at the EU average, thereby reducing their competitiveness. There is thus a positive relationship between foreign direct investment (FDI) and trade balances for the “North” and a negative relationship for the “South.” [...] But is this solution financially stable? In the 1940s, the United States considered a policy of supporting domestic demand through a permanent current account surplus. Evsey Domar showed that a stable share of export surplus to GDP was feasible and stable on one condition: the rate of increase of the outstanding foreign lending was greater or equal to the interest rate charged on the loans. But this is the definition of a Ponzi scheme! And the reduction in efficiency wages and/or currency depreciation required to keep the surplus would dampen domestic demand, producing stagnation. The survival of the euro seems to require the permanent maintenance of a Ponzi scheme or stagflation. This leaves external demand as the only solution to survival of the euro, given the German insistence on fiscal stability. But without the ability to improve external competitiveness through exchange rate adjustment, internal depreciation through wage reductions or productivity increases in advance of wage increases will be required. However, this is also a policy that reduces domestic demand, offsetting the benefits of higher foreign demand. And here is the paradox: all the policies proposed to increase growth of incomes and generate fiscal surpluses ultimately have a negative impact on income growth. Keynes called it the paradox of saving; here, it is the paradox of euro survival. Historically, deflations have produced financial crises just as easily as inflations. While Germany pleads for more political control and integration, the EU may disintegrate through political reaction to prolonged stagnation. full pdf: http://www.levyinstitute.org/pubs/pn_15_1.pdf abstract: http://www.levyinstitute.org/publications/europe-at-the-crossroads-financial-fragility-and-the-survival-of-the-single-currency _______________________________________________ pen-l mailing list [email protected] https://lists.csuchico.edu/mailman/listinfo/pen-l
