A ‘United States of Europe’ or Full Exit from the Euro? (Part 2)

By Marshall Auerback

This is the second in a two-part essay on the origins of the sovereign debt crisis. Here the emphasis is on the present situation within the euro zone and the imbalances between the core, dominated by Germany, and the euro zone periphery.


I ended the last post saying that as far as European Monetary Union goes, the prevailing thought has been that one of the weak periphery countries would be the first to call it a day. It may not work out that way: ass the biggest euro-skeptics in Europe are now the Germans themselves. 

Consider the following examples:

And there is even a book by Hans-Olaf Henkel, formerly of IBM (Germany), and hitherto one of Germany’s great euro-enthusiasts (English translation: Return our Money”)

What would happen if Germany decides to follow Herr Henkel’s advice?

What if Germany left the euro zone?

On the plus side, given Germany’s historic reputation for sound finances, the country will likely emerge with a strong Deutschmark, a global safe haven currency for currency speculators keen to find a true store of value.

But this will likely come with a huge cost:  Germany will probably save its banking system at the expense of destroying its export base.  The newly reconfigured DM will soar against the euro and become the ultimate safe haven currency. This will mitigate the write-down impact of the inevitable haircuts on euro-denominated debt, because the euro (assuming it is retained by the remaining euro zone countries) will fall dramatically.  Even if the euro itself vaporizes, the Germans simply will pay back debt in the old currencies, likely fractions of their previous value.

But Germany’s external sector will be wiped out.  The resultant appreciation of the new Deutschmark, along with the inevitable banking crises in the periphery (which will exert significant deflationary domestic pressures in those countries and therefore reduce consumer demand in the euro zone ex Germany) will engender a huge trade shock: Germany’s growth will slow dramatically, as exports comprise such a large proportion of GDP.

Another interesting by-product: By accounting identity, a fall in Germany’s external surplus means a large increase in the budget deficit (unless the private sector begins to expand rapidly, which is doubtful under the scenario described above), so Germany will find itself experiencing much larger budget deficits.

The financial sector balances approach

Let’s elaborate a bit further (The following is based on a model devised by the late Distinguished Scholar Wynne Godley and detailed in the Institute’s Strategic Analysis series divides the macroeconomy according to its three main sectors: domestic government, domestic nongovernment (or private), and the foreign sector. By accounting identity, the deficits and surpluses across these three sectors must sum to zero; that is, one sector can run a deficit so long as at least one other sector runs a surplus.

https://www.levyinstitute.org/pubs/pn_11_01.pdf )

We start with the standard macro observation that in any accounting period, total income in an economy must equal total outlays, and total saving out of income flows must equal total investment expenditures on tangible assets at the aggregate level. The financial balance of any sector in the economy is simply income minus outlays, or its equivalent, saving minus investment. A sector may net save or run a financial surplus by spending less than it earns, or it may net deficit spend as it runs a financing deficit by earning less than it spends, but at the aggregate level the dollar spending of all three sectors combined must equal the income received by the three sectors combined. Aggregate spending equals aggregate income.

At the end of any accounting period, then, the sum of the sectoral financial balances must net to zero. Sectors in the economy that are net issuing new financial liabilities are matched by sectors willingly owning new financial assets. One sector can run a surplus (spend less than its income) so long as another deficit spends. In macro, fortunately, it all has to add up. This is not only true of the income and expenditure sides of the equation, but also the financing side, which is rarely well integrated into macro analysis.

We can next divide the economy into three major sectors: the domestic private sector (including households and businesses), the government sector, and the foreign sector (imports and exports), and ask a simple question relevant to current developments. What happens if one of those three variables experiences a dramatic shift from surplus to deficit (as we envisage occurring here under Germany’s external accounts)?

The basic income-expenditure model in macroeconomics can be viewed in (at least) two ways: (a) from the perspective of the sources of spending; and (b) from the perspective of the uses of the income produced. Bringing these two perspectives (of the same thing) together generates the sectoral balances.

From the sources perspective, we get this equation:

GDP = C + I + G + (X – M)

This formula simply indicates that total national income (GDP) is the sum of total final consumption spending (C), total private investment (I), total government spending (G) and net exports (X – M).

From the uses perspective, national income (GDP) can in the following ways:

GDP = C + S + T

This equation indicates that GDP (income) ultimately comes back to households who consume (C), save (S) or pay taxes (T) with it once all the distributions are made.

In the aggregate, we can express the formula in the following manner:

C + S + T = GDP = C + I + G + (X – M)

So after simplification (but obeying the equation) we get the three sectoral balances view of the national accounts, which we discussed above:

(I – S) + (G – T) + (X – M) = 0

That is the three balances have to sum to zero:1

  • The Private Domestic balance (I – S) – positive if in deficit, negative if in surplus.
  • The Budget Deficit (G – T) – negative if in surplus, positive if in deficit.
  • The Current Account balance (X – M) – positive if in surplus, negative if in deficit.

These balances are usually expressed as a per cent of GDP but that doesn’t alter the accounting rules that they sum to zero, it just means the balance to GDP ratios sum to zero.

This is also a basic rule derived from the national accounts. It always applies. This is not high Keynesianism, but simple double-entry bookkeeping, developed some 6 centuries ago. Call it the tyranny of Accounting 101.

You can then manipulate these balances to tell stories about what is going on in a country, as we are seeking to do here with Germany. For example, when an external deficit (X – M < 0) and a public surplus (G – T < 0) coincide, there must be a private deficit. So if X = 10 and M = 20, X – M = -10 (a current account deficit). Also if G = 20 and T = 30, G – T = -10 (a budget surplus). So the right-hand side of the sectoral balances equation will equal (20 – 30) + (10 – 20) = -20.

As a matter of accounting then (S – I) = -20 which means that the domestic private sector is spending more than they are earning because I > S by 20 (whatever $ units we like). So the fiscal drag from the public sector is coinciding with an influx of net savings from the external sector. While private spending can persist for a time under these conditions using the net savings of the external sector, the private sector becomes increasingly indebted in the process. It is an unsustainable growth path.

This situation describes the recent history of the United States, notably under the Clinton years when the country was running budget surpluses. By the same token, using the sectoral balance approach, we can say that a current account surplus (X – M > 0), if large enough, allows the government to run a budget surplus (G – T < 0) which applies in the case of many Asian countries or a European country, such as Norway (where the world does its spending for it).

Applying the financial sector balances to Germany

What about Germany today? In the current German situation, although the country runs a large current account surplus, it is insufficient to offset a high private sector predisposition to save (which means there is some deficit). But the current account surplus does allow for a smaller budget deficit than its so-called "profligate" Mediterranean neighbors, whilst still facilitating the private domestic sector’s desire to net save. As we have argued before, it is the “profligacy” of Germany’s Mediterranean trading partners, which has allowed it to rack up huge current account surpluses, and therefore run smaller budget deficits than the likes of the so-called PIIGS countries.

Once divorce from the euro is complete, Germany will regain its fiscal freedom. This is itself something the Germans should celebrate, providing their government takes advantage of their newfound fiscal freedom. Remember, once it returns to the Deutsche Mark (DM), Germany becomes the issuer, as opposed to the user of a currency, as is the case under the euro, and is fully sovereign in respect of its fiscal and monetary policy. Consequently, the German government can offset the external shock by running large government budget deficits, which will add new net financial assets to the system (adding to non government savings) available to the private sector.

It will become almost impossible to run budget surpluses under this scenario, but this is no bad thing for any country which issues debt in its own free-floating non-convertible currency. As unpalatable as this conclusion might be for many, it is entirely consistent with national income accounting. As Bill Mitchell has pointed out on many occasions, “the systematic pursuit of government budget surpluses (G < T) is dollar-for-dollar manifested as declines in non-government savings. If the aim was to boost the savings of the private domestic sector, when net exports are in deficit, then taxes in aggregate would have to be less than total government spending. That is, a budget deficit (G > T) would be required.”2

A budget deficit per se, then, will not cause any problems per se for Germany, as it will no longer have any external constraint, having restored the DM as its currency of choice. But historically, Germany has embraced an export-based model at the expense of curbing domestic consumption.

If we are correct that domestic income deflation will be the end result of fiscal retrenchment colliding with private sector attempts to net save, then surely more desperate citizens will turn to even more desperate acts. Rather perversely, the combined effects of fiscal retrenchment, private income deflation, and rising private debt distress are likely to make moral considerations a second or third order concern for many euro zone citizens.

Second, the export sales of German and Dutch companies will fade with the falling import demand of the periphery. As their domestic incomes fall, they will import less. In other words, the fiscal retrenchment the core nations are insisting upon is highly likely to boomerang right back on them.

As it stands, investors have started to recognize that banks in the region are at risk. CDS for Spanish and Portuguese debt have started to widen more dramatically over the past several months although investors still appear overly focused on government debt CDS. Policy makers have also begun to realize Greece is unlikely to be the last country requiring a bail out, while they at the same time sign on for rapid fiscal “consolidation” (read retrenchment) in order to ostensibly avoid becoming the next Greece.

Sovereignty issues are central

When the euro was launched, leading German politicians used to argue, with evident relish, that monetary union would eventually require political union. The Greek crisis was precisely the sort of event that was expected to force the pace. But, faced with a defining crisis, Ms Merkel’s government is avoiding airy talk of political union – preferring instead to force harsh economic medicine down the throats of the reluctant Greeks.

This is being done through the auspices of the European Central Bank (ECB). With little fanfare, the ECB has been responding to the EMU’s solvency mess by conducting large-scale bond purchases in the secondary market (which, unlike direct purchases of government debt, is not contrary to the Treaty of Maastricht rules) for the debt of the EMU nations. It is remarkable how little press coverage this has generated, but despite saying there would be neither be bailouts, nor unsterilized bond purchases, the ECB is now buying huge amounts of PIIGS debt to ensure the funding crisis in the EMU is contained. Given that this substantially reduces the insolvency risk, this is probably a wise policy, although it does little to address the underlying design flaws in the system which we have discussed before.

But there are fundamentally anti-democratic overtones in the action. Perhaps financial coup d’état is too strong a characterization, but there is no question that the ECB is now by far and away the most powerful institution without peer in the EMU. The ECB stands between the system collapsing or muddling through. And they can force austerity onto citizens throughout the member nations but never face the judgment of the voters.

Which is why we think that questions about the success of the ECB’s alleged sterilization policy is besides the point: the ECB is finally responding to the euro zone’s potential solvency mess by conducting large-scale bond purchases in the secondary market of the debt of the EMU countries. The Eurocrats, who have always found democracy to be antithetical to “sound economics” and “good policy”, now have the opportunity of using this crisis to ram through their vision of Europe, which is fundamentally anti-labour and pro capital.

In economic terms, this action is the same as Warren Mosler’s proposed revenue sharing proposal,3 although it is not done on a per capita basis, and is potentially rife with moral hazard, since it can theoretically mean that the biggest spenders – who will issue the most government bonds, which can then be bought by the ECB in the secondary market – are rewarded. However, the ECB can eliminate this moral hazard problem simply by indicating to miscreant countries that it will refuse to buy their debt in the secondary markets if it does not continue to adhere to “responsible” fiscal policy. By embracing this quasi-fiscal role, the ECB, in effect, becomes the “United States of Europe”. The ‘distributions’ the ECB will make will be via buying enough national government debt in the secondary markets to keep the national governments solvent and able to fund their deficits, at least in the short-term markets.

The reality, then, is that the ECB has become the political arbiter for fiscal decisions made by each of the euro zone national governments. If the ECB determines that any member nation is not complying with their fiscal policy objective, they will start threatening to stop buying their debt, thereby isolating them from the ECB credit umbrella, while allowing the remaining nations to remain solvent. And soon the bureaucrats who run the ECB will realize that the non-sterilization of the bonds does not create inflationary pressures and they will keep doing it, as they will find it to be a very powerful tool to keep national government spending plans which they do not like in check. ECB spending on anything is not (operationally) revenue constrained as the member nations are, so this policy is nominally sustainable, even if fundamentally undemocratic.

The austerity measures which will be enforced (and thereby secure the tacit backing of Germany) will result in lower growth, and maybe even negative growth, but the solvency issue is gone as long as this policy is followed. With the ECB in effect backstopping the bonds of the national governments, it facilitates the latter’s ability to secure funding again in the market place via renewed bond issuance.

Power, then, has shifted inexorably to the ECB, presumably under substantial influence of the national government finance ministers (ECOFIN), as the ECB directly or indirectly moves to fund the entire banking system and national government deficits. This is an institutional structure that is fully sustainable financially, with the economic outcome a function of the size of the national government deficits they allow. At the time of writing (December 2010), there has been increasing evidence in the last few weeks or so that suggest that the public deficits across the EU are propping up demand just enough to stop a depression scenario. Growth in Europe though extremely weak is positive, exports are picking up (for now), and there is some evidence that the falling euro will continue to help the external sector.

But the actions of the ECB are neither politically desirable, nor sustainable over the longer term. The conflict will remain between the money interests in Europe who put currency strength as a priority, versus the exporters who favor currency weakness. The consensus will be that unions and wages in general must be controlled, which will create ongoing social turmoil. That’s not a great environment, especially in the “new normal” of subpar returns on financial assets.

Concluding Thoughts

Ironically, the very ideals which underpinned the creation of the euro – notably the elimination of the “German problem” once and for all and the corresponding threat to any more wars on European soil – are now being exacerbated by the very institutional structures which arose from these ideals. The immediate problem is that we have a monetary union (single currency) without a fiscal union. It works fine when everyone is expanding, but when recessionary pressures set in, the institutional contradiction makes it impossible to shape harmonious EU-wide counter-cyclical fiscal and monetary polices. (Another related problem is that the EU expanded far too rapidly, especially in recent years.) 

But the increasing tensions now manifest in the current financial crisis paints a picture of a continent increasingly marked by divergence with old historical enmities re-emerging. This suggests that the creation of a supra-national fiscal entity, however institutionally elegant it might appear, is probably unworkable (especially given that it would likely represent nothing more than a “United States of Germany” with a European accent). The middle class and upper middle class citizens of the richer countries, especially Germany but also the Netherlands, Luxembourg, and perhaps France would oppose the establishment of such an authority, and doubt whether such a consolidation could have fully fledged representation that does not incorporate German domination.  Designing such a supranational structure via a Strasbourg diktat (like the EU Constitution) is probably not possible and certainly not desirable, because it would be a “Yugoslavia” type solution without a Tito, where the supra national authority has the power to directly transfer wealth from the richer countries (like Slovenia and Croatia) to the poorer countries/regions (like Serbia, Macedonia, Kosovo).  It seems increasingly apparent that a supranational fiscal agency runs the risk of inflaming nationalist passions and making countries like Germany more vulnerable to demagogic “beggar-thy-neighbor” politics.  (In this regard, consider the political complications of transferring counter-cyclical money to the states in the US.  The problems, politics, and cultures in Mississippi are very different from those in California — yet the US is far more “unified” culturally, historically, and politically than the EMU.) Today’s disputes are nothing new, but the current one differs from previous Euro squabbles, which have always been about issues within the existing treaty framework. This one is not because it does not “build on” Maastricht but goes to the core structural flaws at the heart of the EMU. The underlying divisions could be papered over so long as economic times remained good, but in today’s challenging economic environment, these fissures are now re-emerging with a vengeance.

“Pride goeth before destruction and a haughty spirit before a fall.” — Proverbs 16:18


  1. See here for more: https://bilbo.economicoutlook.net/blog/?p=4870
  2. https://bilbo.economicoutlook.net/blog/?p=2418
  3. https://moslereconomics.com/2010/11/26/european-debtgdp-ratios-the-core-issue/

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