The euro disaster is about more than just current account imbalances

By L. Randall Wray

This post first appeared at "Great Leap Forward”, my EconoMonitor blog.

Two weeks ago I cited Paul McCulley’s claim that MMT got it right. I followed that up last week with Brad DeLong’s claim that we’re all Minskians now. Well, most of us, anyway. Is MMT on a roll? Well, maybe not, if you listen to the critics.

In particular, an Italian economist, Sergio Cesaratto called the MMT victory “spurious”. I’ll try to focus in on the main complaint, which seems to be that MMT missed the true cause of the Euro mess: current account deficits run up by some profligate EMU members.

Over at NEP, I have just offered up a number of early examples of MMT analyses that in my view “got it right”. I won’t repeat all of them here as I am going to focus directly on what I see to be the causes of the crisis and link that back to the argument that it is all due to current account imbalances.

Sorry, this is going to be a long and wonky piece, as befits a complex and still unfolding disaster. And it will come in two parts.

First, is it true that MMT has ignored current account problems within the EU and EMU?

Here’s one of the quotes I used, from Jan Kregel:

“Germany appears to have adopted a policy of controlling the growth of nominal wages at a rate that is below its domestic productivity growth. German unit labor costs have been falling …. If Germany does in fact manage, as it seems to have been doing for about two years, to continue to decrease its unit labor costs at 5 percent — that is, at rates that are substantially below those in the other European countries, with no longer a possibility, as has been the case in the past, for the deutschemark to revalue relative to the other currencies — this means that if I am a manufacturer or a government in a non-German European country, I am going to experience declining profit margins until I also manage to compress my unit labor costs.” (This is from a presentation Jan made at an early MMT conference organized in London by Warren Mosler, and published in The Launching of the Euro, Proceedings of “A Conference on the European Economic and Monetary Union,” Annandale-on-Hudson, N.Y.: The Bard Center, 1999)

Well, that is precisely what Germany did for the next half dozen years—helping to fuel current account deficits on the periphery; and Jan also predicted the deflationary impact Germany would impose on Euroland. In 1998. Here is another quote from Jan, this time from an article published in the Eastern Economic Journal, Winter 1999; this was presented at a panel on the Euro organized by Mat Forstater. Jan’s main point was that the construction of the EMU would create deflationary forces that would result in chronic high unemployment; he thus proposed to use the “modern money” approach to formulate a policy response—an employer of last resort program for the EMU. Here I will remain focused on the current account imbalances and the problems these would create (you can read his paper for the ELR proposal for the EMU):

“If France or Italy decided to expand domestic demand, it would be quickly drained out of the country—it would no longer show up in the German balance of payments surplus and an Italian deficit as before EMU, but now appear as increased expenditure flows from Italy to Germany, with the Italian fiscal deficit deteriorating, and credit risks on Italian securities increasing. While both labor and capital costs will be rising in Italy relative to Germany, this will only exacerbate the divergences and make a policy of downward wage convergence more pressing. The single currency will bring the positive benefit of releasing European economies from having to contract their domestic expenditure policies to defend their exchange rates relative to the DM, but it brings with it the cost of requiring that they contract their nominal wages to defend the competitiveness of their domestic production against cheapening German imported goods.”

If that is not prescient, I do not know what is. But wait, there’s more. Kregel examines the possibility that the EMU can resolve internal current account imbalances by exporting outside the union (ie: exporting unemployment abroad):

“The question is whether the increase in demand from outside the European Union resulting from real depreciation of the EURO will be sufficient to offset the decline in internal demand. Whereas external trade was a very large proportion of each member country’s GDP before unification, it will become a very spall proportion after unification. The order of magnitude is not likely to be sufficient to offset the reduction in EU demand. Further since the Euro will float against the dollar and the yen, and given the German obsession with a ‘strong’ euro as evidenced in recent Bundesbank policy, if the Euro were to appreciate relative to these currencies this would eliminate any benefits that might have accrued from the reduction in unit labor costs. If the Euro behaves as the German mark has done over the last twenty years, this means that in the medium term it will appreciate so as to maintain a roughly constant real effective exchange rate, with nominal appreciations offsetting any changes in relative unit labor costs.”

So we were indeed looking at the potential for current account imbalances once the Euro was launched.

More specifically, the way we have usually introduced the current account balance is through Wynne Godley’s sectoral balance approach (which I have explained previously on the GLF and there are many other explications over at NEP and at www.levy.org). For a particularly instructive piece, here is Rob Parenteau’s 2009 take on the macroeconomic identity which states that the domestic private sector balance plus the government balance plus the foreign balance must sum to zero:

“…a trade surplus is the only way both the GFB [government balance]and the PSFB [domestic private balance] can maintain a net saving position at the same time (assuming for whatever reason that was a worthy goal), but at least it is a promising start at representing how sectoral financial balances are related, and it reveals many of the misconceptions that unnecessarily cloud the debate.”

The reason I am pointing readers to Rob’s work is because he went on to extend a simple model created by Paul Krugman specifically to examine the problems in Euroland. Since 2009 Rob has been examining these current account imbalances within the MMT framework. For a very good exposition of this model and charts on the EMU members’ sectoral balances, see Mitch Green’s powerpoint here:

I will present some of the data next week.

I find it perplexing that Sergio thinks MMT has overlooked current accounts and the link to financial crises that first hit the US and then moved on to Euroland. Wynne and I wrote a couple of pieces together back during the Clinton years warning that the combination of a current account deficit plus a budget surplus meant that Goldilocks was going to get murdered by the necessary balancing item—an unprecedented sustained private sector deficit. (You can find them at www.levy.org.) As Rob points out in the quote above, Clinton could have a budget surplus without burdening the private sector with debt only if the US could run a current account surplus. But that was not going to happen, due to the external demand for dollars.

And we rejected the claim that problems could be resolved by exchange rate adjustments—Wynne was always skeptical that dollar depreciation would do much to turn around the US current account deficit. (Now, full disclosure: Wynne and I had a different view about the desirability of reducing the US current account deficit. He would have preferred to reduce it; I wanted to ramp up fiscal policy to allow the domestic private sector to reduce its deficits.) From the MMT point of view (with which Wynne was otherwise quite sympathetic) the main problem with current account deficits in monetarily sovereign nations is the balance sheet situation of the domestic private sector (given a government budgetary outcome). In other words, the problem with the US current account deficits was the flip side of the coin: a private sector that was spending far more than its income for nearly a decade.

Now, some EMU nations also ran chronic current account deficits. And if these had been monetarily sovereign nations (in the sense that they each issued their own floating rate currency), then the worry would have been over the private sector balance. But here the EMU nations diverged significantly from one another—some with current account deficits did not run up huge private sector debts, others did. The balancing item, of course, was the government balance. And, more importantly, these were not monetarily sovereign. Each dropped its own currency in favor of a “foreign” currency—the Euro. So there are two issues: a current account deficit mostly offset by a private sector deficit, versus a current account deficit offset mostly by a government sector deficit. My argument is that for a monetarily sovereign nation only the first of these is a problem; but for Euro nations, either of these can cause trouble.

Now why am I making this distinction—between sovereign and nonsovereign nations (in the monetary sense)? Look at it this way. What is the current account balance between, say, Alabama and Idaho? Does anyone know? Does anyone care? They both use the Dollar. Yet, both Germany and Greece use the Euro and I doubt there is a single reader out there who does not know that Germany runs a positive current account against Greece. And most of them care. A lot.

To be sure, the imbalance among US states is important for some considerations—and regional economists study such things as regional multipliers (if you spend a dollar of fiscal stimulus in Kansas City, how much of the multiplier effect leaks out?). It is important for regional development and poverty alleviation. But the reason why the balance of payments numbers are not the subject of careful focus for others is because we use fiscal policy to try to overcome the negative effects on standards of living across states due to different multipliers and other factors related to these current account flows. Obviously, we do less than an ideal job—poverty rates, average wages, access to good jobs, and per capita incomes vary considerably across states. But Washington’s fiscal transfers are large both in terms of its spending on goods and services, its direct employment, and its spending on “transfer” payments (things like Social Security). And we are not going to kick, say, Alabama out of the Dollar Union because of its chronic balance of payments deficit.

US Federal government purchases amount to 20% of GDP; total spending is almost a third of GDP. It is big enough to do some redistribution to offset some of the current account deficits. The Euroland’s Parliament spends less than 1% of the GDP of Euroland; some of that does redistribute (check out the highways in Sicily, thanks to EU spending) but it is far too small to do the job of offsetting current account deficits. So most of the offset is up to the individual EU nations.

OK so that is part of the EMU’s problem—and note it is not a simple current account story. It is an MMT story about the constraints imposed due to the setup of the EMU, which separated fiscal policy from the currency. MMT has written about this problem since the beginning. Again, there are many quotes in my new piece at NEP; let me just repeat three examples, all from the earliest years of the Euro experiment.

The following is from my 1998 book, “Understanding Modern Money”:

“Under the EMU, monetary policy is supposed to be divorced from fiscal policy, with a great degree of monetary policy independence in order to focus on the primary objective of price stability.  Fiscal policy, in turn will be tightly constrained by criteria which dictate maximum deficit to GDP and debt to deficit ratios.  Most importantly, as Goodhart recognizes, this will be the world’s first modern experiment on a wide scale that would attempt to break the link between a government and its currency. …As currently designed, the EMU will have a central bank (the ECB) but it will not have any fiscal branch.  This would be much like a US which operated with a Fed, but with only individual state treasuries.  It will be as if each EMU member country were to attempt to operate fiscal policy in a foreign currency; deficit spending will require borrowing in that foreign currency according to the dictates of private markets.”

This quote is from a 2002 article by Stephanie Kelton (then Stephanie Bell):

“Countries that wish to compete for benchmark status, or to improve the terms on which they borrow, will have an incentive to reduce fiscal deficits or strive for budget surpluses. In countries where this becomes the overriding policy objective, we should not be surprised to find relatively little attention paid to the stabilization of output and employment. In contrast, countries that attempt to eschew the principles of “sound” finance may find that they are unable to run large, counter-cyclical deficits, as lenders refuse to provide sufficient credit on desirable terms. Until something is done to enable member states to avert these financial constraints (e.g. political union and the establishment of a federal (EU) budget or the establishment of a new lending institution, designed to aid member states in pursuing a broad set of policy objectives), the prospects for stabilization in the Eurozone appear grim.”

The final quote is from Mat Forstater, written in 1998 and published a year later:

“Under the EMU, if investors are at all hesitant about any one member’s debt, they can buy another member’s debt without incurring currency risk, since there is no exchange rate variability among the currencies of member countries. Because member nations are now dependent on investors for funding their expenditure, failure to attract investors results in an inability to spend. Furthermore, should a member’s revenues fail to keep pace with expenditures due to an economic slowdown, investors will likely demand a budget that is balanced, most likely through spending cuts. In other words, market forces can demand pro-cyclical fiscal policy during a recession, compounding recessionary influences…. Even if there were no imposed limits on countries’ deficits and national debts, the structure of the EMU makes it nearly impossible for a country to enact a counter-cyclical fiscal policy even if there were the political will. This is because, by giving up their national monetary sovereignty, countries are no longer able to conduct coordinated fiscal and monetary policy, essential for a comprehensive and effective remedy to periodic demand crises. Why would countries voluntarily sacrifice the ability to conduct a coordinated macroeconomic policy, especially at a time when official unemployment rates are in double digits and there are clear deflationary pressures?”

These all establish the main MMT position on the fundamental flaw with the set-up of the EMU. Clearly, the problem cannot simply be a problem of current account imbalances—we’ve got them all across the US states. And the US, itself, runs a chronic current account deficit. But the US federal government is sovereign, it issues its own currency. It helps to offset current account deficits among states through fiscal transfers; and it can never run out of its own currency no matter how big its budget deficit. It can set its overnight interest rate target wherever it wants—at zero if desired—and hold it there forever, if it wants. That lowers short term treasury rates, and Uncle Sam can—if he wants—issue only short term treasuries. All of these options are fully within the federal government’s sovereign power, although it can choose to do something else.

Individual EMU nations are in a wholly different pickle. They have no equivalent to Uncle Sam to provide significant funding; all they’ve got is an ECB whose stated and legislated mission is to AVOID providing the kind of support Uncle Sam provides to US states. (As we now know, when push comes to shove, the ECB uses “work arounds”, albeit while kicking and screaming.)

Now we come to the actual crisis that hit the EMU. All of the above is preliminary—necessary to understand that the system was vulnerable to crisis. And when Paul McCulley said we should declare victory, I think these analyses were what he was talking about. But where would the tsunami of a crisis come from? Well, we know the bad winds blew in from the west, in the form of trashy US mortgages. But for a while it looked like Euroland might get by with a few scrapes and bruises. Then it was hit with hell and fury—the crisis became a Euro crisis. So while we’ll accept some finger pointing at the US crisis, we want to get more specific about what went wrong in the EMU.

Let me borrow, again from my NEP piece. In order to judge how correct MMT was in its predictions, of course, we have to understand what went wrong in Euroland. Our argument was that separating fiscal policy from currency sovereignty would raise questions of solvency that would constrain the ability of fiscal policy to expand when necessary. That was the basis of all these early MMT arguments. But there was an additional angle: how would the crisis begin? Would it be a recession that no individual government could resolve by fiscal stimulus? Would it be chronic current account deficits of some member states (to the benefit of Mercantilists like Germany or the Netherlands)? Or would it be a financial crisis? Well, how about a Trifecta: all three at once?

I think all readers here now understand the problems raised by recession—so there is no need to go into that one in detail. As individual nations faced a downturn, their budgets would move sharply to deficits (as tax revenue fell and social spending rose) that would rise further above Maastricht criteria; markets would react with higher interest rates that would in turn raise deficits further in a vicious cycle. OK, that happened. And then, of course, we also found out that (Surprise! Surprise!) governments had already been manipulating accounting (thank you Goldman Sachs!) so their deficits had always been higher than supposed.

And we already addressed the current account story—easily understood through the lens of Godley’s sectoral balance approach: a current account deficit must be offset by a combination of a domestic private sector deficit and/or a government deficit. Since these are not sovereign currency issuing governments, private and government deficits can both lead to problems.

However, it is much more than a current account problem, as Rob Parenteau has shown. Any EMU nation can be blown up by its banks even while running a current account surplus. This is the “financialization” or “Money Manager Capitalism” story that comes from Hyman Minsky—probably well over 90% of cross-border finance has nothing to do with the current account, and it was that part of finance that blew up countries like Ireland and Spain. (We’ll turn to that because it is related to the issue.)

So, finally there was the financial crisis angle. So far as I know, Warren Mosler was the first to fully understand this. He was harping on it for as long as I can remember—I’ll present his argument in some detail next week as we turn to a close examination of the data and analysis that will help to disprove the thesis that it all comes down to current account imbalances.