Unlimited Targets? Some pointers

By Sergio Cesaratto (Guest Blogger)

In this short note I will not add anything of substantial to the debate with Marc Lavoie on the nature of the Eurozone (EZ) crisis in view of Target 2 (T2). Readers have numerous papers to look at (including Lavoie 2015a/b, Cesaratto 2013, 2015a/b) and posts (Vernengo 2015, Ramanan, 2015). However, although most of relevance has already been said, there is perhaps still some space for few qualifications.

1. Subject of the dispute is on whether the EZ crisis can be considered a balance of payment (BoP) crisis in view of the existence of T2 and of the Eurosystem semi-authomatic refinancing mechanism, or if it should be considered a crisis derived from flawed institutional mechanisms that led, in particular, to a belated intervention by the ECB to sustain peripheral sovereign debts.

Marc believes that given the existence of T2 and refinancing mechanisms, a BoP crisis cannot occur in a monetary union:

“The point that I have tried to make on a number of occasions at conferences is that outflows are not limited by the amount of foreign reserves in the Eurozone context, in contrast to a country on a fixed or managed exchange rate regime. If a Eurozone country is running a current account deficit that banks from other Eurozone members decline to finance, or if it is subjected to capital outflows, then all that happens is that the national central bank of that country will be accumulating TARGET2 debit balances at the ECB. There is no legal limit to these debit balances. The national central bank with the debit balances, which pay interest at the target interest rate, has as a counterpart in its assets the advances that it must make to its national commercial banks at that same target interest rate. And the commercial banks can obtain central bank advances as long as they show proper collateral. Why would the size of current account deficits or TARGET2 debit balances worry speculators?” (Lavoie 2015: 158)

Marc correctly points out the difference in our views:

“Cesaratto (2015°: 151) and I agree when he concludes that “there are no definite limits to T2 imbalances”; he seems to disagree when he adds that “a political limit has been set by the imposition of harsh austerity measures on peripheral countries in order to obtain positive CA balances”. (ibid)

So the difference is that I see policy limits (perhaps political was not the right word) to T2 imbalances in the sense that policy makers cannot see them growing indefinitely, reflecting growing flow and stock foreign indebtedness and, correspondingly, mounting indebtedness of peripheral private and sovereign debts.

2. To give an example, would a central government with a sovereign central bank (CB) let one region (say Calabria) to expand its expenditure issuing regional bonds by letting its CB to guarantee an unlimited issuance? Notably this behaviour would let this region to accumulate an unlimited balance of payment deficit and foreign debt with the rest of the country and the rest of the world. At the minimum the other regions would like to imitate this (electorally) convenient behaviour. The reader can derive by herself the economic consequences of this behaviour.

If this does not complicate the life of readers, a reference to a view that cannot be suspected of fiscal timidity, that is to MMT, is useful here. Wray and Nersisyan (2010: 16) argue that although there are not “financial constraints [to sovereign debt and deficit] inherent in the fiat system”, nonetheless some arbitrary fiscal constraint, e.g. a balanced budget of the cycle, is necessary to avoid that the government “might spend ‘out of control,’ taking too large a percent of the nation’s resources”.

Would any national government let its CB to back a single region to behave this way? And should we expect the EU sustaining a single member, let alone a group of members, to behave this way? Or could we expect the U.S. printing dollars to check the Argentinian foreign debt crisis in 2001?

On a similar vein Ramanan (2015, italics added) pointed out:

“Let’s consider what happens if there is no federal government and if the ECB is the main supranational authority (ignoring other supranational institutions which have limited powers). Suppose the ECB were to guarantee the debt of governments of all Euro Area nations. There’s nothing to prevent, say, the government of Finland to increase the compensation of its employees every year by a huge percentage and thereby affecting Finnish corporations’ compensation of its employees. This will result in a reduction of competitiveness of Finnish producers and Finnish resident economic units will rely more on goods and services produced abroad. This will raise Finland’s net indebtedness to the rest of the Euro Area and the world. If someone believes that this debt is not a problem, how about the inflationary impact of this rise in demand on the rest of the Euro Area?... 

To summarize, the Euro Area problem wouldn’t have been a balance-of-payments problem had the official sector promised to act as a lender of the last resort to national Euro Area governments without any condition. As long as there are conditions, it is a balance-of-payments problem. One cannot pretend that the European Central Bank has or can be given such powers to lend without any condition. And hence the Euro Area crisis is a balance-of-payments problem.”

3. In this sense I do not agree with the ecumenical view taken by Matias Vernengo (2015) according to which:

“Cesaratto and Lavoie hypotheses are one and the same. The balance of payments and the monetary sovereignty views of the European crisis are two sides of the same coin. The fact that overdraft facilities involved in the TARGET2 system could be used to create credit to finance euro imbalances, or that the ECB could buy government bonds in the secondary market does not preclude the fact that the actual crisis is, in the absence of these policies, the result of the inability to manage a CA deficit.”

It can be noted that Matias eventually endorses the argument (that I refrain to attribute to Lavoie but that, perhaps, he might approve) that the absence of an unlimited credit by the ECB is the ultimate cause of the BoP crisis. My view is that it is unthinkable to believe in an open ended support by the ECB (or by the EU governance) of unlimited Target 2 imbalances. And this is, in my view, the ultimate cause of the imposition of austerity policies on the periphery. The ECB “whatever it takes” (threatened) intervention, finalised to alleviate the austerity costs by reassuring financial markets, was indeed subordinate to the adoption of austerity measures - so that no German court could protest, inspired by Werner Sinn, that the ECB was sustaining unlimited peripheral foreign debts.

In Lavoie’s and Paul De Grauwe (e.g. 2013)’s views austerity was functional to reassure the financial markets about the fiscal sustainability of peripheral debts given the absence of the ECB as lender of last resort (see Cesaratto 2015b for a review). Note that this view is exposed to a fiscal interpretation of the crisis (one that Lavoie and De Grauwe firmly oppose). And, indeed, the reader may wander what is the cause of the crisis, given that Lavoie and De Grauwe tend to neglect Robert Frankel’s and others’ story about the similarities of the EZ crisis with the typical financial crisis of emerging economies (see Cesaratto 2015b for a review)

The next are minor points.

4. Marc is correct when he argues that Roberto Frenkel does not reject the “unlimited Target 2 unbalances view”:

“Let me make a final point. Cesaratto (…) enlists Roberto Frenkel (2012) among the
economists who support his ‘balance-of-payments’ interpretation of the crisis. I got quite
a different impression when I read his paper. While Frenkel (2012: 13) agrees with Cesaratto that the adoption of the common currency was a mistake and that the crisis has its origin in ‘the conjunction of fixed exchange rates, full capital mobility and weak financial regulation,’Frenkel nevertheless believes that the size of TARGET2 balances is irrelevant and argues that the sovereign risk premiums observed with GIIPS countries were tied to the absence of a credible lender of last resort”

And indeed in my most recent paper (Cesaratto 2015b) I had already pointed out:

“A more nuanced position is taken by Frenkel (2014, pp. 13-14). On the one hand he regards the eurocrisis as a balance of payment crisis; on the other, he denies that there can be an “exchange rate risk” (the typical manifestation of a balance of payment crisis) in the euro zone presumably because of the combination of Target 2 and the ECB refinancing operations. The increasing sovereign default risk is then attributed to the absence of a lender of last resort. Notably, with OMT the ECB began to act as a lender of last resort but precisely to defuse what Draghi (2012) called in his most famous speech ‘convertibility risk’, that is the risk of a euro break-up.”

5. Finally, although this is less important, I’d like to point out, in Cesaratto (2015a) I was not so pretentious to claim that Lavoie (2015) was entirely devoted to discuss Cesaratto (2013). Unfortunately this is the impression that the reader may get from Lavoie’s incipit of his Reply. When I began my (2015) paper writing:

“In a general appreciation of my work on TARGET2 (T2) (Cesaratto 2013), Marc Lavoie (2015a) criticized my interpretation of the Eurozone (EZ) troubles as a balance of payments crisis”,

by ”general appreciation” I meant “positive reception” (see e.g. the Microsoft Window Word dictionary), but perhaps the way I expressed myself was ambiguous.

References

Cesaratto, S. 2013. “The Implications of TARGET2 in the European Balance of payments Crisis and Beyond.” European Journal of Economics and Economic Policy: Intervention 10, no. 3: 359–382. link

Cesaratto, S. 2015a. “Balance of Payments or Monetary Sovereignty?. In Search of the EMU’s Original Sin–Comments on Marc Lavoie’s The Eurozone: Similarities to and Differences from Keynes’s Plan.” International Journal of Political Economy 44, no. 2: 142–156. link

Cesaratto, S. 2015b. Alternative Interpretations of a Stateless Currency crisis, Asimmetrie, WP no.8. link

De Grauwe, P. (2013) Design Failures in the Euro zone - can they be fixed? London School of Economics, LEQS Paper No. 57/2013. Link

Frenkel, R. 2012. “What Have the Crises in Emerging Markets and the Euro Zone in Common and what Differentiates Them?”, link

Frenkel, R. (2014) What have the crises in emerging markets and the Euro Zone in common and what differentiates them? in Joseph E. Stiglitz, Daniel Heymann (eds), Life After Debt - The Origins and Resolutions of Debt Crisis, Palgrave Macmillan (quotations from the WP version link)

Lavoie, M. 2015a. “The Eurozone: Similarities to and Differences from Keynes’s Plan.” International Journal of Political Economy 44, no. 1 (Spring): 3–17. link

Lavoie, M. 2015b. “The Eurozone Crisis: A Balance-of-Payments Problem or a Crisis Due to a Flawed Monetary Design?” International Journal of Political Economy 44, no. 2: 157-160. (abstract)

Nersisyan, Y. and Wray, L.R. (2010) Does Excessive Sovereign Debt Really Hurt Growth? A Critique of This Time Is Different, by Reinhart and Rogoff, Levy Institute, WP No. 603

Ramanan (2015) Sergio Cesaratto’s Debate With Marc Lavoie on Whether the Euro Area Crisis Is a Balance-Of-Payments Crisis – II, The Case For Concerted Action

Vernengo, M. (2015) Greece on the verge, Nakedkeynesianism, June 30

What macroeconomic policies were relevant for unemployment reduction in Latin America?

I was reading the book by Giovanni Andrea Cornia on Falling Inequality in Latin America, which suggests that the reduction of the skill premium and macroeconomic policies, together with the expansion of social assistant, in particular but not only by left of center governments, is behind the trend. I'll have more on some of the issues related to the skill premium, which rely heavily on both neoclassical labor market and trade theories. However, the chapter on the macroeconomic causes of reduced inequality caught my eye. The chapter, a previous version can be found here, written by Mario Damill and Roberto Frenkel says that:

"A competitive RER [Real Exchange Rate] provides a conductive environment for growth and development. This view has long been stressed by development economists* and recently documented in many econometric studies. The growth-enhancing attributes of a competitive RER operate through the enhancement of tradable sector profitability."

The idea is that a depreciated currency allows for more exports, less imports, a more relaxed current account, and higher levels of activity and employment. The real depreciation is expansionary. Also, the paper suggests that fiscal policies had been during the last decade more restrictive, and presumably this was a good thing. They say:

"...many countries implemented fiscal rules, fiscal responsibility laws or took discretional decisions oriented at correcting the pro-deficit bias of the past. In many countries these changes contributed to a generalized improvement in fiscal results as well as to a declining trajectory of the outstanding public debt."

Not clear why public debt in domestic currency was a problem. Arguably, they think that fiscal restraint was relevant for supposedly allowing for more price stability, since Frenkel usually has argued that inflation has been caused by excessive demand, which was also conducive to reduction in inequality.

However, the evidence in favor of these views is very thin at best. In fact, the whole mechanism by which a depreciated RER would lead to higher growth, lower unemployment and some improvement on income distribution, which is the change in relative prices and the effects on exports and imports, is never discussed. As I pointed out before, the best evidence still suggests that depreciation is contractionary (see the paper by Fiorito, Guaita and Guaita here, in Spanish).

In order to provide evidence for the positive effect of the RER on growth Damill and Frenkel used a partitioned regression. First they regress growth of GDP on the real exchange rate, they make a residual variable, GDP not affected by RER, and then regress unemployment change on the residual GDP and the RER, in what they term a variation of Okun's Law (sic). They find that unemployment is affected by the exchange rate, but to say that the model is misspecified, and that suffers from an omitted-variable bias is an understatement.

The current account in Latin America improved mostly because of a positive terms of trade (TOT) shock, and was not the result of a depreciated RER, which at any rate as the authors note, was almost at the same level as before the boom by the end of 2000s [that's why Frenkel keeps asking for depreciation to promote growth]. The improved TOT were relevant because they allowed for fiscal expansions without leading to current account problems, and on top, the expansion of the economy allowed for increasing tax revenue and balanced fiscal accounts. In other words, the fiscal rules were not the cause of primary fiscal surpluses, but the result of the economic boom.

Fiscal expansion, and the expansion of real wages, were certainly more important for the reduction of unemployment. The authors are correct, however, in emphasizing the role of employment generation in reducing poverty and inequality. Note, also, that as real wages expanded all countries experienced RER appreciation, but the evidence suggests that income expansion is what led to a reduction in current account surpluses. That's why depreciation cum fiscal adjustment, that Frenkel correctly connects (in Spanish) with IMF policies, are not the solution.

By the way, unemployment fell because GDP grew, and the old and simple Okun's Law, without the exchange rate, still works very well.

* In fact, many development economists starting with Hirschman and the Diaz-Alejandro, later formalized by Krugman and Taylor, suggested the opposite, that depreciation was contractionary. See here.

Was the devaluation in Argentina good and inevitable: A reply to Rapetti

Back in the mid-1990s I was a student of John Eatwell (his last TA in the microeconomics course at the New School, I think, before he went back to Cambridge), and one thing that has stuck with me over the years is that he argued no economic debate was ever solved by empirical evidence. Hyperbole aside, and I should say it is not a great exaggeration, logic has also not been particularly good a clarifying debates in economics (just think of the Capital Debates).

So last week I wrote this post on why the Argentine devaluation is not a traditional Balance of Payments crisis. As I noted it was a policy decision in the works for a long while. At any rate, neither the real exchange rate, nor the current account are in a position that per se is unsustainable. That is still true, however, Martín Rapetti from the Centro de Estudios de Estado y Sociedad claims I am confused in my criticism of his work, as much as that of Frenkel and Bresser-Pereira, the so-called New Developmentalists, which believe that devaluation is good for growth.

He suggests now that he does not claim that devaluation is good for long run growth (my quote from Bresser in the previous post was very clear suggesting that is in fact what New Developmentalists think). In his words:

"Formulations like mine seem to be the source of another confusion in Matias’ analysis. He argues that people like Luiz Carlos Bresser Pereira, Roberto Frenkel and me were advocating for a devaluation because we support the idea that maintaining a competitive real exchange rate (CRER) is good for growth."

He argues now that the reason for wanting a devaluation was:

"based on the inconsistencies of macroeconomic policy and not on my frustration about the abandonment of the competitive RER strategy that Argentina carried out between 2002 and circa 2008."

Althought Martín does not quite spell out what the contradictions are (and they are not the current account or the real exchange rate apparently, since he says: "He [that would be me, Matías] is right: the current account deficit was only 0.5% of GDP in 2013 (although it would higher without the import controls) and the RER is certainly not as overvalued as in Brazil (which, by the way, is very overvalued [that has no run on the currency, I might add])." The imbalances are one might assume inflation, and the cause of inflation as Frenkel and others have suggested is the excess demand (read fiscal deficits). So he wanted, and by the way I've heard this from almost anybody connected to CEDES, more fiscal adjustment. In fact, in the CEDES story, the government started to move away from good macro policy when Roberto Lavagna, which included several CEDES insiders, left the government at the end of 2005.

On this new position, let me refer again to my previous post (from March 2012) in which I quoted a paper Frenkel presented at a conference organized by Bresser, in which he said:

“the monetary and fiscal policies required to accompany the adoption of a SSCRER target must also have special features: the permanent expansionary stimulus that is part and parcel of the SSCRER heightens the importance of the restraining role to be played by fiscal and monetary policies.”

Let me emphasize this, the notion was that a stable and competitive real exchange rate is so powerful (permanent expansionary stimulus he says, sic) as an instrument for growth that you need fiscal and monetary contraction. Note that devaluation and macroeconomic contraction are the traditional tools of the IMF for countries with balance of payments problems. Part of what I suggested in my previous post is that heterodox authors tended to be more circumspect about the incredible advantages of depreciation. Martín's nuance about disequilibria (fiscal expansion) and not the effects of devaluation on growth are really not clear. If I was confused, he must explain how. Did Frenkel and him changed their position? If so I'm glad, but certainly I'm NOT the one confused here.

His other critique is decidedly bizarre. He argues

"Matías seems to miss the important point that as long as expected depreciation at the exchange rate that the Central Bank is defending is higher than the yield of domestic assets, there would be an excess demand for foreign currency that would eventually lead to the depletion of FX reserves and the collapse of the domestic currency."

First of all, in the post Martín criticizes I say the following:

"Note that if the government on top of the current measures adds fiscal contraction (monetary tightening is a given, since higher rates of interest will be needed to avoid more capital flight; and the effects of monetary contraction can be compensated by subsidized public credit) as the New Developmentalists wanted (since for them inflation was caused by excess demand) then the slowdown will be significant and even a recession could take place."

In other words, yes the government must increase the rate on interest to avoid the expectations of a devaluation. My point indeed was that back in 2012 they should have done that, when the blue was closer to 5, and it was easier to do and avoid a depreciation (which Martín wanted and I didn't) and that he used to think it was good, but now that happened he has second thoughts (you'll see why in a second).

Second, exactly because the problem is the low rates of interest when compared with holding dollars, you see that this is not a problem associated to the exchange rate being overvalued or the current account being unsustainable in the short run. It is something that could have been solved long ago with a higher rate of interest. Mind you, Martín is simply wrong when he says that since 2010 the Central Bank of Argentina was using the nominal exchange rate as an anchor for prices (he is really confused on this one; just check the rate of depreciation), and I should know since I was at the bank at some point during this period (actually Brazil did that, and that explains lower inflation in Brazil).

But here comes the cherry on top of the ice-cream. Why would depreciation still be good for Martín? Because the long-term exchange rate elasticity of exports is actually high. The short-term isn't and that's why in the short run the depreciation will be contractionary and he has some doubts about it. But in the long run things are hunky dory. So here is NOT about imbalances, but depreciation is good for growth because it increases competitiveness and exports (wink, wink, devaluation is not good, but yes it is; and I'm confused!). In his words:

"The problem is that Matías confuses an important distinction between short-run and long-run effects of the real exchange rate on economic performance. In Krugman-Taylor, a real devaluation (a change in the RER) has a negative effect on output and employment in the short run; in Frenkel-Taylor, a competitive RER level has a positive effect on long-run growth."

I guess I missed that class by Lance, and that's the source of my confusion. I should note that I had a few exchanges with Martín on Twitter (see below in Spanish) on which he also suggested that in the long run was good for growth.

@mgrapetti @SSAlfredo y Martin si cambiar los precios relativos resuelve el problema externo, cual es la elasticidad? Pq no das el numero
— Matías Vernengo (@NakedKeynes) June 16, 2013

Here is the problem, Martín (neither him, nor Frenkel or anybody else as far as I know) has shown this great long-term elasticities that show that depreciation in the long-run (the Frenkel-Taylor, not Krugman-Taylor story) is good for growth. The evidence I cited here (from this paper by Fiorito and Silvio and Nahuel Guaita) actually shows that there is no indication of a positive elasticity in any run. If Martín shows that there is some evidence on positive and significant long-term real exchange elasticities for exports (I'm really interested in what methodology he suggests for finding this result, and separate the short and long run elasticities), like Keynes I will change my mind, and try to prove Eatwell wrong on the role of empirical evidence in economic debates. But if you (Martín) cannot come up with evidence to support your nice theoretical model (the Frenkel-Taylor that rules in the long run, are we clear?!), what should we call you? Confused does not seem the correct definition for someone that keeps defending an idea for which there is no evidence (don't worry, I'm not in the game of name calling).

Finally, I should add here, that while I do think that the government has committed mistakes, and allowing the blue (the black market) exchange rate to depreciate and not hike interest rates earlier  is one of those (I would add the need for a more aggressive Import Substitution policy to reduce the external constraint, something I defended as early as March 2012; see here), I still think that this government should be supported and is much better than the alternative (Martín is certainly not in favor of the government).

How bad is the Argentine crisis?

There is a certain view about current events in Argentina that tends to emphasize the potential effects of the devaluation as the collapse of the economic model, and, and, hence, suggest that the post-default process of economic growth should not be taken as an alternative for other countries in distress, like for example Greece and other Southern European countries. This kind of view, expressed for example by Walter Molano in the Financial Times (subscription required; minus the strange argument that the Argentine problem is "geographical"), suggests that policies should be aimed at pleasing international financial markets since the goal is to promote "confidence in the country’s economic management," and that devaluation is necessary for solving the "unsustainable economic imbalances."

First, it must be understood that the current devaluation, which was of the order of 20% in nominal terms in the last days of last week, is part of a plan that was most likely in the works, since the change in the economic team at the end of last November, when the current finance minister, Axel Kicillof, became the sole commander of the economy displacing Guillermo Moreno, and to a lesser extent Mercedes Marcó del Pont (full disclosure, I worked in the central bank during her tenure as president) in the internal domestic dispute.

In other words, this is not a balance of payments crisis (or a currency one) per se, even though it might become one, since it was actually part of a policy decision, first to accelerate the depreciation of the currency, which started in the last month of 2013 after the new finance minister assumed his position, and that culminated with the renegotiation of the debt with the Paris Club (to regain access to international financial markets), and the gradual liberalization of the exchange market, trying to move the official rate closer to the 'blue,' that is, the black market rate. Note that the current account, as I noted before here, is not in a terrible situation, the Brazilian position has been far worse for a longer period, and the real exchange rate was not more appreciated than in Brazil either.

Before discussing my views of what might happen, it is important to note the New Developmentalist views, which are often associated to Bresser-Pereira and in Argentina to Roberto Frenkel and his co-authors, that the re-alignment of the real exchange rate was inevitable and necessary to promote more competitiveness and growth does not hold water (see my previous critique here, and Fiorito and Amico's here). Bresser has in fact argued that this devaluation is likely to be good for Argentina. In his words (the whole article here):

"the peso retrieved the lost competitive equilibrium; the government declared that the peso had reached the desired level, and, without fearing an increase in the dollar's official price, it suspended several restrictions to the purchase of dollars , in order to draw the parallel down. If this strategy of keeping the exchange rate at the competitive level is successful, profit expectations will rise, business enterprises will invest again, the current account surplus will be restored, and the Argentinian crisis will be over."

Martín Rapetti (a Frenkel co-author) remains more skeptical here (in Spanish), but insists it was inevitable (the exchange rate realignment).

In my view, the devaluation was not inevitable and is not particularly good. First, it will be inflationary, and as I noted a few years back, also might be contractionary, so expect less growth this year. The reduced growth is what will hold the current account in a reasonable situation, by the way. Hence, devaluation will not solve either the inflationary problem, nor the external constraint one. In this sense, the crisis (manufactured as it is) is worse than most people understand, since it won't solve any of the pressing problems in Argentina.

Note that if the government on top of the current measures adds fiscal contraction (monetary tightening is a given, since higher rates of interest will be needed to avoid more capital flight; and the effects of monetary contraction can be compensated by subsidized public credit) as the New Developmentalists wanted (since for them inflation was caused by excess demand) then the slowdown will be significant and even a recession could take place. The Plan Progresar (that gives money to young students without jobs) might indicate the opposite disposition, but the crisis might force the government to slowdown the economy to avoid a more serious current account deficit.

A more benign scenario would be that the Central Bank manages to control the depreciation, and stabilize the real exchange rate, likely at a somewhat depreciated rate (how much will depend on wage resistance, and how much inflation we get; my guess is that some real depreciation will take place, and lower real wages will follow, which also will add a contractionary force in domestic demand), but this does not turn into a run on the currency.

As I noted before, there are good reasons to believe that lack of growth in advanced economies and low rates of interests in the center will preclude outflows of capital, if higher real rates of interest are imposed in Argentina (they are still negative now) like Brazil has done. Also, the plateau of commodity prices indicates that the balance of payments will not worsen immediately, so there will still be space to solve the long-term problems associated with excessive dependence on the export of commodities, and to pursue the difficult but necessary process of import substitution.

In short, the default and the process of growth (which was possible because of favorable external conditions, but NOT caused just by that; as I noted several times terms of trade improved less in Argentina than in Brazil, and the former grew far more during the commodity boom period), which was based on fiscal expansion and income redistribution is an alternative to Neoliberal policies. And the way to deal with the limits to the model (which are associated to the external constraint) are not related to the exchange rate, but to industrial policy.

PS: Here a video in which Fabián Amico provides a similar analysis (in Spanish).

Where is the elasticity? (or more on devaluation and growth)

Since 2007 mainstream economists, and often some heterodox (or more precisely eclectic) authors, have suggested that the Argentine economy is on the verge of collapse (see for example my good friend Bresser-Pereira here or this). A typical argument made by both orthodox economists (some of which favored the Convertibility Plan of the 1990s) and the more unconventional is that real exchange rate (RER) appreciation is at the heart of the Argentine problems and the more recent lack of growth.

I have discussed this before here with respect to the so-called Sustainable and Stable Competitive Real Exchange Rate literature (see here). The argument for a SSCRER was put forward by Frenkel and Taylor in a well-known paper, but the notion has many defenders (see the good paper by Blecker and Razmi from Setterfield's essential book on growth), including more conventional authors like Rodrik. At the risk of being repetitive let me point out the pros and cons of the arguments for devaluation.

Depreciation protects local industry and leads to a boost to domestic production, and also, by leading to an increase in exports, reduces the external constraint of the economy. That would be the substitution effect associated to the change in the relative prices. Yet depreciation also (everything else constant) reduces wages, increases the profits of exporters, and leads (yes, the economy is wage-led) to a reduction in spending and lower levels of activity. In this case, a depreciation does help reduce your external constraint, but by leading to a contraction. The second effect, associated to an income effect, was well-known by heterodox authors, having been developed by Albert Hirschman and Carlos Diaz-Alejandro (for the Argentine case) and then formalized by Krugman and Taylor (see here; subscription required).

At the end of the day it is an empirical question. All the evidence seems to suggest, at least for the Argentine case (here paper by Fiorito and others in Spanish; but it seems to be more general, see here) that income effects tend to be larger than substitution effects, and hence one might be concerned about possible contractionary effects of a depreciation.

In the case of Argentina, it is clear that the expansion of the volume of exports goes hand in hand with the expansion of the world GDP (Figure below).

The relation between the real exchange rate and exports is less clear. As it is shown below after the large real depreciation in 2002, growth in the volume of exports goes hand in hand with significant appreciation.

No doubt defenders of depreciation will argue that the big depreciation in 2002 was essential for export growth afterwards (see Rapetti here who argues that "competitive RER was a key factor behind Argentina’s recovery and growth"). But if you put the depreciation in the wider macroeconomic context of 2002, and compare with the current one, you are bound to have second thoughts.

The depreciated nominal exchange rate in a context of high unemployment (around 22%) did not lead to inflationary pressures, since wage demands were subdued (and hence the nominal depreciation translated into a large real one). Second, spare capacity meant that the protection afforded by the real depreciation led to a huge expansion of domestic production, spurred by the expansion of domestic demand (higher real wages and expansion of fiscal spending, particularly in social programs). Exports actually don't seem to move much with the depreciation. There is no econometric evidence for large elasticity of exports with respect to the exchange rate, in the short or long-run (if someone has it please, please, pretty please with a cherry on top share it; it's been frustrating to have an argument with people that argue a point for which there is no known evidence).

Note that all the above mentioned conditions are not in place now. Unemployment is considerably lower (around 7% or so), and the expansion of real wages and government spending have slowed down (so much so, that in the last year the economy has stalled). So maybe we need less Frenkel and Taylor and more Krugman and Taylor to understand what is going on in Argentina right now.

Did Inflation Bring Down the Allende Government?

Allende's glasses

Roberto Frenkel, the well-known Argentine economist, gave an interesting radio interview (transcribed, in Spanish, here) in which, as always, there is a lot to learn. In that interview he tells a touching story about his experience during the Allende government. Apparently he was told by the Finance Minister Carlos Matus to make a presentation on inflation, and warned of the dire consequences of not pursuing contractionary demand policies. After that he says (I keep his Spanish version and translate below):

"Yo había explicado cómo la inflación se iba a acelerar, la situación iba a empeorar rápidamente... y entonces se me acerca Allende con quien yo había tenido la oportunidad de estar en pocas oportunidades, y me dice '¿Por qué no me lo dijeron antes?' Y es una cosa que me pesó en el corazón... al poco tiempo el hombre se suicidó en La Moneda. Y eso se lo conté a algunos que estuvieron con el gobierno de Kirchner hasta hace poco y ahora salen preocupados y tratan de abandonar el barco y no hundirse con él, y les conté esta anécdota y los insté a hablar y a hacer explícita su alarma y preocupación por la situación (...)."

"I explained that inflation was going to accelerate, and things would worsen precipitously... and then Allende, with whom I had opportunity to meet in a few occasions, approaches me and says: 'Why didn't anybody tell me?' And that sunk my heart ...not long after that he committed suicide in La Moneda [presidential palace]. I told that story to some people that were members of the Kirchner's government until recently and now leaving the boat to avoid sinking with it and encourgaed them to speak up..."

So now we know. Inflation actually brought down Allende, and Frenkel almost saved the government, but was too late to avoid the military coup. And his concerns with Argentine inflation are similar now, since we are on the verge of total collapse.

All jokes asides, the notion that inflation brought the government down is silly to say the least. As noted here, if anything the nationalization of copper, that did hurt transnational corporations and local elites was certainly more important [note also that by 1973 inflation was not a Chilean problem, but a global one associated to the oil shocks and wage resistance]. So resistance to reforms by powerful groups within the country were at center stage. The connections of Pinochet with US corporations and security and intelligence apparatus are also well documented. Even if Frenkel had told Allende in time about inflation ... Oh well.

There are other nuggets in this interview, in particular the insistence that demand has to be curtailed even when it is admitted that inflation is essentially inertial, but I'll leave those for other posts. It seems that more and more authors at the Centro de Estudios de Estado y Sociedad (CEDES) are converging to mainstream positions, like the economists at the Catholic University in Rio (PUC-RJ) and sociologists like Fernando Henrique Cardoso in Brazil did back in the 1990s.

ECB anti-inflation policy effective in Germany?

Roberto Frenkel published an op-ed in an Argentine newspaper (here in Spanish) in which he says that while anti-inflation policy by the ECB in Spain was ineffective, but "the same anti inflation policy of the European Central Bank was effective in Germany. There it had an important component of cooperation. The Bundesbank participates in the negotiation of wage increases with the unions." The idea that the ECB has been effective in Germany is peculiar, to say the least.

One of the most criticized elements of German policy, at least by heterodox authors like Jörg Bibow for example, is the wage restraint and fiscal austerity. As he says (p. 20):

"With domestic demand persistently 'sick,' thanks to unconditional austerity and wage restraint, exports were Germany’s lifeline and sole—albeit cyclical—engine of growth. Protracted stagnation in Germany meant a correspondingly easier 'one-size-fits-all' ECB stance for Euroland, far too easy for the periphery, where bubbles were nourished as a result."

In fact, as the picture below (h/t Franklin Serrano) shows, real wages in Germany have not expanded with productivity and have been stagnant in the euro era, in fact falling a little bit.

Note also that Germany, in spite of its relative success, has grown over the whole euro period less than the US. A peculiar notion of successful anti-inflationary policy. Frenkel seems to suggest that Argentina may still not need to resort to the sort of stabilization (which he calls heroic) based on a nominal exchange rate anchor, but can do with normal fiscal and monetary restraint. In his view, inflation is always and in every place a matter of excess demand.

It misses the point that fiscal austerity in Germany and in Europe has had the role of keeping the working class demands in line. In other words, the very same real wage stagnation that you see above. I guess in Argentina the 'heterodox' thing to do now, if you believe Frenkel, is the old IMF/Monetarist solution, big devaluation cum fiscal and monetary contraction!

A reply to Wray - Part II

By Sergio Cesaratto (guest blogger)

“The EMU could easily have self-destructed even with no current account deficits anywhere.” (Wray here)

“Trade issues within the eurozone …will remain a point of economic and political stress even with a full resolution of the liquidity issues…” (Warren Mosler)

 In part I, I reviewed the MMT view that full monetary sovereignty is the key to full employment policies in all countries, provided that those with current account (CA) troubles have safe access to alternative sources of foreign liquidity - what is not the case in reality. I also examined the MMT’s claim that the Eurozone (EZ) cannot suffer of internal balance of payment (BoP) troubles as long as fiscal transfers from a significant federal budget backed by a genuine European CB are provided - what again is not the case in reality. In this post we shall return on Wray’s denial of the BoP origin of the EZ crisis. I agree with Wray, Bell-Kelton and other MMTs that in a currency union local states are partially deprived of fiscal policy as a tool to sustain aggregate demand[1] (without forgetting that this power is anyway in many countries subject to the foreign constraint even with full monetary sovereignty), while the institutional design of the EMU is not able to assure full employment and the preservation of the traditional European welfare state in a non-OCA. As Godley 1991 pointed out:

“The fact that individual countries no longer have their own currencies and central banks will put new constraints on their ability to run independent fiscal policies. However, the collective formulation of fiscal policy would be a far more difficult business than passive ‘coordination’. Fiscal policies of the whole Community could be co-ordinated and expansionary: but they could also be co-ordinated and contractionary. How is the common formulation of fiscal policy to be achieved? By what institutions and according to what principles?”

But Godley found even:

“more disturbing … the notion that with a common currency the ‘balance or payments problem’ is eliminated and therefore that individual countries are relieved of the need to pay for their imports with exports. Quite the reverse: the existence or a common currency makes a country more directly dependent on its ability to sell exports and import substitutes than it was before, particularly as it will then possess no means whereby it can (in the broadest sense) protect itself against failure” (hat tip to Ramanan).

Indeed, the crisis did not stem from an undisciplined fiscal behaviour of some peripheral countries – they knew very well that “markets” would have punished them (the EMU was designed for this purpose – but from the lose of competitiveness of some member countries, as Godley feared, and from some additional events brought about by monetary unification that nobody (with one exception) foresaw .

1. Leaps forward and back
The problem with the second post by Wray (here), in which he focuses on the nature of the EZ crisis, is that at least three explanations of the crisis are provided and the reader might be confused by the leaps forward and back from one to another without much coordination among the three. Godley’s stock-flows three balances are sometimes evoked, but as such they are national account relations deprived of causal explanations.[2]

None of the three explanations is per se wrong, what is lacking is a consistent framework, perhaps obstructed by the “Nostradamus race”. Let us examine the single explanations first, pointing out their respective limits as they are presented by Wray, trying later to coordinate them in a more coherent picture. In doing this I will refer to Frenkel (2012), which is however substantially consistent with, si parva licet, Cesaratto & Stirati (2010-11), Cesaratto (2012), Bibow (2012) and others.[3] One thing we should premise: each EZ country involved in the crisis is like Anna Karenina’s family, unhappy in its own way, so generalisations are not easy (see here for a quick glance of the country cases). The three explanations are: CA crisis; sovereign crisis; banking crisis. Let us begin from the former.

1.1. A current account crisis
Wray (here) quotes a “prescient” paper by Kregel (1999) to show that MMT has not neglected the CA problems within the EMU due to a progressive loss of competiveness of more inflation prone countries (including not really peripheral countries like France and Italy). Kregel also argue that a weaker euro cannot compensate the loss of EZ markets for the inflation prone countries. I fully agree that Kregel was “indeed looking at the potential for current account imbalances once the Euro was launched”. If I may indulge in the Nostradamus race, many people including myself (hundred of students may witness this) were sure of this outcome. Without downplaying Kregel’s warnings, this was the easiest part. No doubt Italy lost competitiveness during the EMU years and the same happened to the other peripheral countries. In spite of the enormous disinflation process endeavoured by Italy, Germany did better, playing its traditional game of pursuing though labour discipline an inflation rate below that of the partners within successive fixed-exchange-rate systems (Bretton Woods, EMS, EMU, cf. Cesaratto & Stirati 2010-11). The cause of the CA imbalances is not only, however, in the real exchange rate advantages of Germany (this is especially true for Portugal and Italy), but in the relatively higher growth rate of domestic demand in some peripheral countries, Spain, Ireland and Greece.[4] And this was caused, in Spain and Ireland, by the housing bubble financed by foreign capital inflows. (I also used to warn Spanish Erasmus students that the high rate of growth of Spain was paper-made - or rather bricks-made - and that Spain was accumulating an enormous foreign debt). In Cesaratto & Stirati (2010-11) and Cesaratto (2012) this is described in Kaleckian terms: the mercantilist country finances the absorption of its trade surplus by lending to peripheral countries, a process favoured by financial liberalizations and fixed exchange rates. Frenkel (2012) regards these events as analogous to those who have traditionally taken place in emerging economies. De Grauwe (1998) foresaw that the EMU would have led to a housing bubble in Spain. To sum up: Wray is correct to refer to the CA crisis as an aspect of the EZ crisis, although this has more complex features than those that any single economist (Kregel or De Grauwe) could foresee before the events took place, features that we cannot neglect now.

1.2. A banking crisis
So we arrive to the second explanation of the crisis: a banking crisis. No doubt that the sequence financial liberalisation cum currency unification could not but let (with the benefit of hindsight, of course) to a banking crisis, at least in some peripheral countries (as foresaw by De Grauwe), associated also to a foreign accounts crisis and to a fiscal crisis once banks’ problems were taken over by the state. Saying good bye to Kregel, Wray, however, seems to refer to a different sort of banking crisis as the main and independent cause of the European crisis. He mainly refers to the crisis that involved Irish banks that engaged in risky financial activities in a way not dissimilar to those that involved the Icelander banks, but it extends the case to Spain as well:

“it is much more than a current account problem ... 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… So far as I know, Warren Mosler was the first to fully understand this.” (Wray here)

I may concede that tiny Ireland had a banking crisis similar to that of Iceland (which is not part of the EZ) due to a particularly risky behaviour of banks (I am not expert enough to judge this). This is, however, generalised to all the EZ in a disputable interpretation of the crisis due to “financialization”, a view that is also shared by many mainstream economists. The banking crisis is almost completely detached from the story told by Frenkel and many others that led to the housing bubbles (that are just mentioned in passing, p.9) in Spain and, according to a World Bank report also in Ireland (and Greece!) too,[5] and to the ensuing the CA troubles. Certainly, no risky banking behaviour is behind the Italian troubles.[6] So the banking crisis as told by Wray-Mosler is of very limited if not of nil value. “Financialization” is part of the EZ story, but within the precise context that, to the best of my knowledge, only De Grauwe foresaw. [7]

More in general, “financialization” fits well in a Kaleckian (rather than Miskian) story that regards it as a way to sustain aggregate demand and the realisation of capitalists’ surplus either in the domestic market (as in the U.S. autonomous consumption bubble) or in foreign markets (as in the case of the core-periphery relations in the EZ).[8] Anyway, I myself suggested a convergence between Kalecki and Minsky in the view that capitalism is debt driven (Cesaratto 2012b)

1.3. A sovereign debt crisis
Wray is certainly correct to point out that banks’ troubles are transferred to the public sector once government bails them out. The question is then if the country has or not full monetary soveregnity:

“From the MMT point of view … 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). …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” (Wray here, my italics).

“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.” (Wray here).

“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.”

These passages are important because they show that the ultimate factor at the origin of the EZ crisis is, in Wray’s opinion, the absence of national sovereign central banks: indeed, CA deficits (as long as they correspond to public deficits only) or the associated banking crisis (as long as monetary sovereign states bail then out) appear ancillary/derived troubles.[9] We are somehow sent back to Wray’s arguments reviewed in part 1 LINK of the present post about the thaumaturgic values of either national monetary sovereignty that backs national public finances (the “born in the US” story), or of a fully federal EZ in which the ECB back a federal budget (the “had the EZ been like the U.S. it wouldn’t had a BoP crisis” story).

Beyond doubt, the EZ crisis has eventually become also a fiscal crisis. But this outcome must be placed in a fully consistent historical and analytical account of the events, otherwise the sovereign debt crisis story might perilously resemble the conventional story (mainly by the German economists and by Alesina and his associates) that the crisis originated from the fiscal profligacy of peripheral countries, a story that with (perhaps) the partial exception of Greece (with the political coverage of the Germans) is clearly false. And indeed, everybody in the European public debate knew that with the monetary unification the financial markets (not the Maastricht Treaty) were the watchdog of “fiscal discipline”. In fact, most of the peripheral government behaved in a very “disciplined” way during the EMU years and beyond. Wray and Kelton early warnings of a pending fiscal crisis in the EZ must be intended that had troubles arose from other sources – as they did – then the absence of monetary sovereignty (or of a genuine EZ central bank) would aggravate the crisis.[10]

The differences between Wray’s and my point of views are perhaps not so substantial as it may appear, since partially depend from the angle you look at the events. He finds the origin of the EZ crisis in the lack of coordination of fiscal and monetary policy either at the EMU level, as seen in part 1 LINK or, alternatively, in the lack of full national monetary sovereignty. Being in the middle (never forget out of an explicit choice of the political designers) the EZ developed a crisis that is in the middle between the U.S. crisis – sharing in common with it the housing bubble and the banking crisis – and the traditional financial crisis of the emerging economies as described by Frenkel and many others. The EZ no-solutions also depends on this being in the middle: neither the U.S. relatively efficient solution of a domestic financial crisis, not the traditional solutions in emerging economies in which the adjustment was helped by the recovery of a competitive exchange rate. Perhaps I prefer to stress the events as they unfolded in the given design, while Wray prefers to look at the wrong design of the EMU (but strangely neglecting the importance of an ordered account of the actual events that came out from the wrong design).

2. Comprehensive views
I believe that Roberto Frenkel’s (2012) synthesis of the EZ crisis can constitute a reference point and convergence field for many of us. In short, he sees a similarity between the EZ events (and those of the Baltic and Eastern European countries that pegged their currency to the Euro here) and those that typically took place in the emerging economies till the very beginning of this century. This view particularly applies to the case of Spain, Ireland and Greece. Much less to Italy that is closer to the Kregel loss-of-competitiveness case. The Irish case should also, in addition, be interpreted through the Mosler-Wray lenses of a “pure” banking crisis. According to Frenkel, the similarity with what I called the “this time is different” story (after the otherwise confused book by Reinhart and Rogoff)[11] stops here. There are al least three differentie specificae in the EZ crisis (as also pointed out in Cesaratto 2012a). One is that the EZ nations lack a lender of last resort, so that the fiscal crisis that followed the private sector crisis rapidly acquired an inertia by its own, as Wray, Kelton and Mosler presciently warned us it could. Nonetheless, a second differentia, the Eurosystem refinancing operations have made increasingly possible to domestic banks to sustain national states, so that now the fiscal and banking crisis are intertwined in a fatal embrace, one entity bailing out the other. A third is that the Target 2 scheme, as Wray (here) also points out, let the CA, banking crisis and what are called “sudden stops” (or capital flight)[12] not to explode in generalized banking and state defaults. For how long this situation can continue is not clear. It will explode for political or social reasons. But we must stop here and let this discussion for the (near) future as events unfold. (an excellent post in this regard is by Marshall Auerback).

An even more comprehensive view - that deserves further research – would read as follows. In the pre-crisis EMU years, in the Italian and Portuguese (and French) (PIF) cases the loss of competitiveness was such that a same (albeit moderate) pattern of domestic autonomous (private and public) demand was accompanied by lower output growth and growing external imbalances (notably those countries had not an housing bubble). In other words, the deterioration of the foreign competitiveness is such that the same pattern of domestic investment, autonomous consumption and government spending is increasingly generating a larger output abroad (say in the core-countries), and correspondingly less within her boundaries. Through the lenses of sectoral balances, this means that the country is running an external deficit, and by definition the foreign sector (say, the core-countries) is lending to her, what is not surprising since at the same time the foreign sector is enjoying a higher income, and therefore higher saving. The low interest rates due both to the ECB policy stance, the temporary disappearance of devaluation risk and fiscal discipline permitted to the deficit countries to keep their fiscal accounts under relative control. Nonetheless a trend leading to the deterioration of the domestic balances was there (rapidly in the Portuguese case, slowly in the Italian case; even more slowly in the French case). Once the crisis exploded, as the result of the transmission of the American and global crisis and of the mismanagement of the Irish-Greek-Spanish (IGS) situation by the EZ authorities, in particular the absence of a truly European CB to substitute the disappeared national monetary sovereignty, led to the explosion of a sovereign debt crisis in the PI. The story of the IGS countries is partially different from that of the PIF. Although they share the same underlying events of the PIF, in their case, domestic demand grew faster sustained by foreign capital flows following the Frenkel’s style course of events. The buoyant fiscal revenues gave the impression of sound fiscal finances, while the private balances rapidly deteriorated mirrored by the mounting foreign imbalances. The explosion of the housing bubbles in Spain and Ireland, the insolvency of the Greek government, and the bail out of the domestic financial sector – in the absence of the backing of a central bank - led to the fiscal crisis. As Wray and Cesaratto (2012a) say, had the EZ similar to the U.S. the crisis would have been managed as a domestic crisis involving local banks and states (letting some of them to fail, or to downsize, but supporting the local states through transfers). Had the EZ composed by monetary sovereign states, the crisis would have been managed as the typical financial crisis that often involved the emerging economies. Being in the middle, sovereign spreads reflects the solvency (not just liquidity) risk of the peripheral countries or, what it’s the same, the risk of the break up of the currency union. Be as it may, the scale of the crisis is larger than previous cases and its management very complicated, first of all from a political point of view.[13]

Conclusions
I am sincerely admired from the pieces of prescient views about the various deficiencies of the EMU that came from people associated to the Levy Institute. Yet, I feel, as many others (I’m sure many just keep silent to avoid troubles), uncomfortable with the Nostradamus race initiated by the MMTs that has, in my opinion, impeded them to work at a more comprehensive view of the EZ crisis, one that should have taken into account other contributions from a much, much larger community of heterodox (and even open minded orthodox) scholars. My impression is that the race to show that whatever others have said, one scholar associated to the Levy said it before (likely better), has let to a self-contradictory, disordered explanation of the crisis by some MMTs. I’m ready to use, cum grano salis, the insights from MMTs, while the Levy Institute is an essential lighthouse for all heterodox economists. Hope this is reciprocal. Humility is part and parcel of the scientific enterprise, especially for heterodox economists that already suffer the arrogance of the mainstream..

Addendum:
Wray (here) uses the expression “factors of production” (“One of the goals of European integration was to free up labor and capital flows, removing barriers so that factors of production could cross borders”). This term should not be employed by heterodox economists - unless you believe that a “factor of production” called “capital” measurable independently of income distribution exist, or you think that the question is irrelevant. I believe that capital theory, or distribution theory if you like, marks the boundary between orthodox and heterodox economics, no monetary issues – in principle you can be Chartalist or believe in endogenous money and be neoclassical – let alone methodological issues. Of course, once set free from the neoclassical constraints, good monetary theories and methodologies may give their best.

Further references
Barba A., Pivetti M. (2009) Rising Household Debt: Its Causes and Macroeconomic Implications-A Long-Period Analysis, Cambridge Journal of Economics, Vol. 33, Issue 1, pp. 113-137, 2009.

Cesaratto S. (2012b), Neo-Kaleckian and Sraffian controversies on accumulation theory, Università di Siena, Quaderni del Dipartimento di Economia politica e Statistica, forthcoming Review of Political Economy.

Cynamon B.Z., Fazzari S.M. (2008) Household Debt in the Consumer Age: Source of Growth—Risk of Collapse, Capitalism and Society, vol. 3, article 3.

Palumbo A. (2012), “On the Balance-of-Payments-Constrained Theory of Growth”, in Sraffa and Modern Economics (R. Ciccone, C. Gehrke, G. Mongiovi eds), London: Routledge.

Notes:
[1] Partially because the balanced budget theorem and the possibility of redistributive fiscal policies from the wealthier to the poorer citizens suggest that some space is left to expansionary fiscal policies.

[2] This is not to lessen the important educative role that the “sectoral balances approach” has had on all us in telling macroeconomic stories that take into account the simultaneous evolution of the three balances. The “sectoral balances” must, however, be part of a consistent story. Here (fn 21) I commented a passage by Wray (2009: 6-7): “‘It is the deficit spending of one sector that generates the surplus (or saving) of the other; this is because the entities of the deficit sector can in some sense decide to spend more than their incomes, while the surplus entities can decide to spend less than their incomes only if those incomes are actually generated. In Keynesian terms this is simply another version of the twin statements that ‘spending generates income’ and ‘investment generates saving’. Here, however, the statement is that the government sector’s deficit spending generates the nongovernment sector’s surplus (or saving)’. The Keynesian multiplier is clearly alluded to, but Wray’s preference goes to the ‘stock-flow consistent framework’ (SFCA). The emphasis on the accounting identities may lead to overlooking the Keynesian mechanisms that lead from one equilibrium to another hiding the fact that when the balance of one sector changes, output is also changing. It might thus convey the impression that the argument is carried out for a given level of output. Despite this I do not deny the disciplinarian role that the SFCA has on our way of thinking, obliging us to always keep in mind the necessary interrelations between the three institutional sectors.”

[3] See, inter alia, World Bank (that quotes approvingly Bibow 2012) IMF, EU Commission, Federal Reserve Bank of St. Louis, Merler and Pisani-Ferry.

[4] I frankly felt some annoyance to read this: “How could anyone—let alone an Italian economist—attribute Italy’s problems to profligate consumption of imports? Heck, back in the bad old days before the EMU (when Italy had its “high” inflationary Lira) it actually ran current account surpluses. It was the set-up of the EMU that killed Italy’s exports—exactly as Jan Kregel had predicted.” No heterodox “Italian economist” has indeed accused Italy of profligacy. Had Wray the patience (or humility) to read Cesaratto (2012a), the Italian experience has precisely been illustrated along Kregelian lines. Incidentally, Wray cites several times the German Mercantilism. He could have perhaps learnt something about its nature from my papers (in turn, I was inspired by Marcello De Cecco, the senior Italian international monetary economist, and by the nationalist/mercantilist/political realist tradition in International Political Economy and development studies). It should also be said that, according to many experts, the Italian exports did not fare badly in the last years - and the case is the same for Spain. The problem was likely on the import side. For Spain that was certainly due to the relatively high growth of domestic demand due to the construction boom, and for both likely to the loss of competiveness in the sectors were they were already weak.

[5] “The crisis in Ireland is essentially one of a boom and bust of a real estate bubble. Encouraged by the fall in interest rates that went along with the adoption of the euro, banks obtained funding from British, German and US banks, usually in the form of short-term debt, foreign-owned bank deposits, or foreign-owned portfolio equity, to expand credit to the private sector. …

Fuelled by a rapid expansion of credit, Ireland‘s housing market began to expand in 2000, resulting in a boom in property investment and construction. The wealth effect from this boom spurred higher levels of consumption and helped sustain high growth rates. Boosted by the real estate boom, Ireland's banking system ballooned to five times the size of the economy, and its external debt to over 1000 percent of GDP at the end of 2010. When in the wake of the crisis funds from the US and Britain dried up, the banking system experienced a liquidity crunch, thus slowing credit to the real estate market. As borrowing became more expensive, the demand for housing started to decline, resulting in a fall in prices and an oversupply of housing. This put pressure on the balance sheets of banks many of which had relied extensively on profitable mortgage loans to boost their earnings. The authorities‘ extensive support as well as access to emergency support from the Central Bank was vital to address financial stability concerns. Yet, the bailout or purchase of failing banks also led to a crisis of confidence, as the government bailout package reached 20 percent of GDP and the budget deficit shot to 32 percent of GDP in 2010, leading to outflows of foreign assets.” (World Bank: 17:8). The interpretation of the EZ crisis advanced by this WB report is in line with those of Roberto Frenkel (2012), Cesaratto (2012a), Bibow (2012) and others: “Overall, at the heart of the euro debt crisis is an intra-area balance of payments crisis caused by seriously unbalanced intra-area competitiveness positions and the—largely private—accompanying cross-border debt flows. And as discussed above, the common currency was central to this outcome with its impact on interest rates (both for sovereigns and for credit to the private sector), financial integration and the encouragement of export-led growth in core countries and consumption-led growth in non-core countries.” (15).

[6] Italian banks have not been involved in risky international activities with the exception of lending to Eastern European countries that pegged their currency to the Euro, particularly Hungary, with the standard dire consequences.
[7] Paul De Grauwe’s foresaw in 1998 that financial liberalisation and monetary unification in the EZ would bring about a housing bubble followed by a banking crisis in Spain: the “future euro financial crises … will in one crucial aspect be different from the financial crises recently experienced in Asia. They will not lead to speculative crises in the foreign exchange markets. Thus, if Spain is confronted by a banking crises this will not spill over into the Spanish foreign exchange market because there will be no such market. One source of further destabilisation of the markets will, therefore, be absent. The founders of EMU have taken extraordinary measures to reduce the risk of debt default by governments. Maastricht convergence criteria and a stability pact have been introduced to guard EMU from the risk of excessive government debt accumulation. The Asian financial debacle teaches us that excessive debt accumulation by the private sector can be equally, of not more, risky. This has escaped the attention of the founders of EMU, concerned as they were by the dangers of too much government debt. In the meantime the EMU-clock is ticking, while the institutions that should guard EMU from financial and banking crises have still to be put into place.” This is the standard “this time is different story” of the financial crisis in emerging economies with, as we shall see, an important novelty in the EZ crisis.

[8] Non conventional economists are divided over the deep causes of the crisis that set off in 2007-8 (Palley 2010). Minskian authors, associated to the Levy Institute in the US, tend to see it as the result of periodic cycles of financial exuberance. Many conventional economists also share this view, as suggested by their rediscovery of Hyman Minsky’s lesson. Other heterodox economists go behind the financial excesses and find their origin in the necessity of capitalism, particularly in the US, to sustain aggregate demand after the big change in income distribution that occurred over the last thirty years, from the working and middle classes in favour of an affluent thin minority of capitalists (and relative attaches) (e.g. Barba, Pivetti 2009, Cynamon, Fazzari 2008). A few of open-minded mainstream economist also share this view (e.g. Rajan; Fitoussi, Saraceno).

[9] If, as in the MMT view, public debts backed by a sovereign CB are never a problem, why should the private debts be a problem as long as they can be transferred to the public sector?

[10] As Mosler suggests: “the conditions for a national liquidity crisis that will shut down the euro-12’s monetary system are firmly in place. All that is required is an economic slowdown that threatens either tax revenues or the capital of the banking system”

[11] I do not like this book, but it is not a case that Wray has critically reviewed it (here), while I simply believe that the “this time is different” story is analytically better told by Frenkel and the Latino-American tradition including the seminal paper by Diaz-Alejandro.

[12] That is the refusal by foreign capital to roll over public or private debts. To this capital flights from residents should be added.

[13] So I am very far from the naive views Wray attributes to me: “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” (here). Or (here): “Sergio (Remember him? …) sees all this as a current account imbalance. Those Irish and Icelander consumers just bought too many imports. Living the high life up north.” I never wrote this kind of things (let alone that Iceland is part of the EMU).

A reply to Wray - Part I

By Sergio Cesaratto (Guest Blogger)

“The fact that individual countries no longer have their own currencies and central banks will put new constraints on their ability to run independent fiscal policies. … But more disturbing still is the notion that with a common currency the ‘balance or payments problem’ is eliminated and therefore that individual countries are relieved of the need to pay for their imports with exports. Quite the reverse: the existence or a common currency makes a country more directly dependent on its ability to sell exports and import substitutes than it was before…” Wynne Godley 1991

There are two aspects of the discussion that has taken place in the last weeks (here, here, here, here). The first mainly concerns my first post and regards whether monetary sovereignty is a condition both necessary and sufficient for any country to pursue development and full employment policies; the second concerns the Eurozone (EZ) crisis and was the subject of my second post. Wray mainly focuses on the second issue, and I will do the same. In part 1 of my reply I will, however, briefly dwell on the first aspect that is anyway preliminary and which will lead us to touch upon the EZ troubles anyway. The two questions we deal with in part 1 will, respectively, be: are balance of payments (BoP) preoccupations irrelevant for countries endowed with full monetary sovereignty? Can a currency union suffer of internal BoP troubles? Part 2 (will be posted later) will then be devoted to Wray’s explanation(s) of the EZ crisis.

1. Born in the US
The main argument of my first post was that monetary sovereignty, although a necessary condition for development and full employment policies, is not the magic wand to solve the foreign constraint to those policies. This constraint can be summarised as the necessity for peripheral countries – a set that include from developing countries to highly developed countries like France or Italy – to acquire enough international liquidity to finance the amount of imports generated by a satisfactory level of growth [a useful critical discussion of the theory of the balance-of-payments-constrained growth as presented by Thirlwall - and inspired by Kaldor - is in Palumbo (2012)]. Unless a country issues an internationally accepted currency, no monetary sovereignty would automatically allow fiscal policy to sustain domestic demand in peripheral countries without risking the vicious circle of a falling foreign exchange rate and high inflation. When Mitterand took power in 1981 with strong Keynesian ideas, few month were enough to change his mind – that is to realise that without the German cooperation, that was not there, no expansion in a single country was possible (unless you are ready to adopt more radical measures like import restrictions that, indeed, were in those years proposed by Godley). And that was France! This is not to say that full monetary sovereignty is not relevant, quite the opposite, in the first place in order to pursue a competitive exchange rate and in order to release more space to policies in support of domestic demand consistently with current account (CA) equilibrium. Unfortunately, at least until the late 1990s, peripheral countries have traditionally tried the shortcut of stabilising the nominal exchange rate and financial liberalisations in order to attract foreign capital inflows. In a meaningful sense the poor experience of a number of peripheral countries in the European Monetary Union (EMU) – including Spain, Ireland and Portugal - has been similar and is described on similar lines by Roberto Frenkel (2012), Cesaratto (2012a), Bibow (2012) and many others. We shall come back on this.

From the ensuing debate on blogs, FB etc, it seems that my position has convinced a number of people, likely opening the eyes to some.[1] This was very important for my country in which is very dangerous that too simple formulas enter into the political debate, already suffering of the mainstream vulgarities also influential on the left (see Cesaratto and Pivetti), and of “Berlusconism”. Of course, “Modern Monetary Theory” (MMT) as such has nothing to do with this.[2] I have also been careful to isolate the important messages that come from it, e.g. that a country with full monetary sovereignty cannot default on its sovereign debt if denominated in its own currency. This is important and refreshing, but we cannot stop there.

MMTs recognise of course that CA imbalances can be a source of troubles, but are likely not convinced. With which arguments? Let us quote in this regard a revealing passage by Wray:

“So, yes, the US (and other developed nations to varying degrees) is special, but all is not hopeless for the nations that are “less special”. To the extent that the domestic population must pay taxes in the government’s currency, the government will be able to spend its own currency into circulation. And where the foreign demand for domestic currency assets is limited, there still is the possibility of nongovernment borrowing in foreign currency to promote economic development that will increase the ability to export.

There is also the possibility of international aid in the form of foreign currency. Many developing nations also receive foreign currency through remittances (workers in foreign countries sending foreign currency home). And, finally, foreign direct investment [FDI] provides an additional source of foreign currency.”

So Wray recognise the particularity of the U.S. and of some other developed countries that, as Australia, have enormous endowments of natural resources and stable institutions. What the normal countries might do is then to appeal to official aid, to rely on remittances or on FDI,[3] or finally … to liberalise finance and commit to a stable nominal exchange rate in the attempt to attract foreign capital (what is implied by Wray’s suggestion of “nongovernment borrowing in foreign currency”). A similar position expressed by Bill Mitchell is quoted by blogger “Lord Keynes” (who has words of appreciation for my posts, thanks!) as a possible MMT reply to my view. What Mitchell says is that we should have a new and progressive IMF that alleviates the foreign constraint. But we have not it and we shall not have it, even admitting that it would be sufficiently powerful to solve the problems of big countries.[4] Well, anybody can judge the frailty of these replies.[5] So we remain with a single result: a sovereign central bank is a necessary, essential step, but is not the solution to any problem in all countries.[6]

2. Born in the EU
Of course, the renunciation to full monetary sovereignty is at the bottom of the EZ crisis, but as I argued in my posts, in the first place from the “external” point of view of the ensuing loss of competitiveness for peripheral countries and not-so-peripheral countries like Italy (we shall see in the second part, posted later, that Wray is close to recognise this in his reference to Kregel; monetary unification and financial liberalisation created further troubles on which we shall return in the second part). Wray tends, however, to deny that the origin of the EZ crisis is mainly in the foreign imbalances.

His main argument is that had the EZ been a currency area like the US, it could not have balance of payment crisis. This is so because in the US “we use fiscal policy [that is fiscal transfers] 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.” (Wray here). So the conclusion is that the EZ crisis “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.” Consider also (Wray here): “We went on to examine the claim that the Euro crisis is a simple BoP problem. That, too, is fallacious. If the EMU had been designed properly, it would not matter whether some member nations ran current account deficits—much as many US states run current account deficits.” So the problem is that the EZ is not the US, since if it were, no BoP crisis would have occurred! It is as one warns not to drive a car with three wheels and somebody else replies: don’t worry, just assume you have four. Warren Mosler’s (implicit) reply to my posts admits it: the CA imbalances are a problem that a sovereign central bank cannot solve and one solution is for the EU to have fiscal transfers of the size of the US and nobody would talk anymore of the EU imbalances. Well, but we have not this Europe and we shall never have it (I clearly myself wrote, as “Lord Keynes” correctly recalls, that the EZ could be a perfect MMT country).

To sum up, Wray’s reasoning is the following: the monetary unification might well have created CA problems (see in Part 2, to follow tomorrow, of this post his reference to Kregel). Transfers from a substantial federal European budget backed by a genuine European central bank (CB) could compensate those imbalances without much pain for the richest local states but as a component of full employment policies.[7] We may then deduct from this that since Europe has not this framework, then it suffers of a CA crisis (although a specific one, as Frenkel or myself have pointed out, we shall return on this). Wray, however, infers that since the EZ could have avoided the crisis, had it the right framework, then it is wrong to talk of a CA crisis. This sounds rather illogical, isn’t?[8] However, once the argument is presented in an ordered way – a wrong institutional design of a non-OCA precisely produces a (specific) BoP crisis – the distance be Wray and me may disappear (see Godley 1991 and Kregel). Notably, the origins of this “wrong institutional design” are not in the ignorance of the political designers. The same inventor of the OCA, the conservative economists Robert Mundell, has recently pointed out that the Euro has not been a failure as long as the ensuing disasters are leading to the destruction of trade unions and the social state, but I suppose this is also an area of broad agreement.

Notes:
[1] A commentator wrote: “The balance of payments position is MMT’s Achilles hell and more and more people are starting to realise it”. I do not think this implies that MMT has not very interesting things to say once it becomes less self-referred.

[2] Things have changed in the meanwhile. Stephanie Kelton has showed great understanding for us, and I believe that her feeling is shared also by other MMTs. We are thinking about having an event together in Rome during her visit to Italy (with Auerbach and Mosler). Even if we shall not be able to organize it, the very fact that we tried is very encouraging."

[3] In an old paper, that I quote in Cesaratto (2012), Kregel warns that FDI is a dangerous form of foreign debt.

[4] I found particularly timely the reference by Ramanan, in the discussion of one of my posts, to the Mexican case of 2008 that well illustrates a typical case of a country with full sovereign monetary that has to recur to the IMF and accept its conditionality to avoid an exchange rate crisis. He rejects the thesis, that "with floating rate currency there are always takers [of the currency] at some price” since eventually it “would become extremely profitable for some to buy stuff from Mexico." To this Ramanan retorts that if “that were the case there would have been no need for Mexico to have gone to the IMF. Now you can start arguing that the central bank didn't use this huge line of credit offered but it’s the availability of this line of credit which gave confidence to the currency markets. In this case the IMF helped but it is not bound to rescue every time. And whenever such events happen, domestic demand has to give in to stabilize the external debt. You can't simply say that there is a price and the markets clear and this is the end of the story. A fall in the currency can stabilize temporarily but this is in expectation of something happening such as an intervention. Now, if the central bank doesn't react to this, it could have created a further outflow of funds depreciating the currency further. Also banks - most importantly - have liabilities in foreign currency and an outflow can further increase this with depreciation leading to banks ending up in trouble rolling over their liabilities. It is for this reason as well that Mexico used the Fed's swap lines. In other circumstances, there is sale of reserve assets, incurring of liabilities of the government in foreign currency etc to help the currency markets function. If what you think is true there would have been no need for Mexico to have gone to the IMF at all. Unfortunately that is pure fantasy stuff. There's a huge literature on how the growth of nations is explained by the balance of payments constraint and its funny how ‘modern monetary theory’ suddenly appears as Magic Pudding Economics!” Italy, a leading industrialised country, in a similar situation had to recur in 1975 to an official German loan (that the social-democrat Chancellor Schmidt accorded using nasty expressions about Italy)

[5] I wish to be conciliatory and avoid sarcasms in this note, but these replies remind me the sentence that Rousseau attributed to Marie Antoinette: « Enfin je me rappelai le pis-aller d’une grande princesse à qui l’on disait que les paysans n’avaient pas de pain, et qui répondit : Qu’ils mangent de la brioch » . Unfortunately, like Marie Antoniette’s brioches, neither conspicuous official aid, nor a progressive IMF, nor democratic FDI that distribute or reinvest profits in the host country, nor successful currency board are there to help.

[6] The non generality of the MMT’s view has been acknowledged by “Lord Keynes”: “MMT would work very well for (1) the US, (2) those nations with strong trade surpluses (say, Germany and Japan), (3) those nations that seem to run near perpetual current account deficits but attract a lot of foreign capital (say, Australia), and (4) even the Eurozone, if it were suitably reformed with a union-wide fiscal policy, would be able to achieve full employment via MMT-style policies. In short, for most of the Western world: it certainly makes sense, and can be regarded as just a more radical form of full employment Keynesian economics. That is why Post Keynesians, by and large, are reasonably receptive to it.

To this Ramanan replied that "for most Western nations" is inexact: “Most Western includes Spain as well which obviously has a constraint. You guys will always make overkills to prove a wrong point.” Interestingly Dan Kervick added: “On neo-chartalist principles, the scope of a county's ability to generate demand for its currency would be determined by the scope of its power to tax. If the Duchy of Grand Fenwick can successfully impose and collect a tax on its people payable in Fennies, then it can successfully create demand inside its country and among its own people for Fennies. That doesn't mean it can create demand for Fennies in Indonesia simply by imposing the tax on Grand Fenwickians”. And “Bruce said”: “MMT is not a magic pill that can convert a country that is deficient in vital scientific and business skills into a wealthy nation.” (I do not believe these people are Trolls, although I much preferred that everybody would use their proper name, particularly of academics, that are without problems of professional privacy). All quotations from here.

[7] The direct intervention of the ECB to sustain the public debts of uncompetitive peripheral EZ countries is a surrogate of fiscal transfers, as Wray alludes in a discussion with Ramanan (who, of course, fully agree): “’transfer’ is the wrong word. Uncle Sam issues the currency and does not have to reduce income in one state to increase it elsewhere. … If we had a fixed economic pie then in real terms we'd be transferring real stuff to the poor regions. But that ain't true, either, as outside WWII we've never operated continuously at anything approaching capacity”. In other words, it would be equivalent if, using the MMT’s wording, a federal Bruxelles “writes a cheque” (creating a deposit at the ECB) financing “fiscal transfers”, or if the ECB directly buys the deficit countries public debt (for a clarification of the MMT’s view see Lavoie).

[8] So the presentation of my thesis that Wray provided is rather unfair: “As discussed at GLF recently, Sergio Cessaratto [sic] (and others) think we got it wrong–our claim is ‘spurious’. MMT is not useful for helping to understand the crisis. It is not a sovereign currency crisis, it is a balance of payment crisis. They have not yet explained why South Dakota or Alabama or Mississippi is not suffering the fate of Greece.” Precisely because Greece is not South Dakota, that country is suffering that fate.

Further references:
Barba A., Pivetti M. (2009) Rising Household Debt: Its Causes and Macroeconomic Implications-A Long-Period Analysis, Cambridge Journal of Economics, Vol. 33, Issue 1, pp. 113-137, 2009.

Cesaratto S. (2012b), Neo-Kaleckian and Sraffian controversies on accumulation theory, Università di Siena, Quaderni del Dipartimento di Economia politica e Statistica, forthcoming Review of Political Economy.

Cynamon B.Z., Fazzari S.M. (2008) Household Debt in the Consumer Age: Source of Growth—Risk of Collapse, Capitalism and Society, vol. 3, article 3.

Palumbo A. (2012), “On the Balance-of-Payments-Constrained Theory of Growth”, in Sraffa and Modern Economics (R. Ciccone, C. Gehrke, G. Mongiovi eds), London: Routledge.