PIGS in Madrid

This is the introduction by Sergio Cesaratto at the Meeting in Madrid Economy4Youth held 22-3 November 2012. Press coverage includes here, here, here, here and here, so far. The videos are here, but some better quality videos will likely be posted.

PIGS in Madrid

By Sergio Cesaratto* (Cesaratto@unisi.it)

Dear students and colleagues, ladies and gentlemen, companeros y companeras (if I am allowed to say so), I wish first of all to thank the organisers and the supporters of this event. I believe this is a beautiful opportunity to work side by side with the young people who are fighting against the present state of things and the critical economists. This is not a conference against Europe, or of one part of Europe against the other. As people of “troubled Europe” we feel perhaps more concerned than the majority of our northern fellows. But I think that the message of this meeting should arrive especially at your young northern fellows not just asking for solidarity (a word that I personally look suspiciously at), but because the dismantlement of the social rights in our countries might be the premise to the reduction in their own. I believe that they would defend the idea of their countries being part of a peaceful and prosper continent, and be outraged by the idea of their countries as islands in the midst of deprivation and resentment. I also believe that youth is the time of hope and generosity, the time in which the outrage for social injustice is felt the most. So I hope that our messages, the messages from the young people here, will arrive at the most sensible ears of northern Europe, those of the young people there (let us not forget here the young socialists massacred by the crazy Nazi guy in Norway). It is particularly important that, through any possible channel, more information about the situation in our countries be directed at the likely victims of disinformation, be they youths of Germany, Austria, the Netherlands etc,. We should take some initiative in this direction.

The story of the crisis
The story of this crisis is the story of an imperfect currency union. It is not yet clear to me which political processes led to the European Monetary Union (EMU). Unfortunately economists tend to neglect the analysis of the political processes, and indeed our aim is also to reform the way Economics is done and taught. From a rational point of view, the national leaders and their economic advisors certainly knew that the European Union was not a so-called optimal currency area. Various considerations possibly led to this imperfect union. France and Italy were not happy with the European Monetary System (EMS), the fixed exchange-rate that preceded the EMU: they though that a monetary union could be less German-dominated than the EMS. The German unification in 1989 and the fall of the iron curtain possibly accelerated the process (Germany has traditionally looked east, and the monetary unification was perhaps seen as a way to lock it west, but I cannot judge if this is a legend). Finally, through the common currency the elites in the periphery wanted to import the German renowned labour discipline. Be that as it may, the monetary union lacked the institutions that could make it work, in particular the significant federal budget with regional redistributive functions recommended by earlier unification plans (see also the prescient analysis by Kaldor and later by Godley). The union was designed in negatives, so to speak. To prevent national governments to take too advantage of lower interest rates, the Maastricht Treaty created the famous Maastricht fiscal constraints; the ECB was assigned a monetarist statute with the sole objective of controlling inflation (so that it inherited the Bundesbank function to keep German wages in check). The objective of full employment was assigned to national labour-market flexibility policies, that is to competitive internal devaluation strategies. No to a wider federal budget, no coordination of fiscal and monetary policies, no banks crisis resolution mechanism.

As we know, at the beginning the Euro seemed a success, particularly if judged from the point of view of Spain, Ireland and also Greece. Not much so for Portugal and Italy: the former country already had its demand-led boom in the years before the monetary unification and joined the currency with a negative current account, which explains its later stagnation. Portugal and Italy - but of course this partially also concerns the other southern countries - likely began to suffer from a loss of competitiveness due to more than one factor: an over-valued real exchange rate, the competition from the EU new entrants and from the emerging economies, the stagnation of domestic aggregate demand that depressed productivity growth In Portugal and Italy. As is well known, in Spain, Ireland and also Greece domestic demand was indeed sustained by a construction boom fed by foreign capital flows. The story has been usefully compared to that of the financial crises in the emerging economies: financial liberalisations and fixed exchange rates can easily lead to foreign capital flows that sustain a residential investment-led growth, ending later in a balance of payment crisis. This happens when foreign financial investors stop the refinancing of the peripheral foreign debt and begin to withdraw their investment (what is named “sudden stops and capital flows reversal”).

The peculiarities of the Eurozone (EZ) payment system, the famous and arcane TARGET 2 system, have impeded the eruption of the standard foreign debt crisis, with attendant debt restructuring and currency devaluation, which has been typical of the emerging economies. In this kind of crisis, typically the IMF intervened to assure that the indebted countries could continue to repay the interest and the principal of their foreign debt (so the IMF “saved” the banks of the north); normally the debt was renegotiated; fiscal austerity measures were imposed to obtain a current account surplus necessary to assure the future ability to serve and repay the debt (including that to the IMF); the currency devaluation relieved a bit the country in this effort. Notoriously, Argentina by refusing to repay 75% of her debt avoided the IMF austerity measures and, also helped by a buoyant price of her exported commodities, could manage a demand-led recovery. What has happened in Europe is that, through TARGET 2, the foreign debt of the peripheral countries has “changed hands”: from a liability towards private lenders (who withdrew their loans) it has become a liability towards the Eurosystem (the German conservative economist Werner Sinn has not been wrong in calling it a “stealth bail-out” of the periphery, although he missed to point out the German responsibility in this story. I also agree with him that this re-shuffling of liabilities has not made the German credits safer, contrary to the initial opinion by De Grauwe). In a sense TARGET2 helped to gain time, but this time has so far been wasted by the EZ governments. While no reforms of the institutional architecture of the EZ have been endeavoured, the EZ followed a wrong diagnosis of the crisis that, through austerity, made things much worse.

The peripheral governments have indeed basically backed the German interpretation of the crisis as caused only by the borrowers ( although the SPD also vaguely accuses the deregulation of the financial sector) and by the fiscal profligacy of the peripheral governments. This interpretation overlooks that the peripheral current account deficit financed by the northern capital flows sustained imports from core-Europe. Moreover, it forgets that the fiscal crisis was the result, in Ireland and Spain, also of the bailout of private banks, while the Italian public debt was much older and Italy before 2008 violated the fiscal pact much less than Germany and France. While the Greek centre-right government might have relied too much on an endless cheap foreign support to its public debt, it should not be forgotten that Greece has also been a excellent market for German exports (and possibly still is for the German and French armaments). Be that as it may, lenders are as much responsible as borrowers. But core-Europe is responsible for the crisis in an even more important way: its neo-mercantilist behaviour. The financial liberalisation and the fall in the devaluation risk (the ‘convertibility risk’ as Draghi calls it) and the consequent indebtedness of the periphery have indeed been functional to this behaviour.

This is an old story, indeed. Since the early 1950s Germany took advantage of fixed exchange rates to pursue an export-led mode. The three institutional pillars of the German low-inflation model were

- a paternalistic State, both with regard to the general welfare of the working class (the famous Bismarkian social state) and to trade (the German government has clearly foreign trade and foreign investment policy as its top priority, as the resignation of one President of the Federal Republic reminded to us: he candidly confessed that Germany sent troops to Afghanistan for commercial reasons).

- an accommodating labour movement;

- the Bundesbank as the watchdog of German labour discipline.

Wage moderation, the relative compression of the domestic market and the other countries’ Keynesism made the model successful: it has guaranteed a high standard of living in a self-fulfilling model in which the pursuit of trade surpluses promoted domestic labour discipline. The model was reinforced at the inception of the Euro by the SPD-inspired labour reforms. Although the model assured relatively high wages, following Kalecki we can regard it as a way for capitalists to maximise the level of the “internal surplus” - that is of what remains to them of the social product after having paid wages - and get rid of it (or realize it in Marxian terms) in foreign markets.

Note the parallel here between the U.S. and the EZ crises. In both cases residential investment bubbles (and more in general autonomous consumption financed by consumer credit) within a currency union sustained aggregate consumption from a middle class otherwise impoverished by decades of real wages stagnation. The internal geography, so to speak, changed, but the logic is similar. What is different is, of course, that the U.S. as a complete Federal Union had the will and means to deal with the crisis through monetary and fiscal policies and by implementing bank crisis resolution mechanisms, while the EZ as an imperfect Union retreated back to nationalistic behaviours.

There is a lot of things we must imitate from Germany – and the German people should in no way be regarded here as an enemy. There is a ‘benign’ form of mercantilism (quotation here) that consists of a developmental state promoting welfare and productive capacity. This form of economic nationalism is not at odds per se with a domestic demand-led growth and international economic cooperation. But the German hyper-nationalistic economic model has always constituted a problem for the world economy, and it is basically incompatible with the working of the EZ. This has been defined as malevolent mercantilism (quotation here). The suggestion that all the EZ countries should imitate Germany is a zero-sum game: a suicidal competitive deflation strategy. As Soros summed up, Germany has to lead or to leave.

As I said, I believe that we should decide here a strategy of communication with the German new generations, the only ones that perhaps have not yet suffered for too long from the Build, FAZ, BuBa etc. brain washing. Our student organizations should ask their German twins to be invited in the German Universities to explain the dramatic situation in our countries and the importance of a collective responsibility to bring Europe away from this self-destruction. A specific open letter might be prepared in this meeting in this direction and addressed to the main German Youth organisations (including the SPD’s Jusos, LINKE, Grunen etc.) The rich and generous German progressive foundations might be asked to finance this initiative: one hundred delegations from PIIGS countries to visit one hundred German universities. Germany has to decide if she wants to lead a prosperous Europe or if she just wants a backyard of impoverished countries, possibly a pool of unemployed labour for her ageing population. We must be competent enough to explain the terms of the situation to our German fellows, and so it is important that the interaction with the critical economists continues. It is also important that the European dimension of the crisis is fully endorsed by the movements.

In view of the German neo-mercantilist behaviour, a debate about the causes of the EZ trade imbalances has developed: one thesis emphasizes the structural lack of southern competitiveness often attributed to an unsustainable wage dynamics; more plausibly, another thesis argues that the trade imbalances are mainly due to the combination of the repressed German domestic market and wage moderation, and of the residential-investment demand-led growth in some peripheral countries. This led to higher inflation in the latter and to their loss of competitiveness. In this view, real wages are not the cause of the higher inflation and real exchange rates losses, rather the service/non-tradable sector, protected from external competition, appears to be the cause. Spain seems the typical example (the PIIGS families, as the Anna Karenina unhappy families, are each miserable in her own way, so it is always difficult to generalise). This debate is important to focus on – also in view of some discussion that has taken place on the manifesto of the meeting (I particularly sympathize with the comments by Jorge Uxo). What Europe seems to need is not so much a structural change in the periphery, but rather a German-led aggregate demand growth. This would help to rebalance the EZ. Inspired by an analysis of the periphery problems as due to too rigid labour market institutions and too high real wages – again a wrong diagnosis of the crisis – the widespread labour market reforms and wage deflation have negatively affected consumption demand, thus aggravating the crisis.

All in all, the way Europe has dealt with the crisis has been too little and too late (to kick the can down the road, as it has often been said). But even worse: the austerity imposed on the EZ has made the crisis worse. It may well be said that at present austerity is the main cause of the crisis.

The policies
The main policies so far have been:

a) Bail out packages (ESFS; ESM): used to bail-out Greece, Ireland and Portugal. They have a basic problem: the troubled countries also put the money, so Italy and Spain “loaned” money to their smaller troubled fellows to save the German banks (note that Germany lends at very convenient rates, and borrows also at very profitable rates, the opposite is true for Spain and Italy). Anyway, Spain and Italy cannot save themselves in case they need to be bailed out (it would be a vicious circle, somebody drowning cannot help herself): so the only real money would be from Germany: too much even from this mighty country. To make things worse, the bailed-out countries have been imposed a counterproductive austerity that made the crisis and public finances worse. Presently, everybody is realizing that Greece will not able to redeem the official loans it received (used to save the French and German banks). OSI (Official Sector Involvement) is the new EZ-acronym.

b) The ECB intervention has been limited to the early summer 2011 when the central bank bought about €200bn of peripheral sovereign bonds, without any persistent effect on the sovereign spread. Only an unlimited guarantee can obtain this result.

c) The liquidity made available by the Eurosystem assured that the banking system in the periphery did not collapse in view of the capital flights to core-Europe. As said, the liabilities of the periphery towards the private core-European investors have been substituted by the “official” TARGET2 liabilities towards the Eurosystem. Since most of the capital flights consisted of previous investment in peripheral sovereign debt that foreign investors progressively refused to refinance (roll-over), banks used the liquidity to sustain their respective domestic sovereign debts (In Italy, for instance, the share of foreign-held public debt has fallen form 60 to 30 per cent. This does not mean, however, that the Italian foreign debt has fallen: private loans have just been substituted by TARGET2 loans). What all this produced is that fragile banks sustain fragile states, and fragile states back fragile banks. What we would instead need is an ECB support to sovereign debts and a bank resolution mechanism: a European bail out of banks and deposit insurance (measures that cannot be left to national governments). Both measures would not hit the core-countries tax-payers as far as the intervention of the ECB keeps the sovereign interest rates at bay. The results of the European summit held at the end of June 2012 have been disappointing in this regard: no European banking crisis resolution mechanism seems to be in view.

d) From Summer and Autumn 2011 also Italy and Spain were inflicted various austerity packages. Italy was imposed a change in government with the implicit promise of an ECB intervention that never materialised. In addition, in Spring 2012 the EU approved the six-pack and the fiscal compact directing the EZ countries to balance their budget and to reduce the sovereign debt/GDP ration at 60% by year 2020. The logic of the austerity policy is as follows, austerity leads to credibility, which leads to lower interest rates on sovereign bonds and thus to recovery.

As a mounting evidence is showing, this option simply does not work and will not work.

e) Following his famous August declaration (“The ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough”) in Sept. 2012 Draghi launched his OMT plan [Outright Market Transactions is the way the ECB defines the open market operations (OMO); in the ECB’s jargon OMO means bank refinancing operations]: the ECB cold intervene in the secondary markets buying, in principle, an unlimited amount of sovereign bonds (the big bazooka, although restricted to up-to 3y bonds); the countries asking for assistance should, however, subscribe to an austerity memorandum with the EU surrendering their national fiscal sovereignty. The idea of OMT is that lower interest rates will render austerity a bit less tough, so that unsustainable social unrest (so-called “austerity fatigue”) can be avoided, credibility regained, and maybe - the trust of financial markets being restored - some growth will appear, etc. The ECB will not pre-commit a given interest rate (or a given level of the spreads), so as to be able to blackmail in any moment governments, and anyway the reduction should not be too much, with a view to avoiding moral hazard, that is the temptation of dodging the “structural reforms”, cuts in public spending and labour market reforms. So the OMT does not really break with austerity policies asking the peripheral countries to surrender further national sovereignty to Bruxelles.

As known, the mere announcement by Draghi of this measure determined a fall in the Spanish and Italian sovereign spreads of some 150 basic points. This made plain to the public that the interest rates are determined by the central bank and not by the market, unless the central bank does nothing. It also showed that it is not necessary for the central bank to intervene and buy: the deployment of the big bazooka is enough to intimidate the markets.

We should finally mention the blah blah going on in Bruxelles on a European Federal Budget, nothing very serious, some bland anti-cyclical fund, nothing to do with a real redistributive Federal Budget (in fact, the existing small EU budget has been cut!). Indeed when Germany thinks of a European fiscal policy, it is just proposing the assignment of a pro-austerity power on national sovereign budgets to a fiscal authority in Bruxelles.

Alternative policies
Alternative policies have also been proposed and discussed.

Eurobonds
In my opinion Eurobonds are not an ultimate solution since by putting all sovereign debts in the same pot, the “credibility” of the German sovereign debt would be negatively affected and the political support by Germany undermined. A pan-European sovereign central bank that guarantees a European sovereign debt is the necessary measure to avoid this result. But if the ECB provides this guarantee, do we still need the Eurobonds? Perhaps yes, if the change in the statute of the ECB is deemed to be accompanied by a centralization in Bruxelles of fiscal policies. But this should not be done along German lines, however. The old French proposal (not of shy Hollande, tough) of a stronger Eurogroup that should be transformed from an informal club into the institutional fiscal counterpart of the ECB would be a good compromise to avoid an EZ fiscal Kaiser (the Germans have always refused this change because a political body would be stronger than a technical body like the ECB).

An alternative proposal
My favourite proposal is of an ECB intervention to calm markets down (the big bazooka) conditioned by a fiscal rule; this should consist of the stabilisation of the public debt/GDP ratios (not their reduction). This will be consistent with deficit spending policies. I would call it an “expansionary conditionality” or “Keynesian conditionality”. The rationale is that the savings obtained from the reduction in the interest rates should be used not to reduce sovereign debt/GDP ratio, but to sustain aggregate demand; the larger fiscal revenues will help the stabilization of the ratio. This is the most practical, politically reasonable proposal I can think of.

In addition we need:

- a solution to the banking crisis and a separation of sovereign and bank crises (this would be easier if the European state intervention is backed by the central bank)

- a looser wage and inflation policy, so to let wages rise especially in core-Europe in order to sustain aggregate demand. To this scope we need the right institutions, first of all a cooperative ECB that tolerates a higher inflation target and stops for good being the watch-dog of German wages. Instead of destroying the Trade Unions, the EZ south needs strong TU and income policies, plus measures to modernise the non-tradable sector, the source of the core-periphery inflation gap.

Many other things we need to do, but I do not like endless shopping lists. Let us focus on the macroeconomic measures first.

There are at least two further, opposite alternatives to be briefly discussed, a Federal Europe and a Euro break-up.

A Federal Europe
Optimistic Europhiles are thinking of the crisis as an opportunity to create a Federal Europe. The US could be a good example for a working Federal State from the point of view of fiscal and monetary policies, although less for social policy. We may, of course, dream of a progressive Europe, with social fairness and full employment. Of course Treaties in this direction should be re-written (including the ridiculous EU “Constitution” that says that the ECB must be independent and pursue price stability first). A Federal Budget should progressively be created, perhaps along the lines of the McDougall report of 1977. But I suppose this is not for this generation. The Spanish experience with Catalonia shows how much even old and consolidated states are fragile once exposed to external shocks (the austerity has clearly generated the Catalan resentment against the rest of Spain – that is, by the way, a market for Catalonia, as the Italian Mezzogiorno is for the Italian north).

A Euro Break-up
I am not able to assess how dramatic this event could be, there are different opinions. What is sure is that there should be a preliminary European political agreement, and a lot of peaceful financial negotiation later. The EU must be saved. A German exit might be easier, but do not underestimate the governance problems of a Southern Euro. We must study this, and our governments should study it to have a card to play to deal with Germany. It is clear that Spain, Italy and the other smaller southern fellows cannot endure this situation any further. We must therefore accompany our “reasonable” pro-European proposals with the option that we might go “our way” (a Mercosur with preferential ties with Latino-America and North Africa?).

Our duties
We have a difficult future ahead. But our fathers and grandfathers also had a difficult future ahead. I thought I belonged to a lucky generation that did not suffer hunger and wars, and the same I expected for my sons. It is not anymore true (at least we have not wars, yet). I assumed to be living in a situation in which any single individual was cared by society. It is not true anymore: we see a cynical ruling class, that includes Rajoy and Monti, literally destroying the lives and hopes of entire generations, old and young people alike. But we must fight and resist. Our specific duty as students of Economics and critical economists is to put the European question at the centre. The current European leaders must decide if they want to save Europe or not. They are the anti-Europeans, not us. We must explain to our fellow citizens that austerity is a policy choice and not a compelling fate, that different policies that would save Europe and prosperity are feasible. You must talk also to your young core-European fellows. If I am sceptical about solidarity, youth is the time for solidarity and change. I am sure they will listen. To do this, we must also fight to defend the space for critical economic thought in our universities. The Italian students of LINK have in this regard launched a petition that they will explain. We must defend critical Economics so as to be better trained in view of the tremendous challenges we have ahead. Good luck to all of you, and thanks.

* I thank Jorge Uxo for preliminary comments and Giancarlo Bergamini for valuable help in improving the exposition.

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).

De Grauwe moment: an impressively prescient prediction of the Eurozone balance of payments crisis

Sergio Cesaratto (Guest blogger)

In an article in the Financial Times written one year before the onset of the European currency union, Paul De Grauwe presented a farsighted conjecture of what could follow, something most economists have only recently realised.[i] Indeed, with the benefit of hindsight, the European crisis appears now as the nth ‘this time is different’ episode of the financial liberalisation sequence cum fixed exchange rates, capital flows from the centre to the periphery, housing bubble, current account (CA) deficit and indebtedness, default. Although I find Reinhart and Rogoff (2009) to be a poorly organised account of the history and nature of defaults, their title really conveys the sense of a recurring pattern of unfortunate events. The title of a seminal paper ‘Good-bye financial repression, hello financial crash?’ (Diaz-Alejandro, C. 1985) also sums up the essence of those events. In order to better appreciate prof. De Grauwe’s insight I introduce his article with some notes from a just published WP of mine “Controversial and novel features of the Eurozone crisis as a balance of payment crisis”.

Popularized by Martin Wolf (2012), the interpretation of the European crisis as a balance of payment (BoP) crisis is becoming dominant. Accordingly, the cause of the crisis must be found in the easier access for a number of peripheral EMU countries to the European financial markets at low nominal interest rates. Financial liberalisation and the removal of the exchange rate risk encouraged massive capital flows from core to periphery countries in the ‘periphery’ (e.g. Merler and Pisani-Ferry 2012). Credit-financed autonomous consumption determined a growth both of domestic demand and of nominal wages higher than in core-EZ. Higher inflation rates in the periphery determined low real interest rates, a further support to domestic demand. The growth of domestic demand was associated to a housing bubble in Spain and Ireland, and to the growth of public spending in Greece. This sequel of events, and its consequences, foreign indebtedness and ‘sudden capital stops’ are basically not so different from those that typically took place in developing countries and ended in sovereign defaults (Frenkel, Rapetti 2009: 688-89; Reinhart 2011: 27-9).

A traditional objection to the interpretation of the EZ crisis as a typical ‘this time is different’ crisis is that there cannot be a BoP crisis in a currency union. The question is that the EZ is a hybrid between a full currency union (which also implies a fiscal union) and a traditional fixed exchange agreement. One main difference with the latter is that in a currency union capital flights are automatically compensated by the CB, in the EZ by TARGET 2 (T2) (Febrero et al. 2012). As everybody knows, assuming zero variation of foreign currency reserves, the BoP sheet would read: CA + KA = 0, where KA is the capital account. Normally, in a two countries world, if country A has (all magnitudes are balances) a negative CAA-, country B symmetrically shows CAB+, then KAA + and KAB- (country B is lending to country A). Suppose country B does not lend to country A (so the CA flow imbalance is not financed), and even worse that there are capital outflows from country A (so the stock of debt acquired by B in the past is not rolled-over as it expires). Then both CAA- and KAA-, so that CAA + KAA < 0. What happens in a currency union is that through T2: CAA + KAA + T = 0, where T > 0 means that country A is overdrawing from its CB account. It is as if the ECB were creating foreign currency reserves in a fixed exchange rate system (Leppanen 2012); or as if the deficit countries were creating the international reserves, like the U.S. in Bretton Woods (I or II) (Kohler 2012); or better still, it is as if the EMU worked in an ultra-Keynesian fashion as an International Clearing Union (ICU), with even less prudence than Keynes envisaged (I suppose I am the first to note this similarity).[ii] With T2, the EZ country A has indeed an infinite overdraft possibility (Milbrandt 2012 CESifo). What has happened in the periphery from 2007/8 is that CAA- and KAA -, T+ and symmetrically in the core: CA +, KA +, T- (core-banks receiving hot money from the periphery and reducing their overdraft at their NCB).

Not so paradoxically, given the hybrid nature of the EMU: ‘If, in the framework of a political union, the euro central banks were integrated as dependent branches of the ECB, the consolidation of the branches would dissolve the Target balances in thin air.’ (Neumann 2012; also Ulbrich & Lipponer 2012 CESifo Forum). This makes clear that through T2 the ECB is acting as a regular CB: normally banks rely on the interbank market to finance their imbalances (when they fall short of reserves); if, in exceptional circumstances, this does not work the ECB just fills the gap. As Eladio Febrero wrote to me: ‘If you move your savings from a deposit in Banca Intesa to Unicredit, and the former has no reserves deposited in the Banca d’Italia, the latter would create money and then credit the reserve account of Unicredit so your money would be there now. Then Banca d’Italia would acquire a claim on Banca Intesa. …It should be noted that if Banca d’Italia in the example just above, or the European System of Central Banks (in this discussion on T2) does not provide the banking system with liquidity, the latter would collapse: there would be a bank run and the whole economic system would have very serious problems.’ So, in this respect EMU is not like, say, the EMS. If the ECB interrupts T2 (i.e. it stops acting as a CB with the peripheral banks) this is the end of the EMU. Of course, T2 is not the cause of the problems, but it prevents the EMU from exploding as the EMS did in 1992.

In this regard one might think that if the EZ was a real Federal State, the financial crisis would be a ‘normal’ domestic crisis: if some local banks and some local governments (deprived of monetary sovereignty) are not solvent, nobody would talk of a BoP crisis. Even considering the grand scale of the EZ crisis, a ‘normal’ state would intervene by socializing part of the local government and banks’ debt, imposing austerity and balanced budgets on them; saved banks would be nationalised, restructured or shut down. The CB would cooperate by sustaining the sovereign/federal debt. At the same time the Federal administration would use fiscal transfers to attenuate the crisis. Fine, but this is not Europe! If it were, it would manage to solve the situation without too much hardship.

The question is that the EZ is a hybrid, in between a fixed exchange rate system among independent countries and a fully integrated economy, sharing the possibility of a BoP crisis with the former and national banking principles with the latter. In this spurious set up the ECB has acted somewhat similarly to the FED: through T2 and LTRO it is injecting liquidity and absorbing toxic assets as collateral, letting insolvent local banks and governments survive (although the lack of direct ECB intervention to sustain sovereign debts is putting the solvency of the Spanish and Italian governments in jeopardy by letting the sovereign spreads to explode affecting the in turn the solvency of domestic banks that carry plenty of their bonds).[iii] A fiscal pact has been imposed, but there is no Federal government assisted by a SCB on hand to heal the local states and banks. To sum up, the EZ crisis is not a classical fixed exchange rate crisis (as De Grauwe foresaw) ; it is not a domestic financial crisis; it is what it is: a BoP crisis in an imperfect currency union. If the union were perfected, the crisis could be solved in the same way as a traditional domestic crisis. If it is not perfected, it is an unedited BoP crisis with a still unwritten final.

References

CESifo (2012), Forum Volume 13, Special Issue January.

De Grauwe Paul (1998), The Euro and the Financial Crises, Financial Times, February.

Diaz-Alejandro, C. (1985)Good-bye financial repression, hello financial crash, Journal of Development Economics 19, 1-24.

Febrero E., Uxó J., Bermejo F. (2012), El funcionamiento del sistema TARGET2 desde la Gran Recesión. Una aproximación desde la óptica del circuito monetario, XIII JORNADAS DE ECONOMÍA CRÍTICA, Sevilla, February.

Frenkel R. and Rapetti M. (2009) A developing country view of the current global crisis: what should not be forgotten and what should be done, Cambridge. Journal of. Economics. (2009) 33 (4): 685-702.

Keynes, J.M. 1980. Activities 1940–1944. Shaping the Post-War World: The Clearing Union, Collected Writings of John Maynard Keynes, A. Robinson and D. Moggridge (eds), volume 25. London: Macmillan.

Kohler K. (2012) The Eurosystem in Times of Crises: Greece in the Role of a Reserve Currency Country?, in CESifo (2012) 14-22

Leppänen O. (2012) Eurosystem TARGET balance deviations call for cautious changing of the EU banking landscape, http://www.voxeu.org/index.php?q=node/7884
Merler S., Pisani-Ferry J. (2012), Sudden stops in the euro area, Bruegel Policy Contribution, March.

Milbradt G. (2012) The Derailed Policies of the ECB, iun CESifo (2012), 43-49.

Reinhart C.M., and Rogoff K.S. (2009) This Time Is Different: Eight Centuries of Financial Folly, Princeton University Press, Princeton.

Reinhart C.M., (2011) A Series of Unfortunate Events: Common Sequencing Patterns in Financial Crises, Rivista di Politica Economica, Vol 100 Nopp. 11-36

Ulbrich J. and Lipponer A. (2012) Balances in the Target2 Payments System – A Problem?, in CESifo (2012): 73-76.

Wolf M. (2012), Why the Bundesbank is wrong , Financial Times 10 April.

Notes:

[i] Hat tip Paolo Borioni and Ronny Mazzocchi.

[ii] Indeed Keynes regarded the ICU as an extension of the principles that govern a national banking system, the same principle that informs T2. In 1941 he even called it ‘Currency Union’. In famous passages, he wrote: ‘In short, the analogy with a national banking system is complete. No depositor in a local bank suffers because the balances, which he leaves idle, are employed to finance the business of someone else. Just as the development of national banking systems served to offset a deflationary pressure which would have prevented otherwise the development of modern industry, so by extending the same principle into the international field we may hope to offset the contractionist pressure which might otherwise overwhelm in social disorder and disappointment the good hopes of the modern world. The substitution of a credit mechanism in place of hoarding would have repeated in the international field the same miracle, already performed in the domestic field, of turning a stone into bread’ (CW 1940-44: 75). But he was also very cautious: ‘In only one important respect must an International Bank differ from the model suitable to a national bank within a closed system, namely that much more must be settled by rules and by general principles agreed beforehand and much less by day-to-day discretion. To give confidence in, and understanding of, what is afoot, it is necessary to prescribe beforehand certain definite principles of policy, particularly in regard to the maximum limits of permitted overdraft and the provisions proposed to keep the scale of individual credits and debits within a reasonable amount, so that the system is in stable equilibrium with proper and sufficient measures taken in good time’ (CW 1940-44: 45).

[iii] The Greek, Irish and Portuguese governments are already insolvent. Note also that the solvability of Spanish banks is anyway precarious after the burst of the housing bubble.