At this point, it seems that everybody with an internet connection knows about Herndon, Ash, and Pollin’s (HAP) rebuttal of Reinhart-Rogoff’s (RR) paper on public debt and growth. Minutes after the news started to go round the web though, I was asked what I thought by friends whose interests are quite removed from economics. They were shocked that Harvard professors could make such embarrassing mistakes in their excel file, and that austerity decisions could be based on such an imprudent error.

This is my perspective

On 18 August 2011, I had shared my concerns about the ECB’s approach to financial balances that seemed to reveal:

a) a misunderstanding of how sector financial balances are logically connected; and

b) a misplaced optimism about the fact that austerity measures were helping to “rebalance” sectors.

One and a half years later, those concerns are (sadly, yet inevitably) proved warranted.

The chart below shows overall net government spending in the euro area in billions of euros (what most people call “government deficit”) and the overall euro unemployment rate.

It clearly illustrates the consequence of the austerity grip on the eurozone.

From 1999 through 2009, lacking any fiscal policy rule aimed at full employment in Europe, every time the private sector fell short of savings, the economy went into recession. Each time, this triggered the automatic countercyclical response of the fiscal balance (i.e., higher unemployment, falling tax receipts, and a larger ‘government deficits’). The rising ‘deficit’ eventually provided the greater private savings that eventually helped the economy reverse its cycle. This explains why unemployment is correlated with net government spending, until 2009.

After 2009, however, as the Stability and Growth Pact was made an increasingly harder constraint, fiscal policy ended in the grip of austerity measures, and became pro-cyclical. The standard countercyclical fiscal forces were prevented from operating, and the forced reduction of public deficits has inhibited the private sector from accumulating financial savings as desired.

Far from indicating a positive “rebalancing” of sector balances, the reduction of nominal government deficits and the simultaneous reduction of financial balances in the private sector is the symptom of a building pressure that is pushing the eurozone economy towards higher unemployment rates and economic depression.

The European Commissioner for Economic and Monetary Affairs, Olli Rehn, has said:

What I don’t understand is where on earth the stimulus money could have come from—I sincerely hope that people who are cleverer than me will suggest alternative ways of getting credit flowing into Europe.

Reuters reports that Rehn was quoted as saying:

So far, distinguished economic experts had not suggested any financially or politically realistic alternative.

I do not know who Commissioner Rehn includes under the definition of ‘distinguished’. Anyway, this is a brief lesson on ’stimulus’ (my self-imposed limit was 500 words) for Olli Rehn’s perusal.

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Demand for output depends on the private sector’s desired stock of financial savings. If households and firms deem their savings too small, they cut spending, demand drops and jobs are lost. A ‘distinguished’ economist called this the paradox of thrift.

It works like this: Anyone’s decision to accumulate financial assets entails someone else accepting more liabilities. This means that anyone trying to increase savings will only succeed as long as somebody else is willing to take on more liabilities. Lacking this condition, anyone’s attempt to increase financial savings triggers a reduction of spending by others.

This is Keynes’s cumulative effect and the reason why economies slip into recession: spending cuts by some generate spending cuts by others. And it works quite differently from the pre-Keynesian economists’ (and Rehn’s?) belief that saving by some is neutralized by the spending of others.

The way to prevent/end a recession is for the public sector to deliberately let its own liabilities increase. This means an increase in government net spending (aka “public deficit”) that adds to the stock of private financial savings and restores the flow of spending. This is quite the opposite of austerity measures that work pro-cyclically!

By contrast, the central bank can do little or nothing of this sort. It can swap a financial asset for another, but it cannot add savings to private balance sheets (except when the central bank actually spends, such as when hiring more employees, or upgrading its computer system!).

Because the euro is a currency issued by a monopoly supplier called the ECB, euro households and firms can only pay taxes if they (or their banks) first receive euros from the ECB. Thus, either the ECB lends euros, or governments must first spend euros out of their accounts at the Eurosystem. This means that public net spending is the only net source of financial savings in euros to the private sector. There is no other source, and forcing governments into austerity means cutting the flow of euros to the private sector. This is why, unsurprisingly, austerity pushed the eurozone back into recession.

So, this is the policy recommendation for Commissioner Rehn: Public net spending (tax cuts work as well) support demand and employment. This can be done by raising the deficit/GDP ceiling to 8% (with enhanced enforcement), or by cutting in half value-added taxes across the eurozone.

But wait. Would not a policy that substitutes “public debt” for “private debt” only worsen the government debt crisis? Yes, this can happen if the ECB stops backing government debt, but there is no reason it should, unless the ECB intends to lower the quality of euro-denominated wealth, and ultimately let the eurozone implode.

Far from being an emergency or questionable means of rescueing the private sector, public sector liabilities are the only source of private net financial wealth to the eurozone. They materialize in banknotes, bank deposits intermediated by banks receiving credit at the ECB, or government bonds. They are all Europe’s currency and must be guaranteed as such.

“French industrial production fell in January as Europe’s second-largest economy teetered on the brink of its third recession in four years.”

The current euro predicament has its roots in the troubles of the euro predecessor, the European Monetary System (EMS), and in the problems of the two leading countries of the European Union (EU) and of the Economic and Monetary Union (EMU), namely France and Germany.

Under the EMS, French fiscal policy was constrained by the policy of fixing the value of the French franc to the German mark. Furthermore, France was pegging its currency to the anchor of a trade surplus country, making this problem particularly acute. Pegging your own currency always creates a constraint on your fiscal policy. Pegging your currency to an important trading partner, whose growth model is export-driven, can make things particularly bad. Your partner is redirecting demand from your citizens to its firms by taking advantage of a fixed exchange rate, and you need to create demand through net government spending, but this is prevented by the exchange rate peg. It’s a catch-22.

So went the France-Germany asymmetry during the EMS.

France and Germany must have genuinely thought that a common currency would address the asymmetry. Germany, in its turn, was facing the problem of periodic realignment (revaluations) of the peg that made its export industry lose profits. And, indeed, a solution to the asymmetry could have been an EMU with federal net government spending. This would have spared France the need to create demand internally, as demand would have instead been created at the ‘federal’ level.

Nothing like this, however, was ever seriously designed. And the bottom line is that France got trapped in the same, if not worse, situation: pegging (this time, actually, ‘hard’ pegging) its currency to an export-led trading partner.

The mistaken notion that came to dominate the euro architecture debate was that countries rely on loose monetary policy and deficit spending only to cover their weaknesses; and that price-stability oriented monetary policies and fiscal discipline serve as a spur to gain structural and institutional strength. In this sense, the design of the euro appeared to be an ideal plan for creating a high-quality currency that would discipline all members into becoming more competitive and economically sound.

As my friend and former colleague Joerg Bibow has always stressed, however, the German supply-side deflationary model could only create growth and jobs by relying on some other country behaving differently, notably the U.S., with higher wage and price growth. In addition, the main economic principle that was, and still is, misunderstood, is that the demand necessary to create output and jobs can only come from private credit expansion or net government spending. And when the former reaches its limits, only the latter can play a stabilizing role with no concern regarding nominal magnitudes such as what is called the government ‘deficit’ or its ’debt’.

Germany has always resisted the notion that net government spending can be a source of growth because it has constantly relied on someone else’s deficit. It used to be the U.S., and more recently it was Greece, Spain, and Italy. And now that France is in the same currency area, the German model must look elsewhere, by exporting real goods to China and the U.S., which reduces the “GDP available at home” in Germany.

In the creation of EMU, France has always resisted on surrendering too much national sovereignty, without fully grasping that defending political sovereignty without a national currency is pointless.

And today, only France and Germany, with Italy out of the game as a result of its paradoxical (at best) politics, can find a new political compromise to save the euro. The prospects are slim though, as new proposals and ideas at European summits advance at a much slower speed than social malaise and poverty in Europe.

And Europe has seen this before: early 20s in Italy, early 30s in Germany. Good luck to us.

PS: For a proposal on how to end the recession in Euroland go here.

In the U.S. and (particularly) in euro countries, policies aimed at stimulating exports are (sadly) considered an effective response to lagging growth (U.S.) and recession (Euroland). Viewing a net export balance (i.e., an international trade surplus) as an economic virtue and a growth engine is a relic of Mercantilism that has had a powerful comeback, not coincidentally, with the abandonment of fiscal policy as a counter-cyclical tool.

The following is an illustration of the view that prevailed in the times before the neo-mercantilist revival.

Back in the 1940s, it was common to consider real living standards to be the sum of home production (i.e., GDP) minus any output sold abroad (exports) and plus any output sent from abroad (imports). The table below is reproduced from Keynes’s Collected Works (Volume 27) and had been produced by the Economic Section of the War Cabinet to study how Britain could afford an increase of living standards as compared with the pre-war period.

The index in the last column measures the change in living standards, where living standards are quantified by the volume of output available for use in the nation. This, in turn, is calculated by taking “home production” and then subtracting the exports to obtain “retained home production” and adding the imports.

The simple fact that exports represent the use of domestic resources for the production of output that will benefit foreigners has become (oddly) contentious. Perhaps, it is because of a mistaken belief that accepting that exports are a cost to the nation (and thus lower a nation’s standard of living) means that national policies should turn against exports to prevent a nation from losing any output that it worked so hard to obtain, and should aim at a trade deficit instead.

In fact, the implication of fully acknowledging that exports are a cost (and imports a benefit) is that a net export position (i.e., exports exceeding imports) is a costly one, and one that policy-makers can only justify against well-defined benefits.

How policy should consider exports (as opposed to net exports) is a question that depends on the broader context, such as the one that prevailed when Keynes was advising the Treasury during World War II. Although he was fully aware that exports reduce the nation’s living standards, Keynes claimed that “export industries must have the first claim on our attention” and that “until we have rebuilt our export trade to its former dimensions, we must be prepared to any reasonable sacrifice in the interests of exports.” Britain was then running a significant trade deficit, as exports had shrunk due to enemy action and diversion of production capacity to war production. Britain’s demand for imports, however, was high, and it could be met through a desire of foreigners to net save in pounds, or an increase in Britain’s exports. Alternatively, Britain would have to accept a weaker pound.

Lacking the foreign private sector’s desire to save in pounds (no longer backed by gold), Britain avoided devaluation thanks to the U.S. Lend-Lease Act, and (after the war) an American loan that provided the dollars to support the pound.

Concurrently, Keynes advised the Treasury that “Britain must produce enough exports to pay for what we require to import from overseas.” Far from aiming at an export-driven growth through repression of domestic consumption, Keynes saw the cost of exports offset by the benefit of providing the means to get the desired imports, while avoiding devaluation.

In other words, Keynes saw exports as a cost that is only worth if it is balanced by some perceived benefits.

How does this all matter for today’s growth policies?

A popular view of the crisis in the eurozone is that it is a balance of payments crisis caused by the growing gap in competitiveness between core and periphery countries. This view is equally used to validate austerity-based national policies repressing domestic consumption, as well as pleas for leaving the euro to regain competitiveness through currency depreciation.

This view is based on two (unwarranted) concerns. The first is that a rise in net exports is the best strategy for getting out of recession. This is obviously not true, as fiscal policy is an alternative (and more effective) solution. Yet, the attempt to use exports to drive demand is functional to the refusal to use fiscal expansion.

The second is that trade deficit countries face an unsustainable growing foreign debt. The reality is that all a trade deficit entails is an increased stock of currency-denominated savings held abroad. When this stock happens to be greater than desired, the currency will depreciate. Unless the country specifically negotiates a loan (like Britain in the 1940s), no increase in foreign debt is needed to match the trade deficit.

Rather, trade surpluses (not deficits) need to be funded. In Euroland, for example, the trade surpluses of core countries have been funded by bank loans, and ultimately government deficits of peripheral countries.

It is now a petition to the White House.

Anthony Coley, a spokesman for the Treasury Department, said the Treasury won’t mint this coin: “Neither the Treasury Department nor the Federal Reserve believes that the law can or should be used to facilitate the production of platinum coins for the purpose of avoiding an increase in the debt limit,” he said.

Interesting that the reason he gave is strictly political. He did not say the coin would create inflation, or debauch the dollar!
Read Quote of Andrea Terzi’s answer to Trillion Dollar Coin Idea (January 2013): What would be the consequences of the Trillion Dollar Coin(s)? on Quora

Ulrich Bindseil and Adalbert Winkler have co-authored a consequential paper entitled Dual Liquidity Crises Under Alternative Monetary Frameworks: a Financial Accounts Perspective.

As far as I know, this is the first time an ECB Working Paper characterizes a closed system of financial accounts as “a rigorous framework for analysis” that “has the advantage of making precise the otherwise vague interpretations of liquidity flows and policy options, and in particular how the various constraints interact.”

This sounds strikingly similar to the methodology of using flow-of-funds frameworks and stock-flow consistent models, as several economists working in the Post Keynesian, Kaleckian, and Minskian traditions have been doing during the past three decades.

A conventional criticism of the use of financial accounts in economic analysis is that they are not equipped to provide equilibrium solutions as they overlook optimization (portfolio allocation) conditions. This time, however, the two ECB researchers draw important conclusions of the ability of central banks, under alternative monetary regimes and policy constraints, to absorb liquidity shocks with no use of optimizing behavior functions, and solely on the basis of financial account consistency.

Remarkably, but perhaps not surprisingly, a number of their results resemble those developed within the theory of money as a public monopoly, or neo-chartalism. Yet, there remains a significant gap between the neo-chartalist story of the nature of money and the narrative of money used in the mentioned paper.

How does money enter the economy? The authors follow standard macroeconomic analysis (they cite Williamson’s Macroeconomics) and assume that

“at the origin of the economy stands the household/investor sector. In the beginning, this sector only holds real assets of value E (equity). The household then diversifies into three financial assets, namely deposits with banks D, banknotes B, and sovereign debt S . To the extent that the household diversifies into financial assets, it sells real assets to the corporate and government sectors. However, households do not transact directly with corporates and the central bank but use the intermediary services of banks. Households are strictly non-leveraged i.e. their balance sheet length always remains E.”

The problem here is the assumption that the private sector decides, for an unknown reason, to diversify into financial assets whose value is left unexplained. The private sector obtains financial assets by alienating the property of real assets while accepting claims in a nominal unit of account. The model, however, does not explain why any household/investor should accept such units.

The story continues:

“Corporates and the sovereign finance themselves via bank loans and debt securities issuance. We treat the government and the corporates most of the time as one sector, which is an adequate and parsimonious treatment in our model. We will distinguish between them when central bank actions relate to one, but not the other, as it is the case for a strict “monetary financing prohibition”, i.e. no central bank credit to sovereigns. The real resources that the corporate and the government sector can appropriate correspond to what the household wants to diversify in the form of banknotes, deposits and securities.”

There is an interesting parallel here with the neo-chartalist story: The government provisions itself by paying the private sector with currency. And yet, the parallel ends here. In the neo-chartalist story, the private sector accepts the currency because it is the only means to pay liabilities to the government: taxes create a demand for currency. By contrast, the story told by our authors is that there exists an autonomous demand by households to acquire financial assets that the government (and corporates!) would meet by issuing debt and banknotes. While a form of real debt (i.e., a liability in terms of real assets) would offer no logical difficulties, a debt denominated in nominal units does raise a logical problem: Debt may be paid in banknotes, but why would anyone in this economy demand banknotes? Missing here are both, an explanation for the demand for currency (and thus debt denominated in units of the currency) as well as an explanation for the desire to accumulate financial savings.

The authors continue:

“The corporate and the government sector use the real assets for idiosyncratic illiquid projects (machines, schools, etc.). If the corporate and government sector can no longer roll over the loans obtained from banks and the debt securities issued, they would have to sell their assets at lossmaking prices (e.g. a sophisticated machine being sold as old metal). However, we do not model this case explicitly as we are looking for the conditions that this case can be avoided.”

Indeed, in this model, the central bank is the sole currency issuer. Limits to its capacity to supply “an elastic currency” are the result of “specific central bank policies like collateral policies, monetary financing prohibitions and quantitative borrowing”.

“Debt instruments are issued by the corporate and government sector in exchange for real assets held by households. By contrast, the provision of credit based on the diversification of household assets into banknotes and bank deposits runs via banks. The banking sector is the intermediary between the remaining sectors. First, it offers deposits D to households and invests them into loans to corporates.

Describing the process as banks offering deposits and investing them into loans is a peculiar flaw in the reasoning: If banks intermediate, they do so by making loans to corporates that corporates use to buy real assets from households. This means that loans create deposits, and not vice versa.

“Second, the sector is an intermediary to the operation between the households, the corporates/government and the central bank encompassing the issuance of banknotes B. Banks use banknotes to purchase real assets from households, which they sell on to corporates who finance them through a loan from the bank. Thus, total funding and hence total assets held by banks amount to B + D. Finally, banknotes are issued by the central bank who provides them to banks through collateralized credit operations.”

Although the representation of the chosen financial system lacks a rigorous explanation of why nominal debt is accepted, the authors obtain a notable result: If a country “is linked with the international financial system through a flexible exchange rate with no or limited borrowing in foreign currency”, then “a central bank that operates under a paper standard with a flexible exchange rate and without a monetary financing prohibition and other limits of borrowings placed on the banking sector is most flexible in containing a dual liquidity crisis.”

Not surprisingly, given the unexplained nature of currency and debt in their model, they cannot conclude that government net spending is never operationally constrained by revenues, i.e., that the government can always make any and all payments in its own currency. But they got closer than any ECB paper so far.