Policy Research in Macroeconomics

Lessons for the Euro Area – a simple model of savings, debt & private spending

With the election of President Macron in France, and renewed discussions about the future of the Eurozone, PRIME is keen to engage in the debate on the way forward. We post here the introduction to a 2016 essay by Professor Andrea Terzi, together with the pdf link to the full essay. Andrea Terzi is Professor of Economics at Franklin University, Switzerland, and Research Associate at Levy Economics Institute of Bard College, USA.  

In the year 2010, “Eurozone crisis” became the catchphrase to describe the condition of Europe’s Economic and Monetary Union (EMU) living through its first existential crisis as the risk of an operational breakup materialized. In that same year, the U.S. economy was on its way to recover, albeit weakly, from the Great Recession. By contrast, recession in the euro area (EA) had laid bare some fundamental vulnerabilities, questioning the very survival of the single currency. One of the intended pillars of monetary union was posing a vital threat to the operational sustainability of the single currency. This was the practice that the Eurosystem (i.e., the European Central Bank and the National Central Banks of those countries that had adopted the euro) would not be an outright buyer of national governments’ debt, a practice that was understood to be consistent with the monetary financing prohibition stated in the EU Treaty. 

That this would sooner or later pose an existential threat to the euro had been little understood before the crisis burst upon the scene. In 2010, with the first casualty (Greece) in the emergency room and the first economic adjustment programme (with financial package) approved, the Eurosystem eventually became an occasional buyer of government debt. Two years later, with three more casualties (Ireland, Portugal, and Spain) and a systemic collapse in sight, the ECB added the newly crafted Outright Monetary Transactions (OMT) to its toolbox. This meant that the ECB had formally become ready to be an unlimited, albeit conditional, outright buyer in the secondary market for EA government debts.

The introduction of OMTs was the way to restore systemic liquidity buffers in a monetary system that had become unsustainable, while remaining consistent with the monetary financing prohibition laid down in the Treaty. As events during the crisis unfolded, and depending on the narrative about its causes, several different meanings have been attached to the notion of the Eurozone crisis. This has been seen, alternatively, as the unwinding of intra-euro lending and borrowing, the consequence of private credit bubbles, the product of unsustainable public debt, the failure of inadequately supervised banking and financial institutions, and, most notably, as a double-dip recession followed by an unusually weak expansion combined with a visibly inadequate policy (and political) response.

Today, six years after the crisis erupted, and notwithstanding the modified ECB practice that saved the day, the Eurozone is still visibly failing to enact sustainable policies that can effectively restore economic prosperity. Accordingly, there have been two distinct phases in the Eurozone crisis. Between 2010 and 2012 the monetary union was in jeopardy of undergoing an operational breakdown up until the change in the operational practice in the market for public sector securities, complemented by the banking union reform.

Since 2012, the problems have been the continuing sluggishness of the real economy, the acute lack of demand, vulnerability to internal and external shocks, and, ultimately, the risk of a political implosion. While the ECB has successfully reclaimed one indispensable tool to operationally manage the euro, the deflationary bias of the euro area has not gone away. Effectively, Europe’s economic performance has been vastly disappointing ever since the launch of the euro. The EA (now comprising 19 countries) has been growing at an annual average of 1.1 percent since 1999, compared to 1.8 percent in all OECD countries, and 3.7 percent in the world economy. 

Today [2016], unemployment remains 3.8 percentage points above the OECD average. Considering the impact of the global crisis, annual average growth in the EA between 2008 and 2014 was a negative 0.25 percent, compared to a positive 1 percent in the entire OECD. This portrays the failure of an economy that, nearly one generation after its historic monetary reform, has failed to live up to its affirmed goals. Painfully low incomes and high regional unemployment, especially among youth, have created a fertile breeding ground for resentment towards national governments and for scepticism about the euro and European integration at large. 

A group of European economists who undersigned a Rebooting Consensus Authors document have expressed a true concern that growth and unemployment in the Eurozone “are miserable and expected to remain miserable for years”, that “Europe’s youth have been or will be jobless during the critical, formative years of their working lives”, and that “economic malaise is feeding extremist views and nationalistic tendencies just when Europe needs to pull together”. In their analysis of the Eurozone crisis, however, they do not differentiate between its first and second phases. Their consensus narrative focuses primarily on the first phase and upon the policy failures that “allowed the cross-border imbalances to get so large with such little notice”. In their view, the fact that the ECB was “explicitly forbidden” from lending to Eurozone governments has been one of the “amplifiers” of the crisis. 

The crisis, in their view, was ultimately caused by the unwinding of unsustainable imbalances in public and private debt, as well as in cross-border financial flows driven by national savings-investment gaps. Accordingly, they underscore the important issue of containing inter-regional differences in economic performance, trade flows, and jobs, but lack a satisfactory analysis of the prolonged deflationary bias that has become apparent in the second phase of the crisis. While it is a widely held view that the Eurozone crisis is far from over and more needs to be done to fix it, an agreement on priorities is far off. 

The ‘Rebooting Consensus Authors’ have argued that it is “impossible to agree upon the steps to be taken without agreement on what went wrong”. While such an appeal is reasonable, a constructive narrative should make a sharp distinction between the causes that led the Eurozone to the brink of operational implosion and the long-time issue of slow growth. Missing in their narrative is an explicit account of the reasons why spending remains subdued in the second phase of the Eurozone crisis, as well as an account of how current fiscal constraints add to the vulnerability of the euro area. 

In the United States, where such constraints do not exist, overall spending returned to growth more quickly.  By contrast, fiscal relief has proved impracticable in Europe, where fiscal balances have been austerely constricted.  Also the “Five Presidents’ Report” on Completing Europe’s Economic and Monetary Union does not substantially modify the fiscal “discipline” approach. Its emphasis is upon the notion that “Euro area members depend on each other for their growth” and upon formalizing the process of convergence as a condition for boosting growth and jobs. 

While the Macroeconomic Imbalance Procedure would detect deviations from the common standards and provide guidance to reform implementation, an as-yet- shock absorption mechanism of fiscal stabilization would be available to EA member states only conditionally “to avoid moral hazard and ensure joint fiscal discipline”. While convergence is a desirable, longer-term process, the most urgent challenge that Europe is facing today is that of strengthening domestic demand in the context of weak recovery, high output gap, and high unemployment. Countercyclical fiscal policies are barred by the fact that government debt in those countries that would need them most is too high for European rules, and the EU (“austerity”) recommendation that those countries restore fiscal space by increasing savings in the public sector exacerbates the slowdown. 

Without fiscal stimulus, the strategy to strengthen domestic demand primarily rests upon boosting consumer and business confidence, credit supply, and inflation expectations, as well as upon structural reforms aimed at boosting competitiveness. This strategy is consistent with a well-established, orthodox view of policy effectiveness, according to which the boosting of confidence and of inflation expectations will close the savings-investment gap and fuel more spending, the boosting of credit supply will channel savings into investment expenditure, and the boosting of competitiveness will increase national savings. 

In economics, however, orthodox beliefs are not always the “the best-known answers” of our time, and in this essay I will cast a different interpretation aimed at capturing what we know about the link between saving, spending, and growth, as well as by combining two “best answers” from two classic masters of economics, Adam Smith and John Maynard Keynes. One key lesson from Adam Smith is that the wealth of a nation is measured by its power to acquire real, not monetary, values. 

Correspondingly, one key lesson from John Maynard Keynes is that real economic outcomes are shaped by decisions that agents make on the basis of financial stocks and expected monetary flows. These two views are highly complementary. Smith warns us that policies should aim at the goal of raising the growth of real output and employment and consider financial conditions as wholly functional to achieve real prosperity. Keynes warns us that pursuing Smith’s goals needs effective monetary management to avoid financial mishaps that ultimately affect real prosperity. The combined lesson of Smith and Keynes is that effective monetary management is a condition for achieving the purpose of policy, to wit, real prosperity.

This essay has two parts. Part I elaborates on a simple (“T-shirt”) model of private spending in a monetary economy, where this is a function of the actual and the intended stock of private savings. When savings are in excess of the intended amount, private spenders create jobs, and when savings are short of the intended amount, private spenders destroy jobs. Assuming intended savings as a given, and because the source of savings is debt, then any policy that inhibits the formation of debt also inhibits the formation of financial savings, spending, and jobs.

Part II delineates lessons for the euro area. If debt (private and public) is the final fuel for spending, then European rules produce one chief inconsistency that precludes durable policy success, irrespective of any genuine and well-intentioned efforts to muddle through the crisis by enforcing such rules. The self-imposed cap on public debt seriously inhibits the ultimate source of private savings and cripples policy effectiveness in sustaining an adequate rate of private spending and saving, leaving the euro area with two equally risky alternatives: building up more private debt or counting on a permanently high flow of net exports. As long as a cap on public debt remains, the euro area will continue to live dangerously and remain vulnerable to shocks.

“A T-shirt model of savings, debt, and private spending: lessons for the Euro Area”: To read the full essay, please download the pdf here

The Introduction, as posted above, does not include the footnotes that are provided in the pdf version.  The final edited article was published in the European Journal of Economics and Economic Policies, Vol. 13, no. 1 (2016).

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