The Euro leaders are having another Summit in Brussels today – another one – the 17th in two years. I think they are getting used to the nice wine and sumptuous food that is served up. Little ever comes from these summits that is of any productive import. This time they plan to set in concrete balanced budget rules to be embedded into the national legislation of EU member states yet at the same time propose job creation and growth strategy. The job creation strategy is allegedly going to focus on the youth of Europe who are becoming unemployed and excluded in increasing numbers as time goes by. The lunacy is that Europe’s youth started losing their jobs some years ago yet the leaders are now expressing concern. Also over the weekend, there was a leaked German proposal for today’s summit detailing how Greece should leave the Eurozone and become a German colony. My how audacious our Teutonic friends have become!
Reuters reported today (January 30, 2012) – EU Leaders to Agree on Rescue Fund, Balanced Budget – that:
European Union leaders will sign off on a permanent rescue fund for the euro zone at a summit on Monday and are expected to agree on a balanced budget rule in national legislation, with unresolved problems in Greece casting a shadow on the discussions.
Apparently, there is “up to 20 billion euros of unused funds from the EU’s 2007-2013 budget” that will “be redirected towards job creation, especially among the young, and will commit to freeing up bank lending to small- and medium-sized companies”. I will devote a whole blog to the youth unemployment issue later in the week.
But the “discussions over the permanent rescue fund, a new ‘fiscal treaty’ and Greece will dominate the talks”.
So expect nothing concrete or meaningful to emerge. As long as the Euro leaders are thinking balanced budgets the longer the problem will persist.
A balanced budget means that the private domestic sector balance (the difference between spending and income) will mirror the external balance. So when the nation records an external deficit (more income is leaving the country than coming in – via trade or net income flows – on the current account), a balanced budget would mean that the private domestic sector would be continuously spending more than it is earning and accumulating (as the stock response) ever increasing levels of debt.
The sectoral balances framework that helps us organise thoughts in this regard is well-known to regular readers of this blog. Please read my blog – Saturday quiz – January 28, 2011 – answers and discussion (Question 5 answer) – for more discussion on this point.
By way of summary, the sectoral balances accounting relations for the three aggregate sectors: private domestic; public and external we get:
(S – I) = (G – T) + NX
The sectoral balances equation says that total private savings (S) minus private investment (I) – the measure of the difference between private income and spending – has to equal the public deficit (spending, G minus taxes, T) plus net exports (NX), where net exports represent the net savings of non-residents. Here net exports is equivalent to the current account (and thus includes the net income flows each period).
This holds at all times as a matter of national accounting.
To put framework into use, we note that Modern Monetary Theory (MMT) teaches us that for any level of aggregate demand and national output there are several incontrovertible facts that arise from the national accounting systems we use.
1. Government deficit (surplus) = Non-Government surplus (deficit) – to the cent.
2. Spending equals income and is the sum of net external spending (exports minus imports), private domestic spending (consumption plus investment) and government spending. A fall in overall spending results in a fall in income (output). A fall in one component of spending can be offset by a rise in another component to maintain existing income levels.
3. The non-government sector is sum of private domestic sector and the external sector.
4. If the external sector is in deficit, then a budget surplus or a balanced budget is always associated with a private domestic sector deficit.
5. If the budget deficit is less than the external deficit then private sector will be in deficit overall.
6. If the budget deficit equals the external deficit then the private domestic sector is in balance overall.
7. If the budget deficit is greater than the external deficit then the private domestic sector is in surplus overall.
8. If the private domestic sector is in surplus overall, it is spending less than its income and thus saving.
9. If the private domestic sector is in deficit overall, it is spending more than its income and building up debt, running down saving, or selling previously accumulated assets.
10. If there is an external deficit, the government and private domestic sectors together cannot reduce their respective debt levels.
The following graph provides a range of different national income outcomes and the balances that might be associated. So there have been spending flows between the three sectors which have created a flow of aggregate output and income which then are summarised by these balances.
For example, a rise in government spending will increase national income which provides the opportunity for private households to increase saving. But it also might stimulate private domestic investment and the impact on the private domestic balance (the difference between private domestic spending and income) then depends on the sensitivities involved.
Further a particular sector may desire a specific outcome (for example, the private domestic sector might desire – once all the decentralised decisions about spending and saving are made to save overall – that is spend less than it earns) but the discretionary actions of the other sectors (government and external in this case) might thwart that desire.
The graph and table summarise the binding relationships between the macroeconomic sectors. A negative (positive) private balance is a deficit (surplus) while a negative (positive) public balance is a surplus (deficit). I have constructed this for a persistent external deficit (negative) of 2 per cent of GDP to provide a control for the different states.
State 4 depicts the balanced budget scenario.
So after all the spending flows (and leakages) are exhausted in each period, if there is the coincidence of an external deficit (X – M < 0) and a public surplus (G – T < 0) then the particular national income flows will also force a private deficit (that is, the private domestic sector will be spending more than they earn).
While private spending can persist for a time under these conditions using the net savings of the external sector, the private sector becomes increasingly indebted in the process.
Further, if there is an external deficit then the government sector and the private domestic sector cannot simultaneously be running surpluses (that is, reducing their overall debt levels).
To really use this framework you need to add macroeconomic theory and trace out how different behaviour will interact to generate national income changes which in turn are accounted for in each period.
Imagine if the private domestic sector desires to save 1 per cent of GDP overall (spend less than they earn) and sets about trying to achieve that goal via all the decentralised spending decisions of households and firms. Also assume for control purpose that the external sector is running a deficit equal to 2 per cent of GDP which is draining local demand relative to national income flows.
What will happen to national income as a result of this behaviour? The answer is it depends on what the government is doing (although it is more complex than that because of the feedback loops between the sectors which I will explain).
Imagine if the structural and cyclical budget outcome (that is, the sum of the discretionary policy choices of government and the impact of the business cycle on its spending and tax aggregates) produced a deficit of 3 per cent of GDP. This is State 7, and all the sectoral choices would have been compatible and national income would be stable and consistent with the desires of the private domestic sector, government and the external sector.
In that situation the desires of the private domestic sector which they would have put into place via their spending decisions would not undermine the growth in national income because the government was prepared to run a deficit consistent with supporting aggregate spending which filled the spending drain (gap) left by the private overall saving and the external sector.
What if the government sector at the time the private domestic sector set about saving overall had embarked on a fiscal austerity program and cut? Then the desires are incompatible at the current level of national income and it is the latter that would adjust via spending changes that would occur.
So as the government starts to cuts its spending while households are trying to cut their consumption spending (say) then aggregate demand will fall and output and national income will fall. The falling income would not only reduce the capacity of the private sector to save but would also push the budget balance towards (or into) deficit via the automatic stabilisers. It would also push the external surplus up as imports fell. Eventually the income adjustments would restore the balances but with a lower GDP overall.
What the sectoral balances might end up like is a matter of how the changing income erodes the capacity of the individual sectors to realise their desires.
This is a highly stylised example and you could tell a myriad of stories that would be different in description but none that could alter the basic point.
If the drain on spending outweighs the injections into the spending stream then GDP falls (or growth is reduced).
A balanced budget rule, would be very difficult for a government to achieve given the feedback between the sectoral balances. But what it would ingrain is a recession bias and a bias towards financial fragility in the private sector.
Neither bias would provide the conditions for sustainable growth.
The major risk for the world economy that requires resolution is the massive outstanding private debt that arose from the housing booms.
The housing markets have a long way to go before they will be stable. The incidence of negative equity is rising in all nations and until the balance sheet implications of that are resolved it is unlikely that private households will start spending with any panache.
The days of credit-binged consumption growth are over (at least for now). Without strong consumption growth, there will be relatively subdued growth (if any) in private capital formation.
This means that the private domestic sectors (in the US and elsewhere) have to reduce their debt levels by increasing their overall saving.
The sectoral balances framework provides some organisation for understanding the implications of those points. If the nation wants to grow (that is, achieve nominal spending growth in line with the real capacity growth plus soaking up idle capacity) and it is unlikely to run external surpluses and the private domestic sector is trying to run down debt levels overall, then the growth process has to be supported with budget deficits.
Budget deficits provide the demand support to allow the other desires/requirements/facts to be realised. At present, given the scale of the private deficits (and debt burdens), the budget deficits have to be sustained at proportions of GDP far beyond the current SGP rules, much less the new rules proposed by the Merkozy’s fiscal compact.
The Reuters report mentioned above also says that:
By far the most pressing worry is the seven-month-long negotiation over private sector involvement in the second Greek rescue package. A deal in the coming days may help restore investor confidence, although Greece will still struggle to reduce its debts to 120 percent of GDP by 2020 as planned.
The “deal” which will effectively tell the rest of the world that Greece doesn’t have to pay its debts and that the Euro leaders are happy to endorse that conclusion, will then shift focus immediately to Italy, Spain or somewhere else.
The question will then be – if Greece doesn’t have to pay its debts then why should we? Answer: the politics will not be able to resist that logic and sooner rather than later the bond markets will conclude there is need to be involved in lending to these countries.
The situation will then spin out of control – even more than it currently is.
A stage-managed default (and that is what the PSI is about) will worsen the situation for the Eurozone. It would be better if Greece just upped and left and defaulted as a democratic choice. Then the dynamic would be for Italy and Spain etc to follow suit or not. The politics of that sort of default are quite different to what the Euro leaders are proposing.
The UK Guardian editorial (January 29, 2012) – The euro: more summits, more problems – said that:
Europe’s policymakers are more interested in bailing out bankers than the real economy
They also note that Germany is proposing a sort of viceroy arrangement whereby Greece hands over its economic policy management to some technocrat appointed by the EU.
The English-language Greek newspaper Ekathimerini carried an article (January 30, 2012) – Troika talks push PM’s party leader meeting to Sunday – which spelled out some of the “leaked” German briefing to today’s Summit.
The Germans want, first, that “a European commissioner should be appointed to oversee Greece’s budget, with the powers to intervene if necessary”:
Given the disappointing compliance so far, Greece has to accept shifting budgetary sovereignty to the European level … A budget commissioner has to be appointed by the Eurogroup with the task of ensuring budgetary control. He must have the power a) to implement a centralized reporting and surveillance system covering all major blocks of expenditure in the Greek budget, b) to veto decisions not in line with the budgetary targets set by the troika and c) will be tasked to ensure compliance with the above mentioned rule to prioritize debt service.
So Europe abandons any notion of democracy. The German ideology that could not prevail in several World Wars would thus prevail. Greece leaves the Eurozone and becomes a colony of the Eurozone.
Second, “Greece should commit to using state revenues to first pay its foreign debtors before spending the money on public expenditure”. The document says:
This commitment has to be legally enshrined by the Greek Parliament … State revenues are to be used first and foremost for debt service, only any remaining revenue may be used to finance primary expenditure.
So as in all colonies, the resources of the local economy are at the behest of the colonisers and their “financiers”.
The most recent data from Eurostat (October 2011) – Euro area and EU27 government deficit at 6.2% and 6.6% of GDP respectively – says that in 2010, the Greek government had 329,351 million euros of debt outstanding (or 144 per cent of GDP).
Its annual revenue in 2010 was 39.5 per cent of GDP and its annual spending was 50.2 per cent of GDP. GDP was 227,318 million euros. Its budget deficit was 24,125 million euros or 10.6 per cent of GDP.
Eurostat also tells us that around 15 per cent of government spending is taken up in debt-servicing despite falling interest rates.
The twin goals of cutting the deficit to get back into SGP rules and prioritising revenue to pay foreign creditors (principally French and German banks) would lead to dramatic cuts in public spending.
The Greek economy would shrink even faster than it is at present and the “ratios” that the EU and the IMF are obsessed with would head in the opposite direction to the intention.
Tax revenue would further shrink as a result of the shrinking growth and the vicious cycle would continue. What is required is a virtuous cycle – increased aggregate demand leading to higher output and employment growth and as an endogenous response – lower budget deficits upon the back of higher tax revenue (as activity increases).
Third, no default should be allowed – rather Greece should cut its primary expenditure. “If a future tranche is not disbursed, Greece can not threaten its lenders with a default, but will instead have to accept further cuts in primary expenditures as the only possible consequence of any non-disbursement.”
Yes, and whip the Greeks daily.
The UK Guardian editorial commenting on the viceroy plan said:
Even a watered-down version of this proposal – eurozone supervision of budget decisions made by elected governments of crisis-hit countries, which looks likely if not this week then soon – would represent a dramatic erosion of democracy and autonomy, to say nothing of national dignity … For over a year, economists have advised Angela Merkel and her counterparts to institute some form of fiscal union. But what they’re offering instead is fiscal imperialism.
Apart from the political violation, the proposal to “that every country within the eurozone must turn itself into a version of Germany, with tough budgetary controls even amid severe recession” will never deliver prosperity.
Not every nation can run huge external surpluses. Germany’s surpluses are the result of other European nations running deficits.
If nations run external deficits, then they have to run public deficits if their private domestic sectors are not to be increasingly indebted. That is a simple fact drawn from national accounting.
That is why the SGP fiscal rules were too constraining in the first place. It is also why tightening them to run balanced budgets as a matter of law would be crippling.
Greece cannot deliver economic growth adopting German-style economic policies. Hardly, any economy would be able to to. And Germany would not deliver economic growth if all the Eurozone nations (and everyone else for that matter) acted like them.
The UK Guardian is correct is saying that:
Yet austerity for all is not working. Greece is now in its fourth straight year of a shrinking economy. According to the IMF last week, Spain and Italy’s spending cuts mean that they will be in recession until the end of 2013. Portugal looks as if it is about to go the way of Greece and default on its debts … Austerity isn’t even working for Germany, where growth faltered at the end of last year. Even the strongest economies within the single currency will naturally suffer if their neighbouring export markets dry up.
There is no such thing as a “fiscal contraction expansion” when everyone is doing it.
Today’s Brussels’ Summit is not going to alter much at all. The Euro leaders will just continue (according to the UK Guardian) undermine “democracy in southern Europe” while they crush “growth across the continent” and “are more interested in bailing out bankers than the real economy:.
In the context of Davos and today’s Brussel’s summit, I thought the Sydney Morning Herald article (January 28, 2012) – China’s expansion raises concern – was pure comedy. In the tragic sense that European leaders have put themselves.
Apparently, at the Davos WEF a “powerful panel” has concluded that:
Chinese investment overseas will trigger “political problems” unless Beijing rectifies a reputation as new colonists, intellectual property fraudsters and resource grabbers …
The director-general of the World Trade Organisation said that China was “grabbing resources, being colonialist … stealing technologies … it gives the view this is a country that doesn’t play by the rules”.
Oh, not that the Europeans did any of that! No colonisation, no resource grabbing, no borrowing IP. How much of Europe’s wealth is the direct result of them behaving in this way? Answer: massive amounts.
How much of the world’s poverty is the result of colonial ventures that bled nations dry? Answer: a high proportion.
In English there is an expression – pot calling the kettle black.
And, haven’t the Europeans been trying to beguile the Chinese – still an essentially poor nation – into bailing out them out when they have the resources themselves to provide employment for all their citizens but are to ideologically-blinkered to use them?
But it was a “powerful panel” at Davos that talked about all this.
I also notice that Joseph Stiglitz gave an interview at Davos to – Der Spiegel Magazine (the article is in German) – which reported that he was attending the Public Eye Awards – which recognise the “worst cases of contempt for the environment and human rights” in the previous year.
Joseph Stiglitz was the guest speaker at the Public Eye awards, which gave the 2011 prize to British banking giant Barclays which the Public Eye Press Release described in this way:
The British banking giant Barclays is the world’s fourth-largest bank and arguably the fastest-growing food speculator worldwide. It drives up global food prices at the expense of the poorest. In just the second half of 2010, 44 million people worldwide were driven into extreme poverty due to rising food prices – and women in the Global South are often the hardest hit. Barclays enjoys close ties to the British government, which is threatening to block European regulation that would curb food speculation.
They shared the prize with popular nominee Vale (a Brazilian mining monster).
But in the interview with Der Spiegel, Joseph Stiglitz said that he considered capitalism could be reformed and praised the IMF:
Den IWF etwa lobt Stiglitz mittlerweile, weil der aus seinen Fehlern gelernt habe.
Which says – he “praised the IMF, because it has learned from its mistakes”.
To which I say – no they haven’t. They are just moderating their language at the moment because their past public pronouncements are humiliating in the current context.
But they still promote the concept of “fiscal space”, which the IMF defines as:
… room in a government´s budget that allows it to provide resources for a desired purpose without jeopardizing the sustainability of its financial position or the stability of the economy. The idea is that fiscal space must exist or be created if extra resources are to be made available for worthwhile government spending. A government can create fiscal space by raising taxes, securing outside grants, cutting lower priority expenditure, borrowing resources (from citizens or foreign lenders), or borrowing from the banking system (and thereby expanding the money supply). But it must do this without compromising macroeconomic stability and fiscal sustainability – making sure that it has the capacity in the short term and the longer term to finance its desired expenditure programs as well as to service its debt.
The IMF assumes that national government – whether they issue their own currency or not – has the same constraints that restricted governments during the gold standard when currencies were convertible and exchange rates were fixed. This is a definition that could have been written in 1950.
Fiat monetary systems – which most nations have run since the early 1970s – render the IMF concept of fiscal space seriously deficient. The IMF completely ignore the main points of such system which are:
- a sovereign government is not revenue-constrained which means that fiscal space cannot be defined in financial terms.
- the capacity of the sovereign goverment to mobilise resources depends only on the real resources available to the nation.
The IMF definition is oblivious to this fundamental point. I can accept that many nations struggle with currency sovereignty. Those that have ceded their sovereignty by entering currency zones; by dollarising their currencies; by running currency boards; and similar arrangements clearly are not sovereign and face the same constraints that a country suffered during the gold standard era.
The point is that as long as there are real resources available for use in a country, the government can purchase them using the currency it issues.
Starting with the millions of people who are now unemployed – these are real resources which have no “market demand” for their services. The government in each country could easily purchase these services with the local currency without placing pressure on labour costs in the country.
But then the claim is that these people will want to consume more and this will blow out the current account and cause inflation. All open economies are susceptible to balance of payments fluctuations. But of-course these were terminal during the gold standard for deficit countries because they meant the government had to permanently keep the domestic economy is a depressed state to keep the imports down.
For a flexible exchange rate economy, the exchange rate does the adjustment. Is there evidence that budget deficits create catastrophic exchange rate depreciations in flexible exchange rate countries? None at all. There is no clear relationship in the research literature that has been established.
If you are worried that rising net spending will push up imports then this worry would apply to any spending that underpins growth including private investment spending. The latter in fact will probably be more “import intensive” because most nations import productive capital.
Indeed, well targetted government spending can create domestic activity which replaces imports. For example, Job Guarantee workers could start making things that the nation would normally import including processed food products.
Moreover, a fully employed economy with skill development structure embedded in the employment guarantee are likely to attract FDI in search of productive labour. So while the current account might move into deficit as the economy grows (which is good because it means the nation is giving less real resources away in return for real imports from abroad) the capital account would move into surplus. The overall net effect is not clear and a surplus is as likely as a deficit.
Finally, even if ultimately the higher growth is consistent with a lower exchange rate this is not something that we should worry about. Lower currency parities stimulate local employment (via the terms of trade effect) and tend to damage the middle and higher classes more than the poorer groups because luxury imported goods (ski holidays, BMW cars) become more expensive.
These exchange rate movements will tend to be once off adjustments anyway to the higher growth path and need not be a source of on-going inflationary pressure.
Please read my blog – Bad luck if you are poor! – for more discussion on this point. And then the my fiscal sustainability suite – Fiscal sustainability 101 – Part 1 – Fiscal sustainability 101 – Part 2 – Fiscal sustainability 101 – Part 3.
The adherence to this flawed concept is why the IMF is part of the Euro Troika which is devastating the economies of Euro member states by claiming they have no “fiscal space”.
While the flawed design of the EMU has rendered the member states void of currency sovereignty without a federal fiscal agency being created to take the place of that sovereignty, the fact remains that the ECB is now the quasi-fiscal authority in the EMU and has all the capacity that is necessary to fund growth-generating budget deficits and effectively deal the bond markets out of the equation.
So while the IMF might be moderating some of its language – its fundamental precepts remain unchanged. They are part of the problem and should be closed down.
I was actually going to write a blog today about youth unemployment and the sudden “concern” that the Davos leaders expressed for this issue. That will come soon.
My campaign to raise the policy awareness in Australia about youth unemployment has intensified and there was a lot of press coverage on this issue in the last week. It even got on the ABC National News which is something.
Here is the segment from the news. I gave the ABC a 20-minute interview on Saturday and you can see how much they used. Better than no opposition to the mad plans of the government though.
I won’t describe what I was wearing out of the camera sight (shorts and bare-feet!). It was a hot summer’s day in Newcastle.
That is enough for today!