The European Crisis and Monetary Policy: Origins and Solutions

1. S.CesarattoIntegrazione a capitolo 5 e 6 delle Sei lezioni: The €uropean crisis and monetary policy

2. Index • I) Origin of the crisis • II) Monetary policy in the crisis

3. I) Origin of the crisis

4. Optimal currency areas • Should the EMU be created? • OCA (e.g. Meade 1957, Mundell 1961, Fleming 1971) generally said no. • Mundell 1961: economically dis-homogeneous regions constitute an OCA if there is labour mobility. Otherwise in case of asymmetric shocks: • either the C/A surplus/full employment/low inflation region accepts to sustain domestic AD and accepts higher inflation, • or C/A deficit/less-than-full-employment/inflation-prone regions accept deflation • But in the second hypothesis there will be a deflationary bias in the global economy. • Other alternative: inter-regional fiscal transfers (transfer union) • Final alternative (that justified the EMU): endogenous OCA

5. Barba De Vivo: federal budget irrelevant in the Eurozone (EZ)

6. Is a federal Europe possible? • What is the next question? • Hayek 1939  only a minimum-State/federal State is possible amongst regions that are culturally and economically dishomogeneous • Hayek was therefore in favour of a federal State • 5 Presidents report: no federal budget but central controll of nacional finances • The actual Europe is precisely what «they» wanted: «federal» monetary policy in controll of inflation; no federal fiscal policy and national balanced budgets; full employment to be ursued through «competitive deflation» • Influence of the long-period consuensus on the ineffectiveness of monetary policy (not to speak of fiscal policy) • «tie your hands» argument

7. The influence of standard theory (Barro § Gordon, Kydland and Prescot, Giavazzi and Pagano) • Monetary theory ineffectual in the long run • Governments not credible in promising of not using monetary policy etc. • The promise to keep the exchange rate fixed (and so inflation at the level of the virtuous countries) is not credible • With a currency union monetary policy is transferred to foreign hands for good. • In more practical terms: France was fed up to let Germany (the leading country in the EMS) to fix the interest rate only looking at its own interests; in the EMS Germany decided monetary policy, perhaps with a currency union the other countries would have a say. • Italy and others would have liked to import the German labour market discipline. • Political reasons (German unification)

8. Prescent analyses • The American economists warned that the EZ was not an “optimal currency union” (they were accused of conspiracy against the European challenge to the US $). • Kaldor and Godley warned that you must have a political union ahead of a monetary union • “Functionalism”, the Monnet method, prevailed • As we said, however, a real, solidaristic political union is impossible in Europe

9. What happened? There is a consuensus view now (although in my opinion some economists like DE Grauwe create confusion) • Spain, Ireland, Greece: Frenkel’s cycle (or This time is different or An unfortunate sequence of events…) • Portugal: it had it earlier • Italy (and France): slow erosion of competitiveness • Outside the EMU the Baltic countries, Hungary and perhaps others that pegged their currency to the Euro had their unfortunate sequence of events

10. disappearance of devalution risk + financial liberalisation. Interest rates on long-term treasuries affect also credit conditionsSource: http://www.voxeu.org/content/eurozone-crisis-consensus-view-causes-and-few-possible-solutions

12. Source: http://www.voxeu.org/content/eurozone-crisis-consensus-view-causes-and-few-possible-solutions

16. First explanation: diverging REERs

17. Second explanation: diverging ADs

19. Housing bubble

23. Sudden stop of capital flowshttp://www.economonitor.com/blog/2011/12/which-graph-best-summarizes-the-eurozone-crisis/

24. An ECB fault? • The ECB monetary policy (one fist all, or what fits the core fits all) is often blamed for the crisis:

27. German mercantilism • Germany since Bretton Woods has always found fixed exchange rate arrangements perfectly suited to her mercantilist stance: since the time of Erhard the German strategy was to maintain the inflation rate a little below that of competitors to sustain exports while enjoying a strong currency, what has been named ‘Monetary Mercantilism’ (Holtfrerich)

28. Criticism to German (presumed) mercantilism is not new . Few examples* - The German stabilisation policies of the late 1940s/early 1950s were criticised by the American economists. - Also in the 1950s Germany preferred to blame the others: ‘inflationary policies’ abroad led to the German export upsurge and obliged her to ‘sterilise ‘imported inflation’ by pursuing a fiscal surplus. The surging of the German trade surplus led, after the American and French criticism, to the DM revaluation in 1961 - The case of the ‘locomotive theory’ is well-known: in the late 1970s chancellor Schmidt reluctantly accepted the idea that Germany had to pull the world economy along the US and Japan. The 2° oil shock came: he swore that never again Germany would have played the domestic expansion game.

29. At the origins of the German policy stance: monetary mercantilism?* • The pre-miracle German policy choices that shaped post-war Germany, in oarticular the centrality of price stability, have been denominated ‘monetary mercantilism’ by the historian Carl-Ludwig Holtfrerich. • Holtfrerich, as others (e.g. Bibow), denies that the obsessive objective of price stability by the Buba is due to the memory of the great hyperinflation of 1922. • Indeed, some economists maintain that this “memory” is a well fabricated invention by the Buba (memories are a social construct). An independent central bank is not even a German tradition (the opposite is true), and indeed Adenauer opposed it (he thought that a CB should be accountable!) • Why price stability then? Holtfrerich: “found the clue” in the early German policy decisions.

30. Monetary mercantilism (cont)* In the early 1950s “As protectionist tools could not be used…a different way of achieving mercantilism, namely export surpluses, had to be found. The solution was to keep domestic demand restrained by monetary and fiscal policies, thus keeping imports and domestic inflation low and freeing production resources for more exports. This strategy was contingent on a system of fixed exchange rates…The early Bretton Woods system…left countries the opportunity to gain in international competitiveness by realising relatively more price stability than abroad”. (The main Holtfrerich’s paper is published in a book edited by the Buba celebrating the 50° DM anniversary!) • Observe the combination of lower domestic inflation and fixed exchange rates! The same combination Germany obtained later through the EMS and the EMU!

31. Monetary mercantilism (cont)* • Monetary mercantilism was “conceived and planned” particularly by the president of the Bank deutsche Lander (the Buba was created in 1957) Wilhelm Vocke “as a long-term strategy for German monetary policy” : “keeping domestic affairs tight in order to strengthen exports”. Vocke was lucky: • 1) the Allies forced for an independent CB in 1949 when a Federal gvt was not existing yet; 2) Erhard endorsed Vocke’s policy; 3) the Korean war gave a big push to German exports and the opportunity to keep inflation lower than the competitors. • Erhard: “A great opportunity for the future of German exports has arisen out of the current situation. If, namely, through internal discipline we are able to maintain the price level to a greater extent than other countries, our exports strength will increase in the long run and our currency will become stronger and more healthy, both internally and with respect to the dollar”

32. Monetary mercantilism and Ordoliberismus* Price stability was also the obsessive policy target of Ordo-liberismus (or Freiburg school or social market economy), the dominant economic school in the reconstruction and miracle period. Price stability was associated by the ordo-liberals to the smooth functioning of the price mechanism. In practice, price stability is synonymous of wage and social discipline. • Wage and social order imply that exports, rather than wage consumption, become the natural debouche of the surplus (in the classical-marxian sense). Indeed, income distribution has never been particularly favourable to labour in Germany. • An export-oriented economy becomes in turn a powerful political instrument to obtain labour consent and discipline (reinforced by the German trade unions pursue of co-determination rather than strong wage claims why German trade unions have been so docile in the post-WW period is not clear to me yet).

33. The German model* • The success of the model in leading to improved standards of life (although income distribution, not surprisingly, has never been particularly fair in Germany) and the traditional paternalist Bismarkian welfare state did the rest. • Erhard, declared in 1953: “Foreign trade is quite simply the core and premise of our economic and social order”. • This declaration seems to allude to an export-led model as a way to enforce social order, and to social order as a way to sustain export-led growth: Social order export led growth Price stability

34. Economic surplus and aggregate demand (AD) in capitalism • From a theoretical point of view we may now vindicate the mercantilist obsession with a trade surplus. • They (albeit imperfectly) grasped the idea that net exports might render a low N and a high S sustainable from the point of view of aggregate demand. • S = P – N; P = C + (X – M) = N + X; S = X - M • The German model has a strong ideological content by making the obsession of a trade surplus the “sacred cow” of German politics. • The Buba was the watch-dog of the model. • The government has trade policy as the highest priority (as one German President confessed, “we are in Afghanistan for commercial reasons”).

35. The pillars of the German model and why they do not want to give it up • The three institutions pillars of “monetary mercantilism”: neo-corporativism, mercantilist micro, meso and macro institutions and policies, and …the Bundesbank. • The former implied a direct involvement of the labour movement both at the micro and the macro level in the maintenance of a competitive system, particularly in the export sector. • At the micro-level Germany has a excellent training, educational and R&D system; at the meso-level the reliance on export-led growth creates an ideological climate that induce cooperation and discipline (Crouch 2008); at the macro level the system keep wage-growth below or in line with productivity growth. The government domestic and foreign policies have the promotion of German export as the priority. Paternalism is a traditional attitude of the German government; the sense of the national community, traditions and nature (heimat) is the main component of the “German ideology”. This perfectly suit the mercantilist tradition (Heckscher), particularly in its German version (Cameralism, Historical School) • This model has brought welfare and order in Germany: would you easiliy give it up?

36. Arsenic and Buba • But, of course, as Voltaire said: “Incantations will destroy a flock of sheep if administered with a certain quantity of arsenic” • Just in case, the watchdog role of the model was assumed by the Bundesbank in a unique wage bargaining process directly involving the central bank and the leading trade union IG-metall (Franzese and Hall 2000: 182-83). • This role of the Bundesbank as the watchdog of the German mercantilist model is very important to understand the German opposition to the reform of the ECB from its present “monetarist” constitution.

37. The Buba and the labour market* • A ‘credible’ CB was a central element of the German economic policy, where by credibility is meant that the trade unions considered the German CB commitment to fight inflation at any cost as convincing. • According to Franzese and Hall the centralised wage bargaining in Germany, led by the IG-Metall, made a peculiar interaction between the German CB and the trade unions possible: “The highly public pas de deux between the Bundesbank and the principal wage bargainers, which occurs at the time of every wage round in Germany, is a prominent feature of politics. The bank often issues pointed comments on the initial wage demands made by the union involved in the leading settlement, accompanied by detailed commentary about the state of the economy and warnings about the policy consequences of overly inflationary wage settlements. ... this kind of dialogue between wage bargainers and the central bank is completely absent from U.S. economic politics. … The Federal Reserve and the Bundesbank speak differently because they have audiences with different institutional structures”. …

38. Corporative social-democracy and mercantilism • Interestingly, the Bundesbank’s credibility was reinforced by the export-led model, given the concentration of the strongest trade union in the export sectors: “The German case also suggests that the effectiveness of such signalling mechanisms may be enhanced when the export sector is large and plays a pivotal role in wage bargaining (…). The metalworking sector, which produces the lead bargain in most years, has a high export concentration. In itself, this induces lower settlements because wage bargainers in export sectors are especially concerned to maintain unit labor costs at internationally competitive levels. Actors in such sectors are also especially sensitive to signals from the central bank, however, because the restrictive monetary policies that the bank wields not only depress the level of economic activity but also tend to appreciate the exchange rate, thereby threatening export sectors especially severely by rendering their products more expensive in world markets.” The direct involvement of the German CB in wage bargaining has been inherited by the ECB. Just recall again the two infamous rate increases in July 2008 and April 2011. • Is it a case that most (all?) northern corporative social-democracies are export-led economies (Colin Crouch)? This might be due to the smallness of those countries, but this is not the case of Germany.

39. Corporative social-democracy and mercantilism • Interestingly, the Bundesbank’s credibility was reinforced by the export-led model, given the concentration of the strongest trade union in the export sectors: “The German case also suggests that the effectiveness of such signalling mechanisms may be enhanced when the export sector is large and plays a pivotal role in wage bargaining (…). The metalworking sector, which produces the lead bargain in most years, has a high export concentration. In itself, this induces lower settlements because wage bargainers in export sectors are especially concerned to maintain unit labor costs at internationally competitive levels. Actors in such sectors are also especially sensitive to signals from the central bank, however, because the restrictive monetary policies that the bank wields not only depress the level of economic activity but also tend to appreciate the exchange rate, thereby threatening export sectors especially severely by rendering their products more expensive in world markets.” The direct involvement of the German CB in wage bargaining has been inherited by the ECB. Just recall again the two infamous rate increases in July 2008 and April 2011. • Is it a case that most (all?) northern corporative social-democracies are export-led economies (Colin Crouch)? This might be due to the smallness of those countries, but this is not the case of Germany.

40. Social-democratic mercantilism* • As seen, export led-growth is also functional to secure labour acquiescence and discipline, solving therefore the second Kaleckian concern about the inconsistency of full employment and capitalism. • Germany appears as a high-productivity/low wage economy. This is a classic definition of a mercantile country. • The model, in the German case, is self sustained in the sense that it brings about social and distribution discipline (associated to decent standards of living), that in turn supports the model. • The question is the international sustainability of the model, but perhaps Germans see themselves as a small player at the global level so that they expect the world to tolerate this policy. But they have to solve the European situation first. • There is no reason why Germans (of any social class) would like to abandon the model, so be politically realist and do not talk of European solidarity.* • *See my The European crisis: political and institutional failures or method in the madness? In www.networkideas.org, re-published by www.irishleftreview.org

41. Rigid fixed exchange rate are inconsistent with national independent full-emplyment policy…

42. …with democracy and even with financial stability

43. Rigid fixed exchange rate are inconsistent with national independent full-emplyment policy with democracy and even with financial stability. Comments • In a currency union CA deficit countries suffers of higher interest rates given the “covertibility risk”, as in a fixed exchange rate regime. • Fixed exchange rate regimes require wage and social right repression, that is they are inconsistent with democracy. • Fixed exchange rate regimes and financial liberalisation stimulate the indebtness of deficit peripheral countries leading to financial crisis. This “this time is different” sequence has happened since the gold standard age.

44. References • Cesaratto, S. 2015. Alternative Interpretations of a Stateless Currency crisis, Asimmetrie, WP 2015/08, http://www.asimmetrie.org/working-papers/wp-201508-alternative-interpretations-of-a-stateless-currency-crisis/ • Cesaratto, S. 2015. Balance of Payments or Monetary Sovereignty? In Search of the EMU's Original Sin - a Reply to Lavoie, International Journal of Political Economy, vol. 44, no. 2, WP:Asimmetrie, WP 2014/06 (December), http://www.asimmetrie.org/wp-content/uploads/2014/12/AISWP201406.pdf • Cesaratto, S. (2015) Fra Marx e List: sinistra, nazione e solidarietà internazionale a/ workingpapers 2015/02 www.asimmetrie.org • Cesaratto, S. (2013c): The implications of TARGET2 in the European balance of payment crisis and beyond, European Journal of Economics and Economic Policies: Intervention, 10, 2013 (3), versioni working paper: http://www.deps.unisi.it/it/ricerca/pubblicazioni-deps/quaderni-deps/anno-2013/681the-implications-target2-european-balance e http://www.networkideas.org/featart/sep2013/fa03_TARGET_2.htm • Cesaratto S. (2013). Controversial and Novel features of the Eurozone Crisis as a Balance of Payment Crisis. in Febrero E. et al., editors, Post Keynesian Views of the Economic Crisis and its Remedies,Routledge, 2013. Working paper: http://www.econpol.unisi.it/dipartimento/it/node/1649. • Cesaratto S. (2013). The endless Eurozone crisis, where do we stand? A Classical-Kaleckian overview, StudiEconomici, n.2, 2012 (pubblicatonel 2013) Working paper availabe at: http://www.deps.unisi.it/it/ricerca/pubblicazioni-deps/quaderni-deps/anno-2013/671-endless-eurozone-crisis-where-do-we-stand (n.671) e http://www.networkideas.org/featart/feb2013/fa27_Sergio_Cesaratto.htm

45. References • Cesaratto S., Stirati A. (2011) Germany in the European and Global Crises, International Journal of Political Economy, vol. 39, no. 4, Winter 2010–11, pp.56–87; working paper version: http://www.econ-pol.unisi.it/dipartimento/it/node/1267 • Cesaratto S. (2011), Europe, GermanMercantilism and the CurrentCrisis, in Brancaccio E., Fontana G. (a cura di), The Global EconomicCrisis. New Perspectives on the Critique of Economic Theory and Policy, Routledge, London. WorkingpaperversionQuaderni del Dipartimento di Economia politica,, n. 595 (www.econpol.unisi.it/dipartimento/it/quaderni) • Frankel, J.A., Rose, A.K. (1996), The Endogeneity of the Optimum Currency Area Criteria, National Bureau of Economic Research Working Paper 5700. • Friedman M. (1953), The Case for Flexible Exchange Rates, in Friedman M. (ed.), Essays in Positive Economics, University of Chicago Press, pp. 157-203. [due significativipassaggi del testosonoriportati qui: link] • Godley, W. (1992), Maastricht and All That, London Review of Books, Vol.14, No. 19. [Goodhart, C.A.E. (1998), The Two Concepts of Money: Implications for the Analysis of Optimal Currency Areas, European Journal of Political Economy, Elsevier, vol. 14(3), pp. 407-432. [link] • Kaldor, N. (1971), The Dynamic Effects Of The Common Market, in the New Statesman, 12 Marzo 1971; anche in Further Essays On Applied Economics, Cap. 12, pp 187-220, in The Collected Economic Essays series of Nicholas Kaldor, Vol 6. [link] • Kenen, P.B. (1969), The Theory of Optimum Currency Areas: An Eclectic View, in R.A. Mundell and A.K.Swoboda (eds.), Monetary Problems of the International Economy, Chicago University Press, pp. 41-60. • Mundell, R.A. (1961), A Theory of Optimum Currency Areas, American Economic Review, 51, pp. 657-665. • C.A.E. Goodhart (1998), The two concepts of money: implications for the analysis of optimal currency areas, European Journal of Political Economy, 14, 407-432;

46. References (consensus view) • Matthew Higgins and  Thomas Klitgaard The Balance of Payments Crisis in the Euro Area Periphery, Fed Current Issues in Economics and Finance, Vol.20, N. 2,    2014 • Richard Baldwin, Thorsten Beck, Agnès Bénassy-Quéré, Olivier Blanchard, Giancarlo Corsetti, Paul de Grauwe, Wouter den Haan, Francesco Giavazzi, Daniel Gros, Sebnem Kalemli-Ozcan, Stefano Micossi, Elias Papaioannou, Paolo Pesenti, Christopher Pissarides, Guido Tabellini and Beatrice Weder di Mauro. Rebooting the Eurozone: Step 1 – Agreeing a Crisis narrative, november 2015, http://www.voxeu.org/article/ez-crisis-consensus-narrative 014 • Richard Baldwin, Francesco Giavazzi , The Eurozone Crisis: A Consensus View of the Causes and a Few Possible Solutions, September 2015, http://www.voxeu.org/content/eurozone-crisis-consensus-view-causes-and-few-possible-solutions

47. II) Monetary policy in the crisis

48. Three overlapping aspects of the crisis: banking, sovereign and foreign debt crises • The crisis has not a fiscal origin (with the possible exception of Greece). • Once the housing bubbles exploded in Spain and Ireland the crisis became a banking crisis • Once banks were bailed out the crisis became a sovereign crisis • The fiscal crisis magnifies the banking crisis (given that banks own a lot of sovereign bonds)  doom loop between banking and sovereign crises. • Since private and public debts are held also by (European) foreigners, the EZ crisis is also a foreign debt crisis. • On some degree, the lack of a lender of last resort (a pro-active ECB) facilitated the contagion of the PIGS crisis to Italy that also entered in a sovereign debt crisis (the debt was pre-existing)

49. The three monetarist pillars of European economic policy • Balanced budget constraints (fiscal policy is viewed as a subtraction of private resources) • Monetary policy managed by an independent Central bank (differences with the FED). • Employment policy is a national matter.

50. Monetary policy: objectives and pillars • The Eurosystem as the central banking system of the euro area comprises the ECB; and the national central banks (NCBs) of the 17 EU Member States whose common currency is the euro. • Two main characteristics of the ECB: independence with (below but close to) 2% inflation target; no bail-out clause • Two pillars of the ECB monetary policy ( determination of the interest rate): • M3  quantitative theory of money (less important) • A variety of economic and financial indicators (including indicators of the real activity, current and expected inflation, exchange rate, financial markets indicators, agents’ expectations, labour market indicators) that may influence expected inflation • How monetary policy works? • We move from the concept of endogenous money that is by now increasingly accepted in monetary economics and macroeconomics (the CB fixes the interest rate and let the market decide how much money it wishes at that rate).