Inflation vs. the Autonomous Individual

By Wolfgang Drechsler

Recently, I have argued that the notorious German fear of inflation, allegedly based on Weimar Republic experiences of hyperinflation, is not irrational but very rational indeed, not because of history, but because of the present. In a recent contribution entitled "In Praise of Inflation", James Surowiecki, in my opinion probably the best economics journalist currently active (not surprising as he writes for The New Yorker, the thinking person’s Economist, and then some), explains why moderate inflation as such is often good for the economy and that fear of inflation as such, and anywhere, is irrational. He concludes by saying,

This intuitive prejudice against inflation may not be purely rational, but in normal times it’s beneficial: it encourages sober habits and discourages quick fixes. But, in times of crisis, other policies may succeed where pure rectitude can’t. … the economy doesn’t exist, in the end, to reward virtue and punish vice. It exists to maximize our well-being, and, currently, doing that may require helping the undeserving and irresponsible, if only because there are so many of them. Boosting inflation isn’t the right policy, but it may just be the correct one.

But as is well-known, there are beneficial aspects of inflation well beyond crisis times. This is of course Keynes’ argument, i.e., to quote Rainer Kattel,

Inflation is actually a form of the hermeneutical circle: the way we think the future will pan out changes our current economic behavior. If we think prices won't rise, or even fall, then why should we consume or invest now, since if the real value of our savings is bound to grow, postponing economic activity and hoarding cash makes a lot of sense. However, if everybody does that, we will get a stagnating economy that might easily end up in a crisis. That, and not crisis investment, is the main Keynesian argument for government spending and deficits.

Also, the other way around, if we think that prices will be very volatile in the future, again why should we consume or invest now? However, if we assume that there will be a moderate growth in prices, it makes a lot of sense to consume or invest now, as this way, we can profit from current lower prices and by investing actually reap future higher prices. In that sense, moderate inflation is a function of moderate growth as well. That's why Keynes thought that government should essentially always run deficits, as this way, there's always slightly more money around than really needed and thus there's moderate inflation that then feedbacks into economic behavior.

And of course, in situations with high debt levels, moderate inflation is doubly interesting or good as it favors current investment over past debts and current savings.

The problem with inflation, however, crisis or no crisis, is that “the people” don’t like it much. As Surowiecki explains,

A 2001 study that looked at the “macroeconomics of happiness” found that higher inflation put a severe dent in how happy people reported themselves to be. The distaste for inflation is such that a 1996 study (titled, aptly, “Why Do People Dislike Inflation?”), by the Yale economist Robert Shiller, found that, in countries around the world, sizable majorities said that they would prefer low inflation and high unemployment to high inflation and low unemployment, even if that meant that millions of extra people would go without work.

So, naturally, the challenge to good economists and policy-makers is, according to Surowiecki, to explain to the people why moderate inflation is actually in their own interest.

Or is it? That depends on what economics is for. Keynes, in a speech towards the end of his life, declared that economists are the "trustees, not of civilization, but of the possibility of civilization." The entire idea of democracy is to prevent experts, who do not only think they know best, but who actually do know best, from making the final decisions, because the rule of the expert does not exactly have a good track record in human history. (And the reasons for that are, among other things, that we cannot agree on what is best; that if we could, we couldn’t communicate it; that human happiness is a moving target; and so on and so on.) Our civilization, from the polis to today’s democracy, from public sphere to public policy, is based on the assumption of autonomous individuals who can make up their own minds and who have a meaningful idea of what is good for them. They make the basic choices, and those basic choices actually form what the polis, the comune, the state in the end is about (Leo Strauss’ point) – because choices could be otherwise as well, but they are the way they are, yet they can and do develop. The Good Life in the Good State, Aristotle’s goal of living together in a structured manner in place and time, is objectively ascertainable, but it rests on the combination of subjective decisions regarding what the Good Life actually is. Economics, again, is to enable this; it’s not a substitute for the Good Life – it’s a means, not an end.

If that is so, if a majority of people, everywhere on the globe, say that they'd rather not have inflation, because for them, monetary stability is more important, for a variety of reasons (choosing not to reward the unworthy; choosing as much stability and predictability as possible as high priorities in life), and if they know what the negative effects may be or even will be (and of course, in economics this is never fully clear), then if one basically believes in those autonomous individuals – and the form of human consociation based on this, which is Democracy –, this is a very strong argument in favor of currency stability and against inflation.

In other words, my point is that the popular anti-inflation stand, according to Shiller’s indeed still extremely interesting research, may not be just good or bad economics but rather, like institutions such as private property or monogamous marriage, a way-of-life choice within the polis, and thus beyond the say of the expert.

Of course, these things can change. Of course, things have been different – memories of William Jennings Bryan and the "Cross of Gold" come up. Of course, happiness research has always suggested, and now has come to the agenda again (such as Derek Bok in a recent book) that people do not know what makes them really happy. Of course, in a moderately rational world, people should pay attention to rational arguments. Of course, if one feels strongly that inflation increases human happiness, one should do what one can to make people see this. And thus, the discourse can and must be kept open.

But still, fear of inflation, if, as I suggest, it at least often is really based on choice and priority setting, however subconsciously, is not irrational then, because basic world-view-based goals are beyond the rational/irrational divide – that divide is about questions of how to achieve those goals. That may be very regrettable indeed from an economic policy perspective, but many of our choices are like that. In the end, what matters isn’t the correct policy, but rather the right one, and the system in which we have chosen to live, Democracy, has been set up precisely to make the chances higher that sometimes, the right things are actually done – or at least that the wrong ones are avoided as often as possible.

Tööandjate manifesti tähendusest

By Erkki Karo

Majanduse struktuursete muutuste üle on võimalik arutleda nii emotsionaalselt ja omakasupüüdlikult kui ka neutraalselt ja analüütiliselt. Kumba mõttemaailma võiks kuuluda Tööandjate manifest? Ametiühingute eestkõnelejad ning isegi peaminister on sildistanud manifesti esimesse kategooriasse, kuid neid silte on seatud suuresti samamoodi emotsionaalselt ja ehk ka isiklikest huvidest lähtuvalt.

2008. aastal ilmus innovatsiooni ja tehnoloogilise arengu uuringute valdkonnas raamat Small Country Innovation Systems (toimetanud Charles Edquist ja Leif Hommen), mis võrdleb omavahel viite kiire tehnoloogilise arengu ja majanduskasvuga majandust (Aasia tiigrid ja Iirimaa) ning viite küpsema majandusstruktuuriga ja väiksema kasvudünaamikaga arenenud riiki (Skandinaavia riigid ja Holland). Sellest raamatust võib tuua välja huvitavaid mõtteid ja järeldusi, mis võiksid olla olulised ka praeguse Tööandjate manifesti sisu ja reaktsioonide valguses.

Ühe huvitava paradoksina tuuakse raamatus välja järeldus, et kui vaadata erinevate riikide suutlikkust seada prioriteete majanduspoliitika struktuursete arengute kujundamisel, strateegiliste valikute tegemisel ja poliitikate koordineerimisel (n. migratsiooni- ja maksupoliitika sidumine tööstus- või innovatsioonipoliitikaga jne.), siis kiiresti arenevad Aasia riigid on suutnud seda teha lihtsamini ja efektiivsemalt, kui küpset heaoluühiskonda esindavad Skandinaavia riigid. Skandinaavia riikidele heidetakse ette, et viimastel kümnenditel on nende tegelik arengupotentsiaal pidurdunud ning järjest keerulisemaks on muutunud strateegiliste poliitikate kujundamine ja valikute tegemine. Selle tulemusena on riiklikud majanduspoliitikad muutunud hägusaks ning ei oma piisavalt olulist mõju majanduse sisulistele arengutele, et käia kaasas tehnoloogiliste muutustega. Samas väidetakse, et nüüdseks on need tendentsid üha enam esile kerkimas ka kiire arenguga Aasia riikides.

Huvitaval kombel ei seletata seda paradoksi mitte liiga suure riigi või liiga keeruliste poliitikatega, mida riik ei ole võimeline ellu viima. Vastupidi, raamatu autorid väidavad, et põhjused, miks kiire arenguga riigid on varasemalt suutnud ellu viia tugevaid ja kohenemisvõimelisi poliitikaid ning küpsed riigid on viljelenud pigem struktuurseid arenguid mittetoetavaid hägusaid poliitikaid, seisnevad hoopiski poliitikaid mõjutavate huvigruppide koosseisudes ja tugevuses.

Raamatus väidetakse (hüpoteesi tasandil), et Aasia tiigrid saavutasid majanduskasvu ja tehnoloogilise arengu, kuna nende arengutee alguses puudusid ühiskonnas tugevad huvigrupid traditsioonilistes, kuid väheneva lisandväärtusega tööstusharudes, mille eesmärgiks oleks status quo säilitamine (ehk oma positsiooni säilitamine läbi suuremate riiklike toetuste või väiksemate riiklike piirangute ja koormiste). Seetõttu said ka riigid rakendada tugevate prioriteetidega poliitikaid ja viia ellu põhimõttelisi visioone, mis tagasid tehnoloogilise arengu ja majandusliku kasvu.

Tänaseks on aga Aasias esile kerkinud oht, et ‘eilsed’ uued tehnoloogiad ja tööstused on muutunud samasugusteks traditsioonilisteks valdkondadeks, kus lisandväärtus kaheneb, mistõttu tööstuste huvid ja ootused riiklike poliitikate suhtes on muutumas. Samamoodi, Skandinaavia riikides on raamatu autorite väitel viimastel kümnenditel olnud läbivaks oluliseks mõjuteguriks just traditsiooniliste tööstuste huvigrupid, kelle eesmärgiks on olnud status quo säilitamine, mis on võimalik läbi üldiste, häguste ja horisontaalsete poliitikate, mille peamiseks eesmärgiks ei ole majanduse struktuursete muutuste läbiviimine (horisontaalse poliitika näiteks võiks olla sotsiaalmaksu lagi kõikidele kõrgepalgalistele töökohtadele; tugevate prioriteetidega poliitika näiteks võiks olla sotisaalmaksu lagi IKT ja teiste kõrgtehnoloogiliste valdkondade T&A töötajatele vms.).

Innovatsiooni kontekstis räägivad nii visionäärid kui ka poliitikakujundajad väikeettevõtete, uute start-up’ide (n. IKT puhul poisid naabri garaažist) ja muude seni avaldumata ettevõtlikkuse initsiatiivide tähtsusest ja nende riikliku toetamise olulisusest. Tööandjate manifesti esitanud Tööandjate Keskliidu liikmeskonnas (ja ka nõukogus) on uute tehnoloogia valdkondade esindajad, väikeettevõtjad ja võimalikud uue ‘Eesti Nokia’ omanikud selgelt vähemuses.

Seega, kuigi me ei saa selgelt väita, et Eestis domineeriks tugevad traditsioonilised tööstusharud uute tärkavate tehnoloogia valdkondade üle, võivad huvigruppide mõjujooned ja eesmärgid poliitikas olla ühesemalt selged – eriti kui uutes tehnoloogiavaldkondades domineerivad väikeettevõtted, virtuaalsed ja globaalsed tegijad, võrgustikud jne., kellel ei ole kombeks rahvuslikke huvigruppe ja käegakatsutavaid kogukondi luua, või nendele loota.

Selles valguses, ehk on Tööandjate manifest ‘vanakooli’ (heas mõttes) meeste nägemus, mitte kõikide praeguste ja tulevaste tööandjate nägemus, mille kõrvale oleks vaja konkureerivat mõttekäiku ettevõtjatelt, kelle jaoks ei ole tulevik mitte 2011-2015, vaid kuskil kaugemal tehnoloogilise arengu trajektooril. Samas, kui selline mõttekäik on tõene, siis peaks ehk ka riik vaatama üle oma majanduspoliitika kujundamise mudeli, kus avaliku sektori poliitikakujundamise võimekuse asemel eelistatakse loota ettevõtlust ja tööstust esindavate organisatsioonide visioonide ja nägemuste peale. Kui viimased on selgelt ühele poole kaldu, siis on oht, et kogu majanduspoliitika kisub kreeni või ei vasta tuleviku ootustele ja vajadustele.

The Myth of German Inflation Fears

By Wolfgang Drechsler

Germany’s stubborn insistence on austerity rather than increased spending to stimulate economic recovery is the worst possible stand to take at the current moment of the global financial crisis; it shows that nothing has been learned from history, that Keynes is still not understood in Berlin and that at the end of the day, Europe, the European Union and the Euro, and even the world economy, may go down in flames because of German stupidity. And why are Germans being so stupid? Just because of the irrational fear of the repetition of history, the German hyperinflation of 1922-1923, an outright mythical event which until today conditions Germany’s (and that means the Germans’) attitude towards spending vs. savings. Politicians from Sarkozy via Barroso to Obama and opinion leaders from Krugman via Dean Baker to Soros agree on that, and you can read it in many of the current G-20 and G-8 statements and comments as well.

Nevertheless, this is complete nonsense. The myth here is not the German hyperinflation at all – the myth is that the German attitude towards austerity vs. demand stimulation is in any way significantly based on that historical event. How much does history really matter in Germany – at least, pre-World War II history? How much does the average German really know about the hyperinflation of yore? Next to nothing, I would say – the majority of Germans has probably never even heard of it, as horrible and disastrous an event as it was. But how much can the past really hold sway over the present? It seems to me that only the burned child shuns the fire and that among today’s German decision-makers, opinion leaders and citizens, almost nobody consciously remembers that time. If we say that in order to halfway understand what the inflation meant, you had to be 16 years old when it happened (otherwise this is too abstract a topic, rather than say a war), that means you had to be born by 1907 at the latest. In this case, you would be at least 103 today – which my philosophical teacher Hans-Georg Gadamer in fact was when he died in 2002, and he had remained a public intellectual until the end, but he is still a rare exception. Sure, the hyperinflation is used as an image, as a reference point, as an illustration, but not more – which is also my experience from Germany, where I am right now as well, and one side of my family even did suffer heavily during the hyperinflation. Hyperinflation references in the German media are usually to foreign statements, not to the event itself. Historical events that people don’t remember are not “real” – unless propaganda and/or family lore renarrate them again and again in such a way that they become immediate and relevant again, and the hyperinflation, as I mentioned, seems somehow too abstract and complex for that. In any case, whatever the reason, the hyperinflation is not “immediate”, as Gadamer would have said, in today’s Germany at all.

In order to understand the German attitude right now, therefore, especially if one is concerned about it and if one thinks it stands in the way of crisis-appropriate policy, it is important to discard this faith in the myth and to try to find out what the real reason for this harsh anti-inflation stand is. My answer is that Germany’s strict opposition to inflation is perfectly rational, the opposite of being myth-based, and that there is indeed a connex between spending policies and inflation. Many Germans, if not most (and certainly most of a key segment of the population, the large middle class which is the foundation of the political system), have their assets in currency-based investments and are not in debt, or at lest perceive themselves that way either for now or for the immediate future, and any inflation is a net loss for them, and they have paid into a (currently) very well-working social and medical insurance system that likewise appears to hinge on a stable currency. As their life quality and future rest on this, and as they were always and unequivocally promised again and again by all politicians, experts and bankers that the currency will remain stable, it’s hardly surprising that they would mind, and indeed mind very much indeed, if this were not the case anymore. I basically agree with Adolph Wagner of course that all private property is state-created rather than natural, indeed that it is a function of the state, but it’s hardly surprising that people want to at least keep what they have if they have been assured again and again that they may keep it.

Add to this that a positive overall effect of inflation on the German, and indeed European and global, economy can be claimed but not proven within our ruling episteme, i.e. the system that conditions what we take for true or false: Insisting on a low inflation might bring the entire system to a collapse, so that in the end, Germany would have to pay anyway, but it only might – some, perhaps many (but certainly not all) economists may claim that it does, but how does that add to any likelihood of it being true in the eyes of a well-informed German citizen? Thus, being totally opposed to inflation and to policies that are conducive to or even based on it, is entirely rational for a German citizen. This is also the systemically correct and even ethical position because democracy is based at least to some extent, and even to a necessary one, on voters voting their genuine interests as perceived.

But how can one call the rational pursuit of economic self-interest ethical? Well, one can if one is a Smithian in any case, but the key aspect to realize in this context is that if one claims that Germany should take up its responsibility for the welfare of Europe and the European Union and its fellow Europeans, one ignores that there is no European identity – yet – in Germany or elsewhere. Maybe there should be (I myself would certainly like that), but that is not the issue – the issue is that it is not the case. The European project has, to a good extent even purposefully, dodged the creation of a European identity, and it is just absurd to claim now that there should be one, or even that it should come about because of the crisis. So, even if a higher inflation (even a mildly higher one than exists) were desirable on a European level, on the German level, it is not. A vast majority of Germans do not feel pan-European solidarity to the extent that they want to finance other countries, especially if those – especially Greece – are reported again and again to have brought their economic problems largely upon themselves by corruption and leisure orientation, even if that was well-known but calculatedly ignored by the EU and its other member countries.

All this means that Germany’s stand against inflation is not a case of an evil elite imposing wrong economics on a witless and hapless people, but of politicians representing the well-considered self-interest of their electorate (although it would appear anachronistic to most Germans to ascribe any sort of competence and policy design to the Merkel government right now). And this, in return, is, as I stated just a moment ago, close to the very definition of democracy. One may call it populism, but democracy necessarily entails a popular element.

One may not like any of this, but the problem then is elsewhere. It is in the missing European identity in Germany (and elsewhere), the missing willingness to part with one’s money, a lack of empathy, a lack of leadership – but under the current circumstances, the fact that Germans generally don’t want any inflation of what for them is primarily their currency is as normal as it is that the German leadership therefore doesn’t push, or at least consent to, inflation either, or at the very least, hesitates and delays. It has nothing to do with the legacy of the hyperinflation of 1922-1923, which, if anything, is simply used as an illustration among those in the German discourse who are already familiar with the topic. If one minds the German position and thinks it should be revised, one would be wiser to think about arguments addressing the genuine – and rational – German concerns over inflation, rather than whining about the power of a myth that, in the way it is claimed to, does not even exist.

Euroopa2020 – tagasihoidlik retoorika reform?

By Erkki Karo

Miks võib väita, et Lissaboni strateegia reformimine Eruoopa2020 strateegiaks on kõigest tagasihoidlik retoorika reform?

Esiteks on strateegia puhul tegemist poliitilisele eliidile kuuluva reformiga ehk selle sisu üle otsustamine on poliitilise (ja osalt tippametnike) eliidi privileeg. Osapoolte – nii huvigruppide kui ka tegelikult väiksemate ja uuemate liikmesriikide – kaasamine ja konsulteerimine toimub ennekõike domineeriva retoorika legitimiseerimiseks. Seda seetõttu, et tegemist on väga üldsõnalise ja EL-sisestest erinevustest – nagu regioonide kvalitatiivselt erinev võimekus ja vajadus, poliitilised vaated ja väärtused jne. – ülelibisev strateegiadokument, mille eesmärgiks ei ole midagi sisuliselt ära teha, vaid paika panna järgmiste kümnendite sõnade mäng ja õigustada varem Lissaboni strateegia raames tehtu suhtelist edukust.

Teiseks ja tulenevalt paljuski eelmisest, Euroopa2020 jääbki suure tõenäosusega retoorika tasemele seetõttu, et strateegia koosneb ennekõike liiga ümmargustest ja üldistest eesmärkidest ning puudub tegelikult nägemus ja kokkulepe, et milline on hea plaan nende eesmärkide täitmiseks. Strateegia probleemiks on see, et formaalsete eesmärkide taga (tööhõivest ja innovatsioonist keskkonnapoliitika eesmärkideni) on ka sisulised eesmärgid ehk nägemus kuidas ja milliste meetmetega formaalseid eesmärke täita. Viimane aspekt on aga poliitilise retoorika jaoks liiga detailne ja teiselt poolt on selles ka väga raske EL-tasandil kokku leppida, sest siin muutuvad regioonide erinevad vaated ja nägemused liiga olulisteks. Probleem seisneb selles, et neid eesmärke võib saavutada või nende täitmise poole püüelda nii heade kui ka halbade poliitikate abil.

Seega võib öelda, et Euroopa2020 eesmärkide täitmine ei sõltu mitte Euroopa2020 strateegiadokumendist ja selle detailsest sisust, vaid hoopis keerulisematest EL-i ja rahvusriikide poliitikatest ja tegevustest.

Eesti kui edukas retoorika vabariik?

Eelneva valguses võib väita, et Eesti on äärmiselt osav ja tubli EL retoorika kasutamisel ja selle toetamisel. Eesti nägemus Euroopa2020 strateegia eesmärkidest on ju väga eeskujulik – sisuliselt toetame me kõiki Euroopa2020 põhieesmärke püüdes neid saavutada vähemalt sama hästi või isegi paremini. Ka siseriiklikud eesmärgid (tootlikkus, eksport, haridus) on sisult ideaalsed EL retoorikaga sidumiseks. Samas võib ka siin väita, et tegemist on pelgalt retoorikaga, mille tähtsus Euroopa2020 ja Eesti sisuliste eesmärkide täitmisel on võrdlemisi vähetähtis.

Esiteks, Euroopa2020 põhieesmärkide ja Eesti lisatud eesmärkide puhul ei ole tegemist mitte millegi uuega. Kõige selle olulisus on teada juba vähemalt viimased 10 aastat ja seda sõltumata Lissaboni/Euroopa2020 strateegia olemasolust. Hoopis olulisem küsimus, mis retoorikas on alati tagaplaanil, on selles, et kuidas neid eesmärke realiseerida.

Teiseks, eelnevat toetab ka tõsiasi, et Eesti nägemus Euroopa2020st pigistab silma kinni nii mitmegi väärtuste erinevuse osas. Eesti päevapoliitika reaalsusega lähevad vastuollu EL-tasandil rõhutatavad väärtused nagu liikumine sotsiaalse turumajanduse suunas, tööstuspoliitika olulisus EL-i poliitilises retoorikas jne. Tõsiasi, et EL-i ja liikmesriikide nägemuste vahel võivad tekkida olulised väärtuspõhised erinevused, millest lihtsalt üle vaadatakse, viitab sellele, et tegemist on väga üldise retoorikaga, millel pole suurt kaalu siseriiklikes poliitikaprotsessides.

Kolmandaks, vaatamata sellele, et EL näeb Euroopa2020-s võtmestrateegiat peamiste poliitiliste eesmärkide paikapanemisel ja siseriiklike poliitikate kujundamisel, on Eesti lähitulevikku arvesse võttes tegemist sisuliselt teisejärgulise strateegia ja poliitilise retoorika kujundamise protsessiga. Vaadates EL-i ja Eesti prioriteete Euroopa2020 raamistikus on selge, et suurem osa eesmärkide täitmiseks kasutatavast finantsvõimekustest tuleb ennekõike EL struktuurivahenditest. Seetõttu muutub olulisemaks ennekõike see, kuidas ja milliseid reegleid ja prioriteete kirjutab EL ette struktuurivahendite kasutamiseks.

Paradoksaalselt, Eesti võimekus täita Euroopa2020 raames seatud eesmärke võib olla rohkem sõltuvuses EL-i suutlikkusest koordineerida oma poliitikaid (siduda Euroopa2020 struktuurivahendite poliitikaga) kui Eesti enda sammudest Euroopa2020 retoorika tegudeni viimisel. Kokkuvõttes võib öelda, et Eesti on olnud silmatorkavalt edukas Euroopa2020 retoorika kodustamisel. Sisuliste eesmärkide täitmiseks peaks Eesti veel endale pea ja seda kandva selgroo soetama.

No Sidestepping the Eurozone Implosion?

Originally published on Naked Capitalism

By Jan Kregel, former professor of economics at Università degli Studi di Bologna and Johns Hopkins,m and currently a senior scholar at The Levy Economics Institute and professor at Tallinn University of Technology and Rob Parenteau, CFA, sole proprietor of MacroStrategy Edge, editor of The Richebacher Letter, and a research associate of The Levy Economics Institute

A week ago eurocrats launched their campaign of overwhelming force designed to shock and awe the “wolf pack” of professional speculators and institutional investors (hedge funds and pension fund managers) into a more docile, subservient position. In the currency market, the shock and awe wore off after the first 48 hours, while by the end of the week, it also appeared to be wearing off from the equity markets.

Some of this is undoubtedly just the innate brazenness of the wolf pack being expressed. As a general rule, they do not take kindly to being cowed or constrained in any fashion. It is simply is not in their genetic make up. Consequently, they have no choice but to follow their instincts to call the bluff of the eurocrats, and that is part of the reason we are seeing, for example, the wolf pack dragging the euro exchange rate down to the ground in recent trading sessions.

But this is about more than just testosterone counts. Some wing of the professional investing world is beginning to see the design flaws built into the eurozone from day one. And once the spy these flaws, they begin to realize the nature of the solution is something utterly different than what they are witnessing being rolled out before their very eyes. In the following 11 points, we highlight some of the key aspects of the eurozone predicament using the financial balance approach developed by the late Wynne Godley which we have explored in previous blog submissions, papers, and book chapters. Until more investors and policy makers can understand the true nature of the various predicaments facing the eurozone, and the inherent design flaws exhibited in the European Monetary Union and the (In)Stability and (Lack of) Growth Pact, odds are precious time will simply be wasted trying to make believe the shock and awe fix is already in.

1. Underlying the eurozone predicament is a missing adjustment mechanism. There is neither a price nor a policy mechanism that encourages the current account surplus nations to recycle their surpluses in a win/win, pro-growth fashion. Keynes tried to design such a mechanism into the Bretton Woods agreement, but the American negotiators scotched it. This same pro-growth adjustment mechanism is missing at the global level with regard to China (although they did
report a trade deficit in March).

2. An ostensibly moral stance advocating balanced government budgets is revealing a profound ignorance of the simple accounting of sector financial balances. Those preferring to impose a “fiscally correct” policy on the peripheral nations should best recognize these accounting realities, and soon. If we are correct that domestic income deflation will be the end result of fiscal retrenchment colliding with private sector attempts to net save, then surely more desperate citizens will turn to even more desperate acts. Rather perversely, the combined effects of fiscal retrenchment, private income deflation, and rising private debt distress are likely to make moral considerations a second or third order concern for many eurozone citizens.

3. Ultimately, current account surpluses need to be recycled into chronic deficit nations in a sustainable fashion. Such a mechanism could be set up under the auspices of the European Investment Bank very quickly. Effective incentives to recycle current account surpluses via foreign direct investment or equity flows should be crafted at once.

4. Such an approach is likely to prove superior to funneling financial assistance through the IMF or other multinational arrangements. The IMF will undoubtedly insure that fiscal retrenchment gets imposed across the region. Any fiscal assistance is likely to be imposed with conditionality – a conditionality that fails to recognize sector financial balances are interlinked, both within and between nations. IMF conditionality is bound to set off the twin contagion vectors of falling trade surpluses and rising bank loan losses in the core nations. Surely this is not what Dutch and German policymakers intended, nor is it any way to hold the eurozone together.

5. Rapidly cutting fiscal deficits without considering the impact of such moves on private sector financial balances is a shortsighted, if not dangerous policy direction. Sector financial balances – the difference between saving and investment, or income and expenditures – are interconnected, and cannot be treated in isolation.

6. Hiking taxes and slashing government expenditures will suck cash flow out of the private sectors of the peripheral eurozone nations. These private sectors have been rebuilding their net saving positions in the wake of sharp and prolonged recessions. Companies have been conserving cash by slicing investment spending, inventories, and employment. Households have already drastically reduced home purchases and consumer spending.

7. It is an elementary fact of accounting that the private sector as a whole can only spend less than it earns if some other sector spends more than it earns. That sector has tended to be the government, usually as automatic stabilizers kicked in while recessions deepened. Indeed, most of the dramatic widening of government deficits is due to a collapse in tax revenues, not to discretionary stimulus. Pursuing fiscal retrenchment in order to reduce government debt default risk will merely raise the odds of private sector debt defaults. Cash flow will be taken from households and firms attempting to rebuild their net saving positions, and private debt servicing will falter.

8. The only way to avoid this outcome is if the nations undertaking fiscal retrenchment can swing their trade deficits around in a fully offsetting fashion. Otherwise, domestic income deflation is the likely result, Indeed, this is the madness behind the method of “internal devaluation” so evident in Latvia’s economic implosion. There is no guarantee that trade swings will be large enough to overcome fiscal drag. A return to debt deflation dynamics like those engaged after the Lehman debacle is not out of the question.

9. Furthermore, since the current account surplus of the eurozone has remained between +1 and -1 percent of GDP for quite some time, there is every reason to believe that attempts by the periphery to achieve trade surpluses will undermine the export led growth of Germany and the Netherlands.

10. It would therefore appear that fiscal retrenchment is about to set off two related contagion effects. First, the loans on the books of German, Dutch and French banks are likely to sour as private sector cash flows are squeezed in the periphery. Bank holdings of government debt issued by the periphery may not default, but the mortgages and corporate loans these banks have outstanding to the periphery will experience rising loan losses.

11. Second, the export sales of German and Dutch companies will fade with the falling import demand of the periphery. As their domestic incomes fall, they will import less. In other words, the fiscal retrenchment the core nations are insisting upon is highly likely to boomerang right back on them.

As it stands, investors have started to recognize that bank in the region are at risk. CDS for Spanish and Portuguese debt have started to widen more dramatically over the past two weeks, although investors still appear overly focused on government debt CDS. Policy makers have also begun to realize Greece is unlikely to be the last country requiring a bail out, while they at the same time sign on for rapid fiscal “consolidation” (read retrenchment) in order to ostensibly avoid
becoming the next Greece.

Yet we continue to find many of the points detailed above are not yet recognized by professional investors or policy decision makers. Absent this coherent framework, it will indeed prove very difficult to sidestep an economic and financial implosion in the eurozone, following on the heels of an already historically deep recession, and burst property bubbles in a number of eurozone nations. May wiser heads prevail.