Currency unions and balance of payments: what lies behind the Greek predicament

Posted on November 7, 2011 by haroldchorneyeconomist

One of the relatively unexplored aspects of the Greek debt crisis involves balance of payments issues that are buried beneath the terms of trade upon which Greece entered the European union. Much has been said and written about failure to pay taxes, excessively rich welfare state and excessive debt but very little about the terms of trade under which Germany and the northern countries benefitted considerably but Greece fell further behind. If your exports lag behind your imports something has to give to help pay the bill.

In the case of Greece current exports are 19 % of the GDP but imports are 31 % of the GDP.

If Greece were still a drachma currency with its own central bank the solution is straight forward. The drachma devalues, imports become more expensive and exports cheaper helping to right the balance over time. But if you have had the misfortune of entering into a currency union at the wrong and overvalued exchange rate you suffer from a fixed in stone disadvantage that can only be corrected through deflation of your wages and reduction of your export prices and wherever possible through productivity improvements that cheapen the relative price of your exports.

Because you now lack a central bank you are also at the mercy of your trade balance . To the extent you pay out more of your currency to your trade partners than they return to you in buying your goods, there is a built in tendency to reduce the supply of your currency. Unless you dramatically increase the velocity of circulation of the currency that remains there is a built in tendency to shrink your GDP.

In such circumstances austerity is precisely the worst policy you can opt for unless you wish try to solve the problem through a major fall in real wages, with all the deprivation and turmoil that will cause. This resulting deflation and recession leads to growing unemployment and growing indebtedness, In a strange sort of way a currency union that operates without a proper central bank has recreated the disaster of the gold standard that through its rigidity helped bring about the great depression of the 1930s.

The problems of balance of payments and the crises they can provoke do not disappear with a common currency but are submerged to re-emerge as a sovereign debt crisis.

Posted in austerity, balance of payments, classical economics, deficit hysteria, deficits and debt, European debt crisis, fiscal policy, full employment, Greek sovereign debt crisis, J.M.Keynes, monetary policy, quantity theory of money, Uncategorized | Leave a comment

Papandreou to resign and new coalition government involving Pasok, New Democracy and two conservative minor parties to take his place under new PM

Posted on November 6, 2011 by haroldchorneyeconomist

The latest news from Greece suggests that a new coalition government involving the Greek socialist party, Pasok, the principal opposition party New Democracy led by Antonis Samoras, and two conservative minor parties  is to replace the Government of George Papandreou. (One of these parties , the LAOS party is apparently led by an ultra right wing politician who has been accused of anti-semitism in the past see the article in the German paper BILD  by Paul Ronzheimer on this. His views and possible inclusion in the new Government have aroused concern in Germany. )

This cross party alliance will implement the austerity  and privatization program demanded of Greece by the European union and also receive the bail-out monies that have been promised. The government is likely to be short lived with new elections expected in the spring. It is not clear who the new Prime Minister will be but the Athens press is rumoring that it is likely to be a technocrat, Lucas Papademos a former Vice president of the ECB and former head of the  Bank of Greece. So Mr. Papandreou is the principal victim of the European dictat. We shall see if this ends the crisis. Because of the excessive nature of the austerity being demanded in exchange for help I remain a sceptic.

Europe has forgotten or deliberately suppressed the original Keynes plan to rescue countries that suffered exchange deficits. The idea was that surplus countries who had built up their surpluses at the expense of deficit countries in the trade exchange would be obliged to help out the debtor countries by providing low interest loans out of a common currency fund, bancor,, not imposing draconian austerity which Keynes correctly argued would only worsen the situation and diminish trade. This wise counsel has been turned upside down in Greece and the consequences are quite clear.

Posted in austerity, classical economics, deficit hysteria, European debt crisis, Greek sovereign debt crisis, J.M.Keynes, Uncategorized | Leave a comment

George Papandreou has won the non confidence vote

Posted on November 4, 2011 by haroldchorneyeconomist

Prime Minister George Papandreou has won the vote of non confidence in the Greek Parliament by a margin of 153 to 145  votes .Papandreou will now seek to form some sort of cross party government to broaden the base of support for the course he has chosen and the bailout package.

Posted in austerity, deficit hysteria, deficits and debt, European debt crisis, European financial stability fund, Greek sovereign debt crisis, Mr.Papandreou and democracy, Uncategorized | Leave a comment

Keynes versus the monetarists 2

Posted on November 4, 2011 by haroldchorneyeconomist

 Originally posted  SUNDAY, SEPTEMBER 19, 2010

Keynes versus monetarists 2

Some additional distinctions : Keynes&monetaristsKeynes’ theory of investment depends upon what he calls the marginal efficiency of capital. He defines the mec as follows: that rate of discount from a future stream of earnings that equates the current supply price of capital. All of this takes place under conditions of uncertainty.For Keynes uncertainty is not strictly reducible to a quantitative calculable probability.(See his Treatise on Probability and Ana Carabelli’s interpretation of it.) Because of these factors investment is unstable and strongly affected by the bank rate. Should the bank rate rise this will eliminate investment projects that have a lower rate of return. Obviously it is increasingly difficult to assess risk the further into the future one goes. In addition the stock market is highly risky because of the tendency toward speculative selling of shares and the tendency to operate on short term time horizons . Inherent values matter less than whether one can sell at a higher price than one has bought. Accurate judgement in the market is premised upon being able to judge the likely judgments of others about value and price. Therefore the markets are an unstable source of investment in capital projects.

The monetarists do not seem to have a unified theory of the investment process. Like Friedman’s theory of inflation money in – prices out, what I and others call a black box theory they seem to argue that investment happens more or less naturally because the animal spirits are strong(Keynes’ phrase) or the entrepreneurial knights of creative destruction(Schumpeter) or the waves of technological innovation bring it about. They also argue that statist intervention is antithetical to investment. Some of them, but not Friedman also argue that deficits raise interest rates and thereby crowd out investment. Keynesians would say au contraire deficits in recessions crowd in investment.

The classical quanity theory equation was MV=PT and then MV=PO where M was money stock, V velocity, P prices, T transactions and O output. Since V was regarded as highly stable and predictable and T and O fixed at the full employment level by Say’s law then there was held to be a direct relationship between M and P.

Keynes used the Cambridge variant of the equation M= 1/k (PO) where k is the demand for money balances or the tendency to hold money rather than to part with it. He also elaborated the equation by distinguishing between money stocks, M1, M2 and M3 where M1 was income deposits, M2 business deposits and M3 savings deposits the precursors to his transactions demand, precautionary demand and speculative demand for money. Then P= V1(M-M2-M3)/O where M = M1+M2+M3 .(See his Treatise vol.1 The Pure Theory of Money p.150London: Macmillan, 1930 and Tract, CW)

Friedman alters the classical model by writing it in Keynesian form as the demand for equities, financial assets, real capital assets, and cash. Md = P.f(y,w;R*m,R*b,R*e;u) where Md = the demand for money and P is the price index,y income of a single wealth holder, w fraction of wealth in non human form ; R*m expected nominal return on money; R*b expected nominal rate of return on securities; R*e expected nominal rate of return on phsyical assets, u all other variables that affect the utility attached to the services of money. (See his Quantity Theory of Money in the new Palgrave Money edited by John Eatwell, M.Milgate and P.Newman, eds.London: Macmillan, 1989.p.13; also see Phillip Cagan, Persistant Inflation:Historical and Policy Essays for an interesting” monetarist” approach to what became inflation orthodoxy during the 1970s and 1980s.)

Key Words: “Keynes”; “monetarists”; “Milton Friedman”; “quantity theory”; and from previous entry
“Say’s law” ;involuntary unemployment” “labour market clearing”

Posted in classical economics, deficits and debt, full employment, J.M.Keynes, labour market clearing, Milton Friedman and NAIRU, monetary policy, quantity theory of money, Schumpeter, unemployment | Leave a comment

Keynes versus the monetarists 1

Posted on November 4, 2011 by haroldchorneyeconomist

Keynes versus the monetarists 1

A Quick Guide to Keynes and the monetarists  originally posted Dec 2, 2005 on my blogspot blog.Keynes:
1. Rejects Say’s law of markets that supply creates its own demand; he also doesn’t accept Walras’s law that says non zero supplies are matched precisely by non zero demands for goods and services.he doesn’t believe that the invisible auctioneer eventually clears the market place of gluts.
2. Believes that money is not neutral. In other words once we introduce money into a barter system something significant changes and gluts become possible.

3. Labour markets do not always clear because of uncertainty, disproportionalities; non-homogeous supplies of labour and the importance of aggregate effective demand for clearing the market.

4. Persistant unemployment is possible despite flexible labour markets.Keynes rejects the second classical postulate that the wage is equal to the marginal disutility of labour. Involuntary unemployment is possible.

5. Keynes rejects the quantity theory of money.

6. Interest rates are not determined by the demand and supply of loanable funds. Rather liquidity preference plays a major role . The central bank’s behaviour is also very important in establishing short and medium term rates.

7.Keynes has a sophisticated theory of inflation prior to full employment based on profit push, wage push and savings investment disproportionalities.He elaborates this theory in the Treatise on Money (1930) but refines it and includes it in the Chapter on prices in the General Theory (1936)

8. The decision to invest and the decision to save are separate decisions often taken by very different people. Savings are not automatically and frictionlessly translated into investments.

9. Believes that both monetary and fiscal policy are important. The scissors effect is operational. One needs an accomodating monetary policy for a stimulative fiscal policy.

10. Deficits are a useful and appropriate tool of fiscal policy to help push an economy out of a slump.There is a multiplier effect on increments in investment. Leakages may exist but their impact is not large enough to overwhelm the multiplier.

11. When one stimulates most of the vector forces are on output but some is on prices. As one approaches lower unemployment more of the vector forces transfer from output to prices.GDP consists of PxO. Hence dI leads to dP as well as dO.

The monetarists:

1.They accept Say’s law. They accept Walras’s law.(For a more subtle and somewhat dissenting view of this description of the classical school as a caricature see David Laidler Fabricating the Keynesian Revolution. But also see the work of John Hotson, Paul Davidson,Alan Meltzer,R.Clower, Joe Stiglitz,Joan Robinson, , Axel Leijonhufvud, J.A.Trevithick,Harold Chorney and a number of other writers on these questions.)

2. They believe in the loanable funds doctrine for interest rate determination.

3. They privilege monetary policy above fiscal policy. A stable predictable steady growth in the money stock is desirable.

4. Savings are extremely important and automatically beget investment.

5. The quantity theory of money is sound.

6. Labour markets like other markets will clear so long as there are no frictions preventing this. Typical frictions are labour unions, the excessive social wages of the welfare state, inadequate or inefficient job search. Unemployment is therefore voluntary.

7. Laissez-faire is best. Intervention should be minimal. Allow the natural forces of the market to operate and all will be well.

8. Deficits are bad because they facilitate the growth of government which is bad.

9. Uncertainty is not a problem.

10. Inflation is the problem. Unemployment is taken care of by the natural rate approach. It is almost always voluntary.

Posted in business cycles, classical economics, deficits and debt, full employment, J.M.Keynes, Keynesian multiplier, labour market clearing, Milton Friedman and NAIRU, monetary policy, unemployment | Leave a comment

Papandreou reverses position:no referendum, confidence vote takes place this evening

Posted on November 4, 2011 by haroldchorneyeconomist

Premier George Papandreou after coming under heavy pressure from European leaders and the perhaps temporary desertion of several of his Parliamentary colleagues  reversed his position on holding a referendum. In exchange, he may have persuaded some of the opposition party politicians in the Greek parliament to support the bailout package and possibly even create a coalition government of national unity. However, some opposition leaders are opposed to Papandreou remaining the Prime Minister.The vote of confidence  apparently takes place at 10 pm GMT this evening. S0 we on the east coast of North America should know the outcome at our supper hour.

The ECB has begun to buy the sovereign debt of Italy and other countries which is a good move that should help ease the pressure on interest rates and cause the speculators to be more prudent.

One of the monetarist German members of the European Central Bank, Jurgen Stark has stressed that the move is only a temporary measure and that he was generally opposed to it, because of its positive impact upon easing the burden of high interest rates that put pressure on countries like Italy to clean up their act. This is akin to telling countries suffering from an influenza epidemic that even though you possess a life saving vaccine, it is better for them to suffer through the illness without resort to this treatment, so if they emerge from the illness through their own means they would somehow be better people. Not exactly a progressive sentiment.

Italy and other countries should , of course , undertake necessary reforms of their tax and expenditure systems, but it is foolish not to use all the modern means at the disposal of banking and governmental institutions to improve the lives of citizens. Like millions of others, I await the results of tonight’s Greek parliamentary vote. Whatever else it may accomplish it has , at least , made much more transparent the nature and potential contribution of central banking and sensible debt management to managing the business cycle.

Posted in austerity, business cycles, classical economics, deficit hysteria, deficits and debt, European debt crisis, European financial stability fund, Greek sovereign debt crisis, J.M.Keynes, monetary policy, quantitative easing, treasury view, Uncategorized, unemployment | Tagged | Leave a comment

Greek Government seeks referendum approval of latest measures:panic among some lenders at prospect of democracy

Posted on November 2, 2011 by haroldchorneyeconomist

Prime Minister Papandreou has apparently shocked some European leaders by announcing that he and his cabinet have decided to submit the latest bail-out and austerity package to a democratic referendum. In the crucible of democracy this seems wholly appropriate since the Greek people are being asked to shoulder a huge burden for years to come. I think it speaks well of Mr. Papandreou’s democratic credentials that he is willing to do this. Some critics argue that that it is a bargaining ploy on his part to put pressure on the foreign lenders and politicians to come up with an improvement of the package and lessening of the austerity which accompanies it. That may be so.

After all, if the European Central Bank had behaved differently much earlier much of what has happened might not have. The total outstanding Greek debt owed to foreigners is of the order of 190 billion euros. M2 according to the European central bank is of the order of 8,605 billion euros. If the ECB had simply bought temporarily half of the 190 million euro foreign debt  in the form of Greek government bonds the crisis would have been reduced considerably. It could have done so with near zero risk of inflation because of such an action. Of course, the problem of Greece also involves a large quantity of credit default swap bonds that have been bought and sold on Greek debt in a highly speculative fashion by banks throughout Europe.(See the very revealing article in Forbes,Why Europe is really freaked out over a Greek Default by Adrian Ash, July 15, 2011 on this)  Deficit hysteria has also played a major role, of course , in grotesquely exaggerating the risks associated with sovereign debt and supporting a failed policy of excessive austerity.) These practices need to be much more tightly regulated and the speculative aspects of the derivative drastically curbed.

If Mr.Papandreou wins his confidence motion in Parliament and his government lives on to fight and win the referendum my earlier optimism about resolving the crisis may well turn out to be justified.

If not, perhaps the package can be improved upon or the increasingly popular alternative of leaving the Euro and returning to the drachma will over time solve the problem. After all paying off the debts in drachmas will shave more than likely 50 % off the debt load forcing the bondholders to take the haircut they are currently being offered in any case, substantially increase the attraction of Greek exports and locally provided services, lessen austerity thereby permitting economic growth and allow Greece over time to reform its tax practices and social welfare state.

But as I wrote at the outset much of this could and can still be avoided if the ECB steps up to the plate and becomes a true central bank.

Posted in austerity, deficit hysteria, deficits and debt, European debt crisis, European financial stability fund, Greek sovereign debt crisis, Mr.Papandreou and democracy, Uncategorized, unemployment | Leave a comment

MF Global brokerage goes bankrupt :Excessive leverage and overexposure to European debt seem factors

Posted on October 31, 2011 by haroldchorneyeconomist

MF global a U.S. brokerage house headed by Jon Corzine, a former executive with Goldman Sachs, a former U.S.Senator and former Governor of New Jersey has declared bankruptcy in New York, apparently a victim of excessive leverage and over exposure to European debt. The bank, with significant exposure to this , J.P.Morgan Chase claims its exposure is less than 100 million on the 1.2 billion in debt on which  it acted as an agent. MF Global had bet on some 6 billion dollars of European bonds and it was apparently this bet that caused its downfall because rating agencies according to the FT considered this too aggressive.  Lets hope that this is an isolated case because the last thing we need now is more panic in the banking sector. If, in fact, excessive leverage was involved in this bankruptcy it is a sign that further reforms are needed to limit leverage to much more prudent levels.History has taught us that excessive leverage , essentially taking out large  speculative bets with borrowed money is a very risky strategy that sometimes can backfire big time. No one is immune to this kind of outcome, even the most sophisticated of investors as MF Global surely was. The days ahead will reveal if this is just an isolated event or if it has repercussions elsewhere.

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European solution seems on track for the moment:Falling financial dominoes to be shored up.

Posted on October 27, 2011 by haroldchorneyeconomist

While the financial markets wait with keen anticipation it does seem from studying the entrails of reports emanating from Brussels that the long awaited made in Europe solution to the sovereign debt crisis triggered by the spectre of the failure of Greece unleashing a chain reaction in Europe and abroad of falling financial dominoes is about to be announced.

The solution is composed of various strategies and initiatives. These include: the European central Bank buying up a portion of the sovereign debt in play; the more than doubling of the size of the European financial stability fund to over 1 trillion € ; the shoring up private bank capital by raising the target ceiling of tier one capital to 9 %; the possible involvement of offshore countries like China in contributing to the purchase of sovereign debt; the arranging of a substantial haircut on existing bondholders’ returns; the long run target for the Greek debt to GDP ratio of 120 % by 2020 down from 186 % in 2013. These are all good measures(although the target may be too severe a reduction in such a short time)  which should help calm the nervous markets but they must also be accompanied by some easing of the austerity program in Greece to provide both a measure of relief to Greece’s people and permit Greece to recover the path to economic growth.

For ultimately it is economic growth that will spur the solution to the debt burden by shrinking the weight of sovereign debt in the GDP. We shall see what tomorrow brings but these are hopeful signs that Europe has risen to the occasion and thereby strengthened its unity and economic coherence.

Posted in Uncategorized | 2 Comments

Keynes:Alive and Well

Posted on October 18, 2011 by haroldchorneyeconomist

Way back in 1996 I wrote an op ed piece for the business pages of the Toronto Globe and Mail in response to the anti-Keynesian musings of Terence Corcoran a business columnist for the Globe and Mail who was convinced that Keynes was dead and buried for good. Clearly I didn’t agree and I said so in my piece. I think the piece still speaks to some of the current situation so I am reprinting it in this post. It appeared in the Globe and Mail,  April 2, 1996.

Terence Corcoran is convinced that in the long run Keynesianism is dead. He could not be more wrong. In fact we are on the brink of a major revival of Keynes’s approach to policy. The suggestion that government spending cuts stimulate private investment other things being equal clearly violates both common sense and economic logic. Before people will invest, they need strong positive expectations about the future aggregate demand for the products and services their investments will produce. Keynes called these expectations “animal spirits.”

To the extent that government cuts withdraw purchasing power from the economy, as they must, since the saved revenues are being directed at deficit reduction, the only alternative source of domestic demand for these new products and services are the untapped savings of consumers and producers themselves, or the new incomes associated with the new investments. These incomes must initially be derived from bank loans  or entrepreneurial savings. Since in Mr. Corcoran’s vision savings fuel new investments, we have to look elsewhere for the source of demand. Workers laid off from the public sector cannot be the source, and the workers involved in producing the new investments are bound to be too few to buy all the goods and services produced. Where will the aggregate demand come from ?

The layoffs of public sector workers simply fuels the fear of other workers that they may suffer layoffs in the future. Consumers rationally assume that job security everywhere is lessened whenever downsizing and layoffs become the order of the day. What starts as a public sector depression quickly spreads to the economy as a whole. If downsizing is practiced by our trading partners increased foreign demand cannot be the source of the required demand. Whatever stimulus to investment is given by the spectre of government cuts and the vague promise of future tax cuts is quickly overwhelmed when entrepreneurs discover that aggregate demand is not up to their original expectations.

The resulting wave of bankruptcies ensures that in the future these products and services are not produced and national income adjusts downward to a level more commensurate with the higher unemployment and the increased propensity not to spend. Since more than two thirds of government spending are investments in human capital in the health, education and social services sector, simply cutting them to substitute private investments guarantees no new net investment.

The large budget deficits that Canada has been experiencing are the result of excessively high rates of real interest and the higher unemployment they generate. Budget deficits can only be stimulative if they are accompanied by low real rates of interest brought about by greater central bank accommodation of debt. The quickest way to crowd in investment and increase the growth rate is to cut interest rates and restore confidence to consumers that the days of downsizing are a thing of the past. The suggestion that cutbacks in the OECD countries  have not slowed growth, other things being equal, flies in the face of the experience of the past decade where elevated unemployment and depressed growth rates have been the predicament of virtually all G7 countries that have followed the monetarist model.

The last time the classical school of laissez-faire ruled the policy roost, it took ten years of depression and a world war to convince people that that classical economic thinking …might be flawed. Despite this abysmal record, half a century later we have forgotten the lesson. Keynes’s original dictum “in the long run we are all dead” could well turn out to be the signature of our age as well as his.

Fortunately, there are signs within academic economics and public policy analysis of a revival of Keynesian thinking. This time it will not be marred by Paul Samuelson’s misinterpretation of the Keynesian model that allowed stagflation to undermine the credibility of Keynes’s doctrine. In Samuelson’s version…(using the Keynesian cross diagram) inflation could only apppear( as excess aggregate demand )only…after full employment was reached. Keynes never believed this to be so, arguing that as the unemployment rate dropped, inflation would rise well before the full employment point.

As Hegel pointed out the owl of Minerva takes flight at dusk. The dark ages of elevated unemployment and unnecessary suffering will be lifted as the light of this change in thinking spreads from the academy. Mr.Corcoran’s column will join those of the writers of the 30s who applauded cuts in hard times as celebrated follies of the financial press.

Posted in austerity, Canada, classical economics, deficit hysteria, deficits and debt, fiscal policy, full employment, J.M.Keynes, labour market clearing, treasury view, Uncategorized, unemployment | 1 Comment