By Marshall Auerback, a portfolio strategist, hedge fund manager, and Roosevelt Institute Senior Fellow.
Like marriage, membership in the euro zone is supposed to be a lifetime commitment, “for better or for worse”. But as we know, divorces do occur, even if the marriage was entered into with the best of intentions. And the recent turmoil in Europe has given rise to the idea that the euro itself might also be reversible, and that one or more countries might revert to national currencies.
As far as European Monetary Union goes, the prevailing thought has been that one of the weak periphery countries would be the first to call it a day (in Ireland’s situation, one could make a good case for it on the grounds of persistent spousal abuse). It may not, however, work out that way: All of a sudden, the biggest euro-skeptics in Europe are not the perfidious English, but the Germans themselves. Take a look at these headlines (kindly drawn to my attention by James Aitken of Aitken Advisors, LLP):
Germany and the euro: We don’t want no transfer union | The Economist
And even a book by Hans-Olaf Henkel, formerly of IBM (Germany), and hitherto one of Germany’s great euro-enthusiasts: English translation: “Return our Money”
So let’s consider what happens if Germany decides to follow Herr Henkel’s advice. On the plus side, given Germany’s historic reputation for sound finances, the country will likely emerge with a strong Deutschmark, a global safe haven currency for currency speculators keen to find a true store of value.
But this will likely come with a huge cost: Germany will probably save its banking system at the expense of destroying its export base. The newly reconfigured DM will soar against the euro and become the ultimate safe haven currency. This will mitigate the write-down impact of the inevitable haircuts on euro-denominated debt, because the euro (assuming it is retained by the remaining euro zone countries) will fall dramatically. Even if the euro itself vaporises, the Germans simply will pay back debt in the old currencies, likely fractions of their previous value.
But Germany’s external sector will be wiped out. The resultant appreciation of the new Deutschmark, along with the inevitable banking crises in the periphery (which will exert significant deflationary domestic pressures in those countries and therefore reduce consumer demand in the euro zone ex Germany) will engender a huge trade shock: Germany’s growth will slow dramatically, as exports comprise such a large proportion of GDP.
Another interesting byproduct: By accounting identity, a fall in Germany’s external surplus means a large increase in the budget deficit (unless the private sector begins to expand rapidly, which is doubtful under the scenario described above), so Germany will find itself experiencing much larger budget deficits.
Let’s elaborate a bit further: We start with the standard macro observation that in any accounting period, total income in an economy must equal total outlays, and total saving out of income flows must equal total investment expenditures on tangible assets at the aggregate level. The financial balance of any sector in the economy is simply income minus outlays, or its equivalent, saving minus investment. A sector may net save or run a financial surplus by spending less than it earns, or it may net deficit spend as it runs a financing deficit by earning less than it spends, but at the aggregate level the dollar spending of all three sectors combined must equal the income received by the three sectors combined. Aggregate spending equals aggregate income.
At the end of any accounting period, then, the sum of the sectoral financial balances must net to zero. Sectors in the economy that are net issuing new financial liabilities are matched by sectors willingly owning new financial assets. One sector can run a surplus (spend less than its income) so long as another deficit spends. In macro, fortunately, it all has to add up. This is not only true of the income and expenditure sides of the equation, but also the financing side, which is rarely well integrated into macro analysis.
We can next divide the economy into three major sectors: the domestic private sector (including households and businesses), the government sector, and the foreign sector (imports and exports), and ask a simple question relevant to current developments. What happens if one of those three variables experiences a dramatic shift from surplus to deficit (as we envisage occurring here under Germany’s external accounts)?
The basic income-expenditure model in macroeconomics can be viewed in (at least) two ways: (a) from the perspective of the sources of spending; and (b) from the perspective of the uses of the income produced. Bringing these two perspectives (of the same thing) together generates the sectoral balances.
From the sources perspective, we get this equation:
GDP = C + I + G + (X – M)
This formula simply indicates that total national income (GDP) is the sum of total final consumption spending (C), total private investment (I), total government spending (G) and net exports (X – M).
From the uses perspective, national income (GDP) can in the following ways:
GDP = C + S + T
This equation indicates that GDP (income) ultimately comes back to households who consume (C), save (S) or pay taxes (T) with it once all the distributions are made.
In aggregate, we can express the formula in the following manner:
C + S + T = GDP = C + I + G + (X – M)
So after simplification (but obeying the equation) we get the three sectoral balances view of the national accounts, which we discussed above:
(I – S) + (G – T) + (X – M) = 0
That is the three balances have to sum to zero (see here for more)
• The private domestic balance (I – S) – positive if in deficit, negative if in surplus.
• The Budget Deficit (G – T) – negative if in surplus, positive if in deficit.
• The Current Account balance (X – M) – positive if in surplus, negative if in deficit.
These balances are usually expressed as a per cent of GDP but that doesn’t alter the accounting rules that they sum to zero, it just means the balance to GDP ratios sum to zero.
This is also a basic rule derived from the national accounts it always applies. This is not high Keynesianism, but simple double entry bookkeeping, developed some 6 centuries ago. Call it the tyranny of Accounting 101.
You can then manipulate these balances to tell stories about what is going on in a country, as we are seeking to do here with Germany. For example, when an external deficit (X – M < 0) and a public surplus (G – T < 0) coincide, there must be a private deficit. So if X = 10 and M = 20, X - M = -10 (a current account deficit). Also if G = 20 and T = 30, G - T = -10 (a budget surplus). So the right-hand side of the sectoral balances equation will equal (20 - 30) + (10 - 20) = -20. As a matter of accounting then (S - I) = -20 which means that the domestic private sector is spending more than they are earning because I > S by 20 (whatever $ units we like). So the fiscal drag from the public sector is coinciding with an influx of net savings from the external sector. 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. It is an unsustainable growth path.
This situation describes the recent history of the United States, notably under the Clinton years when the country was running budget surpluses. By the same token, using the sectoral balance approach, we can say that a current account surplus (X – M > 0), if large enough, allows the government to run a budget surplus (G – T < 0) which applies in the case of many Asian countries or a European country, such as Norway (where the world does its spending for it). What about Germany today? In the current German situation, although the country runs a large current account surplus, it is insufficient to offset a high private sector predisposition to save (which means there is some deficit). But the current account surplus does allow for a smaller budget deficit than its so-called "profligate" Mediterranean neighbors, whilst still facilitating the private domestic sector’s desire to net save. As we have argued before, it is the “profligacy” of Germany’s Mediterranean trading partners, which has allowed it to rack up huge current account surpluses, and therefore run smaller budget deficits than the likes of the PIIGS countries. Once divorce from the euro is complete, Germany will regain its fiscal freedom. This is itself is something the Germans should celebrate, providing their government takes advantage of their newfound fiscal freedom. Remember, once it returns to the DM, Germany becomes the issuer, as opposed to the user of a currency, as is the case under the euro, and is fully sovereign in respect of its fiscal and monetary policy. Consequently, the German government can offset the external shock by running large government budget deficits, which will add new net financial assets to the system (adding to non government savings) available to the private sector. It will become almost impossible to run budget surpluses under this scenario, but this is no bad thing for any country which issues debt in its own free-floating non-convertible currency. As unpalatable as this conclusion might be for many, it is entirely consistent with national income accounting. As Bill Mitchell has pointed out on many occasions, “the systematic pursuit of government budget surpluses (G < T) is dollar-for-dollar manifested as declines in non-government savings. If the aim was to boost the savings of the private domestic sector, when net exports are in deficit, then taxes in aggregate would have to be less than total government spending. That is, a budget deficit (G > T) would be required.”
A budget deficit per se, then, will not cause any problems per se for Germany, as it will no longer have any external constraint, having restored the DM as its currency of choice. But historically, Germany has embraced an export based model at the expense of curbing domestic consumption.
So its policy makers face a choice: will the country offset the decline in its current account surplus via a more aggressive fiscal policy by choice (i.e. proactively, in search of a full employment policy), or reactively via the growth in the automatic stabilizers? If the Germany economy slumps (as I expect it will), the deficits via the automatic stabilisers will rise as a matter of course. Germany can easily counter that if it chooses to do so.
It’s never a laughing matter to see any economy slump, but anybody with a sense of irony will naturally be wondering whether the German government and its voters will get themselves in a frenzy about being so “profligate” as the inevitable trade shock develops. I suspect there will also be a touch of “schadenfreude” on the part of its recently divorced euro zone “ex-spouses” (how does one say “schadenfreude” in Greek or Spanish?). Personally, I’ve never seen the merits in eliminating government debt just so that the private sector is forced to go into greater deficit, and perhaps the Germans will eventually figure that out as well, In any case, one suspects that we are about to get a nice “teachable moment” for Frau Merkel, if Germany does embrace the course of action now so enthusiastically endorsed by the likes of Herr Henkel.
But the country might well find truth in the adage, “Be careful what you wish for”.
“At the end of any accounting period, then, the sum of the sectoral financial balances must net to zero” (your accounting rules).
That embodies the assumption that the equation actually does balance. Keynes’ “National Income Accounting” equation has never balanced (something the masses intutively already know).
“That embodies the assumption that the equation actually does balance. Keynes’ “National Income Accounting” equation has never balanced (something the masses intutively already know).”
The masses are wrong. It does balance. Deficits in one area are always balanced by surpluses somewhere else. Its a matter of reading the data correctly. As Auerback says;
“This is not only true of the income and expenditure sides of the equation, but also the financing side, which is rarely well integrated into macro analysis.”
Look at the FINANCING side of it as well and you will find the balances.
You repeatedly contradict yourself. Banks doen’t loan out reserves, etc. But banks don’t loan out savings either.
Any institution whose liabilities can be transferred on demand, without notice, and without income penalty, via negotiable credit instruments, and whose deposits are regarded by the public as money, can create new money, provided that the institution is not encountering a negative cash flow.
From a systems viewpoint, commercial banks, as contrasted to financial intermediaries: never loan out, and can’t loan out, existing deposits (saved or otherwise) including existing transaction deposits, or time deposits, or the owner’s equity, or any liability item.
When CBs grant loans to, or purchase securities from, the non-bank public, they acquire title to earning assets by initially, the creation of an equal volume of new money- (transaction deposits) — somewhere in the banking system. I.e., commercial bank deposits are the result of lending, not the other way around.
The non-bank public includes every institution, the U.S. Treasury, the U.S. Government, State, and other Governmental Jurisdictions, and every person, except the commercial and the Reserve banks.
I.e., the “S” in your equation is unbalancing – since the utilization of bank credit to finance real investment or government deficits does not constitute a utilization of savings since financing is accomplished by the creation of new money.
I’m trying to figure out where your disagreement actually is. Your 2nd, 3rd, and 4th paragraphs aren’t in contradiction whatsoever to “loans create deposits.”
Regarding the accounting, non-bank public is referring to the non-govt sector that isn’t banks. Define non-bank public however you want, but that’s the definition Auerbach is using.
I’ve been grinding on this stuff with my peanut sized brain for months and I was always channeling up an air tight room with the molecules moving around.
That never seemed right, despite all the equals signs. Because it isn’t growth, it’s only circulation.
I think you’ve helped illuminate something for me — which is obvious in hindsight. The newly created money is the air coming into the room, which creates the growth. And when the money comes into the room, then it comes in as both liabilities and assets at the same time, which clearly is double-entry bookeeping.
It’s remarkable to me that everything metaphysically speaking brings forth its reciprocal opposite. Even money, in the form of assets and liabilities. Just like waves and particles, matter and energy. This stuff really gets weird. Something is going on here that’s more than my peanut brain can even grasp. It’s almost Fortean in its strangeness. There is no doubt that each human body cell corresponds to a star somewhere in the universe. This was recently proved by science.
I know it sounds crazy, but it’s true . . .
* * *
“It’s fun because it gets you thinking about these large numbers,” Conroy said. Conroy looked up how many cells are in the average human body — 50 trillion or so — and multiplied that by the 6 billion people on Earth. And he came up with about 300 sextillion.
So the number of stars in the universe “is equal to all the cells in the humans on Earth — a kind of funny coincidence,” Conroy said.
Hehe… you’re about two steps away from entropy, Maxwell’s Demon and all that thermodynamics/cybernetics jive. You read Mirowski? I think you’d appreciate it…
I gotta weigh in here – this has been annoying me for a few days (shows how much of a life I have, I guess). But on reflection, I think this is a very fundamental question – and I don’t seek to answer it, so much as to provoke debate.
“the “S” in your equation is unbalancing – since the utilization of bank credit to finance real investment or government deficits does not constitute a utilization of savings since financing is accomplished by the creation of new money.”
So, your conception seems to be – if I understand correctly – monetary. What I mean by that is that you conceive money supply as the key factor in government spending – and not vice versa.
I believe – and correct me if I’m wrong – that this is a monetary conception of how things work. In essence, money is the causal factor.
Now, my guess is that Auerback – and Marshall, correct me if I’m wrong – doesn’t adhere to this, because he’s a Keynesian. He thus believes that money is tied to the laws of supply and demand and that government debt is a more important factor than the growth in the money supply.
Now onto the next interesting comment.
““This is not only true of the income and expenditure sides of the equation, but also the financing side, which is rarely well integrated into macro analysis.”
Look at the FINANCING side of it as well and you will find the balances.”
This assumes that – in essence and agreeing with Auerback – creditors and debtors balance. For every $1 in debt; there is $1 in credit – thus, on a macro level this balances.
Implicitly, this assumes that the economy is inherently balanced and that there is no ‘money-as-causal-factor’.
When money is pumped in, then, it makes no real difference – provided that the economy is not operating at an efficient level.
Why? Well, in my understanding of Keynesianism, because if there’s no demand for money then there won’t be any demand generally – because broke, unemployed people won’t borrow (or, conversely, lenders don’t trust the unemployed). This means that companies – seeing that the market is bad – won’t invest, because they don’t think anyone will buy their products.
I must say, given the economic circumstances Keynesianism seems a better approach to understanding the problem than monetarism. But still – keep the discussion going… this is fascinating!
“When money is pumped in, then, it makes no real difference – provided that the economy is not operating at an efficient level.”
Sorry, I meant: “provided the economy IS operating at an efficient level”.
My bad – this stuff makes my brain hurt. An ‘edit’ button is required Ms. Smith!
Sh*t, no I didn’t… I meant what I originally said – although I’ll supplement it:
When an economy is operating well below an optimal level – let’s call a spade a spade: when its in a state of deflation and major contraction – increasing the money-supply won’t lead to anything ‘real’ happening (just more bubbles).
When the economy is operating reasonably normally, increasing the money-supply will lead to inflation (which is, in a way, a bubble).
So, this seems – in my mind – to confirm Auerback’s – and Keynes’ – thesis. Money-supply is peripheral – government spending, saving and consumption are the real key.
On another note: a ‘delete’ key is required Ms. Smith!
Absolutely agree that the newly created DM will rapidly appreciate if Germany exits the euro. By the same token, if ANY of the PIIGS exits the Euro, shouldn’t the EUR appreciate? Most commentators seem to suggest the reverse.
A Germany unilateral exit the euro (or maybe joined by a petty court of rather small Nordic countries) raises major issues:
1. Would the EU (which has other aspects, specially the common market and the free travel “Schengen” zone/EU super-citizenship) survive. If so would the pre-euro European Monetary Union be revived? This would imply narrow fluctuation bands for the member currencies (though special situations may apply – I think it happened with the pound once, long ago).
2. It’d be a Germany-France divorce first and foremost. And France would keep all the “PIIGS” (except probably Ireland) in its area of influence, plus Belgium (or whatever is left after it breaks up). I do not have figures but this area, including France, Italy and Spain, must be the main euro-market for German exports and speculations. As I have said before, finances are not the crux of the matter but the real economy is instead; finances can, should and eventually will be sacrificed to the real economical imperatives. And in real economy, after Queen Germany, it is this area what weights most in the Eurozone. A “Latin” Eurozone would not be the EU but would be half of it: it may be viable (after serious, more monetarist and less strictly budgetary, adjustment).
3. Germany would look then to the East, to Central and Eastern Europe, where it already has a clear economic and largely political hegemony. Somebody argued that this would push Germany towards Russia… but Russia, like Poland and the rest, is more an exporter than an import market. It would not allow Germany to avoid the harsh reality of imploding markets in general after the Bubble Burst, the overproduction crisis we are witnessing. Whatever the course, it is an uphill one.
4. Miscellaneous stuff, specially where does that leave Britain?
I do not think that Germany can afford to leave the euro (much less under such German impractical conditions), the same that it cannot afford to let Ireland (nor Spain) go bankrupt. The elites and public opinion, in Germany specially, are not addressing the bull by the horns, they are misleading themselves and the rest about the nature of the problem, and therefore they cannot provide any effective solutions. They are also showing their lack of commitment to the European project, which is in fact the main issue here.
“how does one say “schadenfreude” in Greek or Spanish?”
I could not find any clearly similar expression in Spanish. “Malicia” (malice) maybe but does not capture the whole meaning, right?
There are instead expressions like “verguenza ajena” that is like the reverse of shcadenfreude: literally “alien shame”: shame because of others’ fault (lowliness, shamelessness, stupidity…).
Also the saying “mal de muchos, consuelo de tontos”: loss of many, consolation of the dumb.
And that other saying: “el que no llora, no mama”: who doesn’t cry, is not breastfed. This IMO applies for Germany, which I understand has been getting all this time the share of the lion and now cries like a baby. It should assume its responsibility as economic, and largely also political, leader of the Union, instead of being so selfish and petty nationalist.
The Scandinavian countries well before Schengen have had “Nordic Passport Union” that start 1952.
“The Nordic Passport Union allows citizens of the Nordic countries: Denmark (Faroe Islands included), Sweden, Norway, Finland and Iceland to travel and reside and work in other Nordic countries without a passport or a residence permit. Aliens can also pass the borders of the Nordic countries without having their passport checked, but still have to carry a passport or another kind of approved travel identification papers.”
It have worked excellent and that without a common currency or anything that is remotely like the EU bureaucracy or bloated overpaid political and bureaucracy class with salaries, pensions and benefits that is far beyond what they can get in their home country topped with in practice tax exemption, (they only pay 17% tax on their exuberance salaries next to nothing in an European context).
“Anything that cannot continue WILL end.”
The euro cannot continue only the timeing of it’s end is now in play.
What’s the foreclosure process like in the Fatherland? They too were into this securitization frenzy, the bank that bears the countries’ name received massive assistance, I wonder what life is like for the disenfranchised, or the immigrant during Merkel’s reign.
Yes, the “Neu-Mark” would gain 30% against the Euro at birth and then overshoot another 20%.
Germany would suffer a big recession but holidays in Greece would get affordable again. Big turmoil but life would go on.
The bigger problem comes earlier and I am astonished that Auerback et aliis are not thinking about it: Who gets Neumark and who gets Euros. Euro-Notes will cross the borders to cash in Neumark – you have to restrict Cash changes. Okay, one can do that, our state is already Orwellian enough for it.
But bank deposit. A Greek shipowner took up a loan in Athens, secured by his fleet ( or not), and deposits the money with Deutsche Bank in Frankfurt. Do you give him Neumark? It would make him very rich if the Neumark springs out at the top and the New-Drachma at the bottom… This is just one theme.
What about MultiNational Companies? They are the ones to make the Killing of a lifetime. Bonds and Loans in Paris, Madrid, Italy, Athens – and money in Frankfurt. How to avoid this?
What about German companies with Euro debt and assets out of Germany? Do they owe Neumark Monday morning ? Then they are bankrupt Monday evening!
I fear there is non-reversibility. One can make fishsoup out of an aquarium. But try to do the opposite….
Common currency was sold to Europeans as a means to reach more unity in Europe. Now it is achieving quite the opposite. There is a EU beyond the Common Currency and beyond a Brussels-Superstate. 80% of Europeans would like the have more “subsidiarity”, not a Super-State. The political elites drive for the opposite and a big backlash will come. In the end you can only force a Fiscal Union with a military back-up and they are not ruthless enough to do that. So it most probably will end much later in a much bigger mess…..
Hubert said: “In the end you can only force a Fiscal Union with a military back-up and they are not ruthless enough to do that.”
Even though this statement flies in the face of classical economic theory, its veracity has been demonstrated repeatedly by events over the past 200 years.
Oh well, so much for the myth of a coercion-free economic paradigm.
Of course no contracts based on debt would be rewritten to the new currency. Only new contracts, labour contracts etc. would switch to the new currency.
Thanks for the lesson in macro accounting, Mr. Auerback. I bookmarked this page. If the Germans do go back to the DM, I hope they finance deficits without debt. Just print and spend the new money. No new debt equals no hysteria about the National Debt and no free ride for the usury class.
Also, perhaps a distribution of currency to the population (Social Credit?) might be the least destructive means of government spending if needed. Let the population decide how to spend the money. I image that would be a huge draw for young immigrants since Germany is aging and needs them.
how does one say “schadenfreude” in Greek?
Back on the topic, in EU we need a fiscal union.We need a good plan to get us out of the mess.
I was going to say “Epikhairekakia”, but that’s prolly Ancient Greek.
Well, which do you want, a fiscal union or a good plan?
The monetary union sure worked out well, and especially abdicating monetary sovereignty….
What’s Greek for, “when you’re in a hole, stop digging”?
(Not that anybody in America has stopped digging either.)
“What’s Greek for, “when you’re in a hole, stop digging”?
(Not that anybody in America has stopped digging either.)”
This makes me think that whatever is going on, it is at a level much deeper than the levels at which America and Europe seem different.
One may also want to take into consideration the following:
“German banks have over a $400 billion exposure to peripheral-nation banks, $550 billion if exposure to Italian banks is included.”
regodearse in spanish ;)
Auerbach’s reflexions on the ‘return of the Deutschemark’ all ring true until this off-note is struck:
‘A budget deficit per se, then, will not cause any problems per se for Germany, as it will no longer have any external constraint, having restored the DM as its currency of choice.’
True as far as it goes. But endless budget deficits engage the power of compound interest in a destructive way. Eventually debt service becomes unsupportable. The temptation to print the currency to service the debt becomes irresistable, and hyperinflation looms.
This is not to argue against cyclical deficits. However, the absence of external constraint does not mean the absence of internal constraints against chronic deficits.
The wheels of financial justice grind slowly, but exceedingly fine.
But endless budget deficits engage the power of compound interest in a destructive way. Eventually debt service becomes unsupportable. Jim Haygood
So don’t borrow the money; just spend it into circulation
and tax it out of circulation. No debt and no interest.
However, the absence of external constraint does not mean the absence of internal constraints against chronic deficits. Jim Haygood
True and one way to deal with chronic government overspending is to eliminate legal tender laws for private debt and to allow private currencies. Floating exchange rates between them would keep the government honest. If the government overspent then it would have to explicitly raise taxes (unpopular with the voters) to maintain the purchasing power of its money.
Yep. Well said.
Thanks for us audio connected types for giving your time to one of our favorites: Harry Shearer. It is unfortunate that a program featuring music and satire must inform us of these things.
Maybe, I should remind you about the history of the CA balance of Germany. In the eighties, indeed the situation was somewhat similar to todays situation, but after the reunification, Germany ran a deficit in the 90s, until the CA surplus surged in the 2000s – possibly triggered by effects of the Euro introduction.
I don’t see, why it would be impossible to go back to a situation like in the 90s, if Germany would reintroduce the DM.