Monetary Realism

Understanding The Modern Monetary System…

“The Maastricht Treaty Could Make a Huge Difference to their Lives”

  • Home
  • Uncategorized
  • “The Maastricht Treaty Could Make a Huge Difference to their Lives”

Well, it’s become pretty clear by now that the Euro is a failing project.  But it’s still odd how so many people don’t seem to, in my opinion, connect the dots entirely.  What Europe is ultimately confronted with is not a debt crisis or a current account crisis, but a currency crisis resulting from a lack of political unity within a single currency system.   Yes, there’s a debt crisis and a current account crisis, but these are symptoms of the failed monetary union.  They are not the cause of the disease.

It’s not a perfect analogy, but the USA is still a good one here.  The US states are all users of the dollar.  Just like the European nations are users of the Euro.  Now, the European nations could technically become currency issuers (they have their own central banks with a phone to the ECB), but the political will doesn’t exist to let these nations just print Euro at will (there is no true political unity).  So they’re really currency users for all intents and purposes.  In the USA, the states are also currency users, but the big difference is that state budgets get a 20% padding every year (sometimes more, sometimes less).  So what you avoid is solvency crises once every 10 years at the state level because the Federal government is there to provide fiscal aid on a regular basis.  You can basically think of it like a permanent “bailout” if you’re into that sort of politically charged rhetoric.

It’s also interesting here to go back and look at some of the comments regarding the Euro in the years before it was fully implemented.   It’s clear that some people understood all of this long ago.  Ramanan had a very good post on this the other day in which he cited Wynne Godley’s famous Euro prediction:

I was reading this article by Ken Coutts and Wynne Godley from 1990 [1] where the authors point to different kinds of arguments put forward by others to defend this position (“current account deficits do not matter” provided markets are made free).

There appear to be six different lines of argument to the effect that the current account deficit can be ignored …

… (v) A different kind of argument makes a comparison between a nation with an external deficit and a relatively poor region within a nation. It is pointed out that there is no balance of payments problem for Scotland or for Northern Ireland and from this it is concluded that as soon as Britain joins a European monetary union its balance of payments ‘problem’ will disappear permanently …

… The argument (v) that a region within a country cannot have a balance of payments ‘problem’ ignores the fact that if a region imports more than it exports its trade deficit is automatically paid for by fiscal transfers.[footnote: Strictly speaking, the fiscal transfers will always exactly compensate for any trade deficit only after allowing for the acquisition of financial assets by the private sector as implied by the ‘New Cambridge’ identity (exports less imports equals net government outlays phu the ‘trade’ deficit). The identity says, of course, nothing whatever about the level of real income and output which trading performance will have generated]. The point may be illustrated by considering an extreme case where a region consumes tradables but cannot produce them at all. In this case there will be a trade deficit exactly equal to imports of tradables, but the flow of government expenditure and net transfers will provide a minimum level of income support and keep life of a kind going without any borrowing at all taking place. If an uncompetitive region were not in receipt of fiscal inflows, its inhabitants would have no alternative but to emigrate or starve. This example illustrates that merely by sharing a common currency with another area, a region or country does not automatically dispose of its balance of payments problems since its prosperity still depends on how successfully it can compete in trade with other areas. The Delors Report itself correctly observes that a monetary union transforms a weakness in the ability to compete successfully from being a balance of payments problem into a regional problem to which there is only likely to be a solution by using the instruments of regional policy.

The movement toward more integration by giving higher powers to the European Parliament was also suggested by Wynne Godley and Marc Lavoie in 2007 [2]:

… Alternatively, the present structure of the European Union would need to be modified, giving far more spending and taxing power to the European Union Parliament, transforming it into a bona fide federal government that would be able to engage into substantial equalisation payments which would automatically transfer fiscal resources from the more successful to the less successful members of the euro zone. In this manner, the eurozone would be provided with a mechanism that would reduce the present bias towards downward fiscal adjustments of the deficit countries.

Godley’s Euro comments are almost unfathomably prescient.  Granted, he wasn’t the only one making similar comments in the 90’s (many MMTers and other PKers were as well – though much later), but Godley was the one leading the charge here.  He’s on record as early as 1992 saying this integration would encounter problems as originally designed (I am posting his entire comments because the word “epic” is the only one that comes to mind when considering how right he was):

A lot of people throughout Europe have suddenly realised that they know hardly anything about the Maastricht Treaty while rightly sensing that it could make a huge difference to their lives. Their legitimate anxiety has provoked Jacques Delors to make a statement to the effect that the views of ordinary people should in future be more sensitively consulted. He might have thought of that before.

Although I support the move towards political integration in Europe, I think that the Maastricht proposals as they stand are seriously defective, and also that public discussion of them has been curiously impoverished. With a Danish rejection, a near-miss in France, and the very existence of the ERM in question after the depredations by currency markets, it is a good moment to take stock.

The central idea of the Maastricht Treaty is that the EC countries should move towards an economic and monetary union, with a single currency managed by an independent central bank. But how is the rest of economic policy to be run? As the treaty proposes no new institutions other than a European bank, its sponsors must suppose that nothing more is needed. But this could only be correct if modern economies were self-adjusting systems that didn’t need any management at all.

I am driven to the conclusion that such a view – that economies are self-righting organisms which never under any circumstances need management at all – did indeed determine the way in which the Maastricht Treaty was framed. It is a crude and extreme version of the view which for some time now has constituted Europe’s conventional wisdom (though not that of the US or Japan) that governments are unable, and therefore should not try, to achieve any of the traditional goals of economic policy, such as growth and full employment. All that can legitimately be done, according to this view, is to control the money supply and balance the budget. It took a group largely composed of bankers (the Delors Committee) to reach the conclusion that an independent central bank was the only supra-national institution necessary to run an integrated, supra-national Europe.

But there is much more to it all. It needs to be emphasised at the start that the establishment of a single currency in the EC would indeed bring to an end the sovereignty of its component nations and their power to take independent action on major issues. As Mr Tim Congdon has argued very cogently, the power to issue its own money, to make drafts on its own central bank, is the main thing which defines national independence. If a country gives up or loses this power, it acquires the status of a local authority or colony. Local authorities and regions obviously cannot devalue. But they also lose the power to finance deficits through money creation while other methods of raising finance are subject to central regulation. Nor can they change interest rates. As local authorities possess none of the instruments of macro-economic policy, their political choice is confined to relatively minor matters of emphasis – a bit more education here, a bit less infrastructure there. I think that when Jacques Delors lays new emphasis on the principle of ‘subsidiarity’, he is really only telling us we will be allowed to make decisions about a larger number of relatively unimportant matters than we might previously have supposed. Perhaps he will let us have curly cucumbers after all. Big deal!

Let me express a different view. I think that the central government of any sovereign state ought to be striving all the time to determine the optimum overall level of public provision, the correct overall burden of taxation, the correct allocation of total expenditures between competing requirements and the just distribution of the tax burden. It must also determine the extent to which any gap between expenditure and taxation is financed by making a draft on the central bank and how much it is financed by borrowing and on what terms. The way in which governments decide all these (and some other) issues, and the quality of leadership which they can deploy, will, in interaction with the decisions of individuals, corporations and foreigners, determine such things as interest rates, the exchange rate, the inflation rate, the growth rate and the unemployment rate. It will also profoundly influence the distribution of income and wealth not only between individuals but between whole regions, assisting, one hopes, those adversely affected by structural change.

Almost nothing simple can be said about the use of these instruments, with all their inter-dependencies, to promote the well-being of a nation and protect it as well as may be from the shocks of various kinds to which it will inevitably be subjected. It only has limited meaning, for instance, to say that budgets should always be balanced when a balanced budget with expenditure and taxation both running at 40 per cent of GDP would have an entirely different (and much more expansionary) impact than a balanced budget at 10 per cent. To imagine the complexity and importance of a government’s macro-economic decisions, one has only to ask what would be the appropriate response, in terms of fiscal, monetary and exchange rate policy, for a country about to produce large quantities of oil, of a fourfold increase in the price of oil. Would it have been right to do nothing at all? And it should never be forgotten that in periods of very great crisis, it may even be appropriate for a central government to sin against the Holy Ghost of all central banks and invoke the ‘inflation tax’ – deliberately appropriating resources by reducing, through inflation, the real value of a nation’s paper wealth. It was, after all, by means of the inflation tax that Keynes proposed that we should pay for the war.

I recite all this to suggest, not that sovereignty should not be given up in the noble cause of European integration, but that if all these functions are renounced by individual governments they simply have to be taken on by some other authority. The incredible lacuna in the Maastricht programme is that, while it contains a blueprint for the establishment and modus operandi of an independent central bank, there is no blueprint whatever of the analogue, in Community terms, of a central government. Yet there would simply have to be a system of institutions which fulfils all those functions at a Community level which are at present exercised by the central governments of individual member countries.

The counterpart of giving up sovereignty should be that the component nations are constituted into a federation to whom their sovereignty is entrusted. And the federal system, or government, as it had better be called, would have to exercise all those functions in relation to its members and to the outside world which I have briefly outlined above.

Consider two important examples of what a federal government, in charge of a federal budget, should be doing.

European countries are at present locked into a severe recession. As things stand, particularly as the economies of the USA and Japan are also faltering, it is very unclear when any significant recovery will take place. The political implications of this are becoming frightening. Yet the interdependence of the European economies is already so great that no individual country, with the theoretical exception of Germany, feels able to pursue expansionary policies on its own, because any country that did try to expand on its own would soon encounter a balance-of-payments constraint. The present situation is screaming aloud for co-ordinated reflation, but there exist neither the institutions nor an agreed framework of thought which will bring about this obviously desirable result. It should be frankly recognised that if the depression really were to take a serious turn for the worse – for instance, if the unemployment rate went back permanently to the 20-25 per cent characteristic of the Thirties – individual countries would sooner or later exercise their sovereign right to declare the entire movement towards integration a disaster and resort to exchange controls and protection – a siege economy if you will. This would amount to a re-run of the inter-war period.

If there were an economic and monetary union, in which the power to act independently had actually been abolished, ‘co-ordinated’ reflation of the kind which is so urgently needed now could only be undertaken by a federal European government. Without such an institution, EMU would prevent effective action by individual countries and put nothing in its place.

Another important role which any central government must perform is to put a safety net under the livelihood of component regions which are in distress for structural reasons – because of the decline of some industry, say, or because of some economically-adverse demographic change. At present this happens in the natural course of events, without anyone really noticing, because common standards of public provision (for instance, health, education, pensions and rates of unemployment benefit) and a common (it is to be hoped, progressive) burden of taxation are both generally instituted throughout individual realms. As a consequence, if one region suffers an unusual degree of structural decline, the fiscal system automatically generates net transfers in favour of it. In extremis, a region which could produce nothing at all would not starve because it would be in receipt of pensions, unemployment benefit and the incomes of public servants.

What happens if a whole country – a potential ‘region’ in a fully integrated community – suffers a structural setback? So long as it is a sovereign state, it can devalue its currency. It can then trade successfully at full employment provided its people accept the necessary cut in their real incomes. With an economic and monetary union, this recourse is obviously barred, and its prospect is grave indeed unless federal budgeting arrangements are made which fulfil a redistributive role. As was clearly recognised in the MacDougall Report which was published in 1977, there has to be a quid pro quo for giving up the devaluation option in the form of fiscal redistribution. Some writers (such as Samuel Brittan and Sir Douglas Hague) have seriously suggested that EMU, by abolishing the balance of payments problem in its present form, would indeed abolish the problem, where it exists, of persistent failure to compete successfully in world markets. But as Professor Martin Feldstein pointed out in a major article in theEconomist (13 June), this argument is very dangerously mistaken. If a country or region has no power to devalue, and if it is not the beneficiary of a system of fiscal equalisation, then there is nothing to stop it suffering a process of cumulative and terminal decline leading, in the end, to emigration as the only alternative to poverty or starvation. I sympathise with the position of those (like Margaret Thatcher) who, faced with the loss of sovereignty, wish to get off the EMU train altogether. I also sympathise with those who seek integration under the jurisdiction of some kind of federal constitution with a federal budget very much larger than that of the Community budget. What I find totally baffling is the position of those who are aiming for economic and monetary union without the creation of new political institutions (apart from a new central bank), and who raise their hands in horror at the words ‘federal’ or ‘federalism’. This is the position currently adopted by the Government and by most of those who take part in the public discussion.

Amazing stuff.  It seems like that Treaty is making a huge difference to their lives.  The saddest part is, I am not entirely sure that anyone in power in Europe really truly understands the root cause of the crisis.  And if they do, they appear unwilling to make the necessary changes to fix it.

*  Update – A lot of people ask me why it matters that Europe can’t essentially print Euro at the national level.  Well, it results in a huge amount of turmoil.  Some of these nations are literally in depressions.  That’s not destabilizing.  It’s a wrecking ball in an economy that strangles it for decades.  I think it’s reprehensible that depressions occur in developed nations today given the understandings and tools we have to avoid them.  And the USA is a pretty good model here again.  By having a fiscal entity that eliminates the solvency at the state level you create a huge amount of long-term stability.  Can you imagine where unemployment would be right now if California were on the verge of bankruptcy?  It would be a total disaster.   Sign up for that once every few decades and what you don’t end up with is the world’s largest economy generating a whopping 25% of all global output….Obviously, the USA made a wise choice a long time ago when we created a monetary union fully aligned on political and monetary lines….The stability has paid off in spades.


Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering asset management, private advisory, institutional consulting and educational services. He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance and Understanding the Modern Monetary System.

View all posts by

25 Responses

  1. beowulf says

    Let’s see, we gave Britain pretty generous terms for reconstruction loans (Congress not willing to fund Lend-Lease for one day longer than necessary), 50 year, 2% fixed with payments not starting for 5 years. The loan amount was approx 2% of US GDP in 1945 (so in 2012 terms, $300 billion loan).

    No reason the Fed couldn’t structure a USD-Drachma (or any other currency) swap with similar terms, no?

  2. Michael Sankowski says

    Isn’t it sad we’re talking about a shooting war when all we need is a few more bits in a computer to make the problem go away?


  3. Dan Kervick says

    So maybe Greece has a lot more leverage than people think it does?

  4. AndyCFC says

    Also should note that the Greek military is very capable and due to their squabbles with Turkey always in readiness, the only part of the Greek budget not cut was military spending. The German military of course since the last war is like the JSDF very much designed around defence and I would expect not really able to mount much of an offensive war. Paper exercise only isnt going to happen.
    Would be more concerned with a military junta taking over Greece as it isnt that long ago they were in power.

  5. beowulf says

    Actually, that’s one of the reasons the NATO alliance was created, as the saying goes, its purpose was to keep the Russians out, the Americans in and the Germans down. Its no accident that every Supreme Allied Commander Europe (since 2003, commands NATO operations worldwide) has been an American.

    Its unthinkable that the German army would attack anyone (particularly, a NATO ally like Greece) contrary to SACEUR orders– you’d see Bundeswehr officers mutiny first. its illegal under the German Basic Law for the military to deploy abroad unless its on the basis of “mutual collective security”, which is to say, by order of whichever American is the current SACEUR.

  6. Michael Sankowski says

    Those bid/cover ratios were records during QE.

    I’d agree with that word change Greg.

    You’d think a guy who writes about currencies as much as I do would have more to say on this topic. ;) well maybe…

  7. Erik V says

    Yeah, in this day and age it’s hard to envision an anti-muslim halocaust type situation, but I definitely forsee more social unrest. Unemployed people, especially the youth, have nothing to do with their free time but protest and riot.

  8. Cullen Roche says

    Who needs a Eurozone military? We all know Germany is steering this ship. Piss on their boots and you’re bound to get a foot up your ass one way or another.

  9. Dan Kervick says

    This was supposed to be under Cullen’s 11:15 reply.

  10. Dan M. says

    Last time we saw economics in Europe like this too many people all-too-happily gave into MilitaristiKeynesioNationalism and blamed all their problems on people unlike them.

    With the muslim population in Europe bringing social tensions to a head, I am wondering what it would take economically to bring about something similar, today.

  11. Dan Kervick says

    Right, but the Eurozone doesn’t have an Army. It doesn’t even have a legislature. As I understand it, it has no pre-defined procedure for getting a country out of the Eurozone with a clean excision. And if they come down heavy then all kinds of people in the EZ don’t get paid. Isn’t there a possibility that there will be all kinds of angry words and wagging fingers, but that the Frankfurt Euro Gestapo will just have to let it happen?

    I suppose the ECB could shut Greece out of the payments system somehow, and then credit the accounts of each and every creditor who is owed anything at all by a Greek firm, household or government agency to bail them all out.

    Then everyone else in the EZ says, “Hey that was easy!” Why can’t we get some of those magic bail-out Euros too to put our people back to work? Fork it over or we’ll do what Greece did”

    If Germany actually made a military move, I would suspect that would cause millions of people throughout Europe who had previously supported Merkelism to say, “Hey, who elected you guys head of the whole damn Eurozone? We didn’t sign on for the Fourth F-ing Reich!”

    Also, Greece could then switch to drachmas. Their political leader could say to their people: “I know you wanted to stay with the Euro, and we tried, but the EZ is kicking us out.” Germans show up with their tanks, and the Greeks say, “We use drachmas now, so we’re not breaking any of your stinking rules. What are you doing here?”

    Possibly the result then is that Germany would bail first, and go back to DMs. Then Tsipras could tell his people, “We didn’t bail on the Euro; the selfish Germans did.”

  12. Erik V says

    Godley was quite prescient indeed. It’s really amazing the economic destruction that is being imposed on a continent by the people in charge over there. I’m glad to be learning this stuff correctly at a young age. There is an army of Phd technocrats running the show in Europe, but since they learned economics wrong they will take their beliefs to the grave. They will never understand how they system they’ve constructed is fundamentally unworkable.

    I think the endgame is one where Germany partially relents and allows for Eurobonds or some transfer mechanism that solves the solvency problem, but still doesn’t allow for growth. There will never be a big deficit spending program or export boom to really get their economies going. It’s sad. I think the periphery might be better biting the bullet and getting out now because I don’t think Germany will ever release them from their “poor region” status.

  13. Cullen Roche says

    They’d be in violation of the Treaty. Imagine a US state with a USD printing press just deciding to go off the rails and spend at the state level. What would happen? They’d get reprimanded by Congress and if they didn’t conform they’d likely have the US military on their doorstep overnight. It’s a breach of the rules that bind the union. Conform or get out. That’s the message basically. And Germany steers the ship over there so it’s “don’t print, or get out”. And who knows, if Greece decided to fire off a few trillion Euro into the economy they might find a German tank squadron on their doorstep. Extreme, but hey, money has driven countries to do just about anything to survive…..

  14. Dan Kervick says

    I have a question. The national central banks are bound by their treaty obligations to coordinate their operations with the ECB and operate in a way which is consistent with ECB dictated monetary policy.

    But what if they don’t? What if some of these periphery nations reach the end of their rope, and their heads of government start directing their country’s NCB to conduct operations that implement a national monetary policy?

    For example, the Greek public doesn’t want to withdraw from the Euro, but they want to do something differently. So suppose the new government directs the Greek NCB – not to change its unit of account to drachmas and start reissuing drachmas – but to credit some amount of Euros to the government account to finance a Greek fiscal expansion?

    I understand this would cause some kind of major crisis. The price stability vigilantes in Frankfut would have a major meltdown. It would be clear that these countries were breaking their treaty obligations But how would that play out? What punitive measure could the ECB take? For example, if they somehow shut down access by Greek banks to the Target2 system to retaliate, wouldn’t the effects ripple dangerously throughout the non-Greek parts of the system and cause a payments crisis?

    What sorts of systems are in place that allow the ECB to police its monetary policy?

  15. Dan M. says

    Great… thanks so much for the clarification.

    I’d suggest (if I may) a rewording from “production collapse” to “productive capacity collapse,” as the former implies that a sharp decrease in GDP is an example of what to watch out for before a hyperinflation, when it’s really almost the opposite happening.

    Though I 100% know what you mean and agree completely. I always tell people that it would likely take PK’s oft-mentioned “Alien Invasion” to bring us to hyperinflation, so the best way to prevent it is his ridiculous Keynesian military expansion to prepare for said invasion. I love sarcastic irony.

  16. Cullen Roche says

    So, the Fed can always fund the Tsy. But the scenario to think about is one in which the currency becomes unstable for whatever reason and the PD’s start to boycott the auctions. Keep in mind, this is nowhere close to happening right now so don’t get me wrong. But it’s entirely possible that the Central Bank would have to become THE funding source. So yes, the Fed can ALWAYS fund the Tsy, but who cares in this scenario, right? Once the PD’s have started to sidestep the action, it’s game over. This was the mistake so many people made with QE. They thought this was happening. But if you looked at the actual auction data, the PD’s were still showing up in spades. We didn’t need the Fed to buy. So QE remains a misguided policy approach and certainly not monetizing since that assumes lack of bidders or currency demise.

    To me, it all circles back to production again. The relationship in money between a govt and its users is based largely on this private sector driven phenomenon (you HAVE to understand S=I+(S-I) here or you don’t see it our way!). It’s not driven by taxes, or laws or any of that. Those are all secondary features. Production is the backbone of the currency. Lose it, and you lose the currency. Hyperinflation is the result. So yeah, the Tsy won’t ever “run out of money” because it can always tap the Fed, but once the PD’s step out of the game or start to lose faith, it’s a slippery slope. How do we get there? In the USA, I’d say the big risk is production collapse. It’s not happening obviously and won’t happen any time soon.

  17. Dan M. says

    So we’re basically saying that the fed can control rates “to a certain degree,” and not once you get outside a likely realm of possibilities?

    Since this all requires member bank participation (unless the fed were to step outside its normal operations and fund the treasury directly), does this mean the treasury CAN go bankrupt?

    My impression was that even though the fed is separate from the treasury, the fact that it had both the power and the implied duty (within its role in maintaining monetary stability) to achieve monetary stability mostly via interest rates, via treasury bond purchases, and manages (as well as sets the price) of treasury bond issuances, that it effectively put the treasury in a fundamentally different role than “currency user” that can go bankrupt… if this is only true until crisis hits and member banks say “No way, we don’t want to play any more,” then what are the conditions in which that will happen (besides hyperinflation… if there is any)?

    Thanks again!

  18. Cullen Roche says

    The USA is a strategic currency issuer as JKH said, but only because they can harness their banks (and central bank) as agents. It’s not impossible for the USA to become a currency user in some sense. Lose the will of the banks and the Primary Dealers and the USA’s status as “issuer” is essentially a moot point. There’s a balance in this relationship. To a certain degree, we let the govt use/issue our currency (yes, OUR money is a social construct, but more than a state construct since the state is an extensionmof the people). It is not just some legal construct imposed on us and driven by state structures. You can virtually prove this by going through a hyperinflation scenario and how the PD’s would react….they’d be the first guys to boycott the auctions in an attempt to avoid insolvency….

  19. Dan M. says

    Gotcha… Ok… Sorry I haven’t had much time to scour these things.

    Your work is much appreciated, fellas. I’m constantly bumping people over to this site from (a Permanent Portfolio forum) in economic discussions. They’re often impressed with MMT, but some real haters on certain assertions on MMT are hugely impressed with CR’s breakoff on certain points that they thought to be errors in MMT. I’m talking Austrain types that hate gov’t.

  20. JKH says

    “In conjunction with the operational classifications above, we might say that the USA is a “strategic currency issuer” for the dollar and Greece is a “strategic user” of the Euro.”

  21. Dan M. says

    I thought the central bank was issuer, not “gov’t”… Per new MMR conclusions.

  22. Cullen Roche says

    Yeah, really good stuff, 20 years ahead of the curve….

  23. Cullen Roche says

    Well, they did predict the Euro crisis. Granted, not as early as Godley, but they did predict it.

    Not sure what your angle is FDO. You seem intent on stirring the pot and contributing little of real value….

  24. FDO15 says

    I thought it was funny the other day when Scott Fullwiler tried to claim the MMTers predicted the Euro crisis. Yeah right. They just happened to know some guy named Wynne Godley and they ran with his analysis because it meshed with their own.

  25. Sirsty says

    Godley’s comments are remarkable. Thanks for posting.