Posted by: Dirk | November 3, 2011

Wynne Godley on Maastricht and All That

I remember that at the start of the financial crisis, the Queen asked why economists did not see this one coming. The question was often used by conservative economists to claim that indeed no one saw it coming when in reality some people warned early on and very clearly about the dangers of the international economic (dis)order. On the European side, the article that is perhaps a future seminal contribution to European economic history comes from Wynne Godley and was published in … 1992! Here is the long last paragraph:

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 the Economist (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.

So, the structural setback has arrived, and what happens is economic calamity in a situation of intellectual confusion. The ECB has turned into a church of low inflation, and does only accept one god. Central banking has been almost completely disconnected from international macroeconomics, which in times that history will record as the period of globalization will be a nut for future generations of historians of economic thought. Brad DeLong calls it the ECB’s battle against Central-Banking, and he is right:

The ECB continues to believe that financial stability is not part of its core business. As its outgoing president, Jean-Claude Trichet, put it, the ECB has “only one needle on [its] compass, and that is inflation.” The ECB’s refusal to be a lender of last resort forced the creation of a surrogate institution, the European Financial Stability Facility. But everyone in the financial markets knows that the EFSF has insufficient firepower to undertake that task – and that it has an unworkable governance structure to boot.

And here we are now, a week after the euro had been saved for the umpteenth time, with record highs on Italian government bond spreads. Those in power in politics and academia, with few exceptions to the rule, have based their actions on wishful thinking and theories built on assumptions that have turned out to be wrong decades ago. The truth in (monetary) economics lies in the balance sheets, and if these are not understood, then turning to models that hide balance sheet issues behind assumptions about how people are rational and markets always work will lead to failure. Here is an old Chinese myth which hopefully helps me make my point:

“Truth has nothing to do with words. Truth can be likened to the bright moon in the sky. Words, in this case, can be likened to a finger. The finger can point to the moon’s location. However, the finger is not the moon. To look at the moon, it is necessary to gaze beyond the finger, right?”

The economic theories can describe the economy (society), but they are just like words or the finger in the paragraph above. They help you to understand the economy (society). They are NOT the economy (society). It seems to me that economists, especially those at the central banks, have mistaken models for reality. For that case there is a Chinese proverb:

“When the wise man points to the moon, the fool looks at his finger.”


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