Posted by: Dirk | May 24, 2012

Euro in Danger (Walters Critique revisited)

The euro is now in clear and present danger, as the Euro-Europeans cannot agree on how to proceed. The analysis of how the troubles started, I think, has been clear for more than two decades now. Basically, the Walters Critique was right. Sir Alan Walters, deceased in 2009, was an adviser to Margaret Thatcher. The Guardian wrote in his obituary:

After his resignation as adviser to Thatcher, Walters campaigned against Britain’s membership of the ERM, and predicted doom once the decision to join in 1990 had been taken: the core of his attack became known as the Walters critique. He argued that a member of the ERM experiencing excessive inflation would, because it was unable to change interest rates, have low “real” interest rates, which was the opposite of what was needed. Similarly a member with weak demand and low inflation would have high real interest rates and would sink further into recession. The arguments were developed in his book Sterling in Danger (1990).

What happened in the euro zone was that some countries had a real-estate boom (Ireland, Spain) and that led to higher than average inflation. Since real interest rates are calculated as the nominal interest rate minus inflation, real interest rates fall when inflation rises. This leads to a cumulative process, which reminds one of the Keynesian multiplier: a rise in investment (real estate) generates higher incomes (for construction workers), which increases consumption (of these workers) and therefore leads to higher incomes – and so on and so on.

At the same time, German inflation was suppressed – because wages were brought down to increase competitiveness – and therefore German real interest rates were relatively high. The economy experienced weak domestic demand, which prompted the government to spend more than the allowed for 3% of GDP (net) and in this way fill the demand gap.

However, these arguments did not get through on the continent while they did in the UK. It is ironic therefore that the UK, which does not have to run an austerity policy, now runs one and acts as if it would be part of the euro zone. The austerity policies on the continent are a predictable disaster, since the intellectual framework that dealt with the creation of the euro is a purely neo-classical one. Demand deficiencies cannot exist by definition, and since the capital markets are efficient any such argument as the Walters Critique – which is based on the idea that people make mistakes in predicting the future – is not acceptable.

And here we are, within a euro zone which has experienced negative asymmetric shocks in the periphery and a positive one in the core (through lower real interest rates as a result of capital returning from the periphery) and no solution of how to prop up the demand in the periphery. It’s not as if nobody saw it coming. Here is Wynne Godley (deceased in 2010) in the London Review of Books (my highlighting):

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.

Once again, the world can benefit by reading what dead English economists had to say.


  1. “there is no evidence of the growing divergence predicted by the Walters critique”

    From a paper presented by an ECB staffer in 2008, which was reviewed by current VP Constancio. The paper was published two years after Blanchard’s paper “Adjustment within the euro. The difficult
    case of Portugal”, which demonstrated the very problems the ECB denied.

  2. […] πλήρες κείμενο […]

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