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MOSLER'S LAW: There is no financial crisis so deep that a sufficiently large tax cut or spending increase cannot deal with it.

WARNING- Euro Zone Automatic Fiscal Stabilizers Deactivated!

Posted by WARREN MOSLER on March 30th, 2011

I now believe that system risk in the euro zone is being grossly under discounted.

The implied assumption for the major currency regions is that during a slowdown the automatic fiscal stabilizers- falling government ‘revenues’ and increased transfer payments- will kick in to increase deficit spending, and thereby add the income and savings to catch the fall and support the next expansion.

This has always been the case, and as we all know, the most accurate forecasts are the ones that assume it’s not different this time.

But the relatively new and evolving euro zone arrangements are qualitatively different.
Spending by euro zone national governments is now market constrained in Greece, Ireland, and Portugal, with the rest looking like they aren’t far away from those same market constraints.

In a slow down, this means as tax revenues fall, markets may not permit government spending to rise, unless the ECB immediately funds all the national governments as well as the banks. Just as we see happening to the US states.

Not that the ECB won’t eventually do that, but that they are unlikely to proactively do it.
In other words, it will all have to get bad enough for the ECB to write the check that only they can write.

This means the euro zone is now flying without a net.

And the potential drop in aggregate demand is far higher than markets are discounting.

And that kind of catastrophic collapse in aggregate demand in the euro zone will have immediate catastrophic global impact.

And the fiscal discussions going on in Japan and elsewhere tell me there is a clear risk even the operationally unconstrained nations will be very reluctant to immediately and proactively move towards fiscal expansion.
Instead, they will let it all deteriorate until their automatic fiscal stabilizers to kick in.
Much like what happened with the 2008 financial crisis, where the lack of a will to engage in an immediate fiscal response let that financial crisis spill over into the real economy.

Can all this be avoided? Yes, and the remedy is both simple, immediate, and would quickly lead to unprecedented global prosperity.

All the euro zone has to do is have the ECB write the check, and announce immediate and annual distributions of 10% of GDP to member nations to pay down their outstanding debts, and at the same time impose national deficit ceilings sufficiently high to promote desired levels of aggregate demand. And the penalty for non compliance would be the withdrawal of ECB support. This would remove credit concerns, without increasing government spending, so there would be no inflationary impact.

And all the rest of the world has to do is recognize that federal taxes function to regulate aggregate demand, and not to fund expenditures per se. And then set taxation and/or government spending at levels that sustain desired aggregate demand.

They need to know the question is not whether longer term the budget deficit is sustainable- as it’s always nominally sustainable- but instead worry about sustaining aggregate demand at desired levels, both long term and short term.

But, unfortunately, I see the odds of a catastrophic collapse in aggregate demand as far higher than the odds of an awakening to a global understanding of actual monetary operations.

32 Responses to “WARNING- Euro Zone Automatic Fiscal Stabilizers Deactivated!”

  1. zanon Says:

    so what you are saying warren? is the obama boom over? is it time to move out of this great bull equity market and back into cash?

    Reply

    Tom Hickey Reply:

    Ed Harrison, The QE2 Trade is now officially over

    Reply

    WARREN MOSLER Reply:

    it’s got me worried.

    it doesn’t have to be over, but they are working hard to end it.

    my fear is they will all succeed.

    if they were so sure the ‘stimulus’ worked you’d think they’d do another one.
    so obviously they have their doubts and it shows.

    Reply

  2. roger erickson Says:

    > Can all this be avoided? Yes, and the remedy is both
    > simple, immediate, and would quickly lead to unprecedented
    > global prosperity.

    COULD you mean. Just like it did just prior to 2008? Fiscal sanity may be necessary, but it’s CERTAINLY not sufficient, as Bill Black especially has been pointing out.

    There remains the subtle but tricky tasks of smart, distributed allocation, including adequate staffing of regulatory agencies. By not prefacing those straw men UP FRONT, MMT remains easy prey to Austerian propagandists. Please, please, please add a PR agent intern to MoslerEconomics, to amplify the power of your insights.

    Reply

  3. Kristjan Says:

    I’ve read your proposal before Warren for example here
    http://www.huffingtonpost.com/warren-mosler/the-eurozone-solution-for_b_497170.html
    “My proposal is for the ECB to distribute 1 trillion euro annually to the national governments on a per capita basis. The per capita criteria means that it is neither a targeted bailout nor a reward for bad behavior. This distribution would immediately adjust national government debt ratios downward which eases credit fears without triggering additional national government spending. This serves to dramatically ease credit tensions and thereby foster normal functioning of the credit markets for the national government debt issues.”

    This really doesn’t differentiate the EMU countries. Their “currencies cannot fluctuate”. Am I missing something here?

    Even with the 10% GDP proposal, I read every day MMT saying that budget deficit is outcome and nobody knows the right %.

    Are you saying this just to get the fire out and there is no permanent fix for euro zone unless It becomes a federation(with central fiscal authority like US)?

    Reply

    roger erickson Reply:

    thought that was obvious from the beginning?

    Reply

    Kristjan Reply:

    Ok, just confirming :)

    Reply

    WARREN MOSLER Reply:

    that is a permanent fix.

    for better or for worse, the size of the deficit has to be targeted from the top, like it is in the US, UK, and Japan. So the ECB is as good as any to do it over there.

    there’s nothing to differentiate. all the distribution does is repair creditworthiness.
    it doesn’t give anyone any euro they can actually spend. and that’s why it’s not inflationary

    Reply

    Kristjan Reply:

    “All the euro zone has to do is have the ECB write the check, and announce immediate and annual distributions of 10% of GDP”

    OK, I am with you so far whatever the %.

    “and at the same time impose national deficit ceilings sufficiently high to promote desired levels of aggregate demand.

    still with you, full employment can be supported by this

    “And the penalty for non compliance would be the withdrawal of ECB support.”

    I don’t understand this, non compliance of what? The debt ceiling?

    Reply

    WARREN MOSLER Reply:

    Non compliance with annual deficit limits as with the current stability and growth pact

    Kristjan Reply:

    OK, deficits are partially floated but not entirely.
    It cannot be done because member states might start abusing the system, that’s why you have the deficit ceiling right?
    the deficits are floated to a certain limit.
    So if a member state decides that It’s a good idea to have most of the population on social security and import whatever they can they are going to hit that limit.
    In other words if they hit that limit then ECB is saying we don’t like the structure of your economy.
    Is my understanding of your proposal correct?

    WARREN MOSLER Reply:

    today they have a growth and stability pact that says deficits can’t be over 3% of gdp.

    not that 3% is the right number (it’s probably not) but that they need that kind of dictated limit
    once credit is repaired to prevent an inflationary race to the bottom where whoever runs the highest deficit wins

    MamMoTh Reply:

    All the euro zone has to do is have the ECB write the check, and announce immediate and annual distributions of 10% of GDP

    Wouldn’t that create an incentive for a country to run a budget deficit as large as authorized to inflate GDP?

    WARREN MOSLER Reply:

    yes, except they are all above any limit likely to be set, so it would not today increase net govt spending

    and in any case with the lack of demand there they could use a fiscal adjustment to keep aggregate demand at desired levels

  4. roger erickson Says:

    This is analogous to what’s playing out here in the USA too. Just slightly different kinetics & scale.

    The USA is a historical niche where audacious people came to invent. Along the way, we consciously traded much local family, clan & tribal Automatic Stabilizer methodology, in return for novel national Automatic Stabilizer methodology. The results were spectacular. However, after 200 years, many note that both flexibility & kinetics of our existing Constitutional Methodology are failing to match the ever scaling demands of context. We know we cannot change without tuning our methodology. US citizens simply have group options to explore, and group decisions to make: whether to be predominantly Luddites, or to win an adaptive rate race by exploring more group options, faster. Our chief decision is what methodology to use in order to actively manage the Luddite/adapter ratio.

    Hidden behind that is a deeper question: What methods to use to recruit, quickly enough, THIS electorate to this emerging context?

    Population responses to context can remain irrationally slow longer than most of us can stay alive. Are we satisfied to leave a downsized number of descendants to simply repeat our failure spiral? It’s no longer a question of what to do, but precisely HOW to get these electorates to do something closer to what makes group sense. It’s methodology.

    Too bad Hamlet didn’t follow up his famous action query with one about adequate kinetics. http://www.phrases.org.uk/meanings/385300.html

    Darwin’s version of Shakespeare?
    “To be or not to be agile enough,
    Whether ’tis nobler for the group to suffer
    The speedily changing slings and arrows of outrageous context,
    Or to explore adequate options fast enough, against a sea of troubles,
    And by opposing within critical time periods, survive them?”

    Reply

  5. jcmccutcheon Says:

    Warren, what is the investment playbook here for this scenario? Long the dollar? Short Euro-zone equities ?

    Reply

    roger erickson Reply:

    There are always two investment playbooks, that HAVE to be played in proportional unison:

    1) sequester adequate local resources, as a local buffer;
    (follow Warren’s advice re bonds/currencies/equities)

    2) invest in group intelligence, as a systemic buffer
    (hope your policy staff follows expanding MMT/other advice, before it’s too late; invest by writing, campaigning, voting – or your personal investments won’t matter; no sense in rats hoarding seeds on a sinking ship; at some point it’s clear to abandon hoards & ship & swim for it; or mutiny?)

    Reply

    WARREN MOSLER Reply:

    if you have a low risk tolerance, wait it out in dollars.
    I still like the 30 year tsy 0′s i mentioned a while back.

    too soon to make any speculative bets based on this.

    it’s just a warning of an under appreciated downside risk that may or may not happen.

    Reply

    Geoff Reply:

    Long bond futures, baby.

    Reply

    art Reply:

    There will be so many heads scratched to the point of bleeding if that works. So many poor confused heads.

    WARREN MOSLER Reply:

    :)

  6. roger erickson Says:

    should have said:

    ….Darwin’s version of Shakespeare?

    “To be or not to be, agile enough,
    Whether ’tis nobler in the group to suffer
    The varying slings and arrows of outrageous context,
    Or to grow ability to change, fast enough, against a sea of troubles,
    And by re-aligning within critical time periods, survive them?”

    This should be practiced in Kindergarten, and in Economics 101, not just in sports, choreography & military science.

    Reply

  7. hbl Says:

    “And the potential drop in aggregate demand is far higher than markets are discounting. And that kind of catastrophic collapse in aggregate demand in the euro zone will have immediate catastrophic global impact.”

    Warren, thanks as always for offering your thoughts.

    Calculated Risk (who has a good forecast track record, but has been too optimistic at times) said about Europe:

    http://www.calculatedriskblog.com/2010/12/question-8-for-2011-europe-and-euro.html

    “There are two main channels that could impact the U.S. economy: trade, and financial spillover / credit tightening. The impact on trade will probably be minimal, even if the euro falls sharply against the dollar (a small percentage of U.S. GDP is from exports to Europe (edit)). The financial channel is much more of an unknown, and there is significant downside risk.”

    I wonder how much of your apparent difference in forecast (though he admits his forecast is very cloudy) is that you expect a larger drop in EU demand than he does, versus differences in opinion as to the nature and magnitude of the transmission channels to the US and the world?

    Reply

  8. okl Says:

    don’t be too pessimistic Mr. Mosler, it could just be words to please the German voters in their state elections this year.

    Reply

    WARREN MOSLER Reply:

    thanks, hope so!

    Reply

  9. Dan Kervick Says:

    if they were so sure the ’stimulus’ worked you’d think they’d do another one, so obviously they have their doubts and it shows.”

    Warren, you assume that their actual aim is to improve real economic performance, rather than just get Barack Obama re-elected.

    To me it looks like this administration’s fatalistic and cynical attitude is that the country voted in the Fall of 2010 to drive the economy over a cliff in the Austerity Wagon, just as they are doing in the UK. The White House is happy to go along for the ride without trying to take control of the wheel to attempt the politically uphill drive back in the opposite direction, and plans only to do just enough back seat driving that, when the crash occurs, they can point the main finger of blame at someone else.

    Reply

    Dan Kervick Reply:

    Sorry about the extra italics. Turning them off now.

    Reply

    WARREN MOSLER Reply:

    :(

    Reply

  10. JCD Says:

    Warren,

    I’m not sure I understand the premise.

    Why is it that Greece is now “market constrained”? They can still issue Euro denominated debt can’t they? ECB is still buying Greek Euro debt at a price other market participants won’t.

    Is there some limit to this? Is Greece somehow meaningfully prohibited from playing chicken with ECB by spending beyond its means and daring ECB not to buy Greek debt?

    JCD

    Reply

  11. BFG Says:

    Warren, they are doing just as you said.

    And the penalty for non compliance would be the withdrawal of ECB support.

    31 March 2011 – ECB announces the suspension of the rating threshold for debt instruments of the Irish government”
    The Governing Council of the European Central Bank (ECB) has decided to suspend the application of the minimum credit rating threshold in the collateral eligibility requirements for the purposes of the Eurosystem’s credit operations in the case of marketable debt instruments issued or guaranteed by the Irish government. The suspension applies to all outstanding and new marketable debt instruments. It will be maintained until further notice.

    The Irish government is implementing the economic and financial adjustment programme negotiated with the European Commission, in liaison with the ECB, and the International Monetary Fund. The Governing Council has assessed the programme positively. The suspension announced herewith is based on this positive assessment of the programme, the commitment of the Irish government to fully implement it and the Irish government’s decisions of 31 March 2011 to ensure – following its thorough asset valuation exercise – a capital increase totalling EUR 24 billion (out of which EUR 3 billion in the form of contingent capital), for four Irish banks, and to deleverage and downsize the banking sector.

    The Governing Council therefore deems debt instruments issued or guaranteed by the Irish government to fulfil the credit standards required for collateral in Eurosystem credit operations. The relevant risk control measures will be reviewed on a continuous basis.

    Reply

  12. Mosler : Solution to euro crisis – Smart Taxes Network Says:

    [...] Mosler on eurozone slow crash… Can all this be avoided? Yes, and the remedy is both simple, immediate, and would quickly lead to [...]

  13. Philip Pilkington: The Irish Establishment – Mad as Goats? « naked capitalism Says:

    [...] The first requires that the European authorities and the ECB stop bickering like children, get their act together and make fiscal transfers to the distressed sovereigns – Ireland included. And not simply transfers that will allow for the alleviation of the current crushing debt burdens, but also transfers that will promote growth and expansion in these economies. Will this happen? Two words: ‘fat’ ‘chance’. [...]

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