Great Leap Forward


You don’t often encounter controlled experiments in the social sciences. Nations usually balk at using their economies as Guinea pigs. But right now they’re lining up to see if it really is possible to cut your way back to prosperity. So here’s the question: is starvation a cure for hunger? Over coming months we’ll find out.

I’ve just returned from interesting conferences in Berlin and Helsinki. The first was a Levy Institute-Ford Foundation Minsky conference held at Deutsche Bank in Berlin on Debt, Deficits and Unstable Markets. ( It more-or-less followed the format of the long-running Levy-Minsky conferences held each April in New York. Unlike most academic conferences, these Minsky conferences actually include interesting presentations that touch on real world policy issues. One of the better presentations was by Vítor Constâncio, Vice President, European Central Bank, titled “Completing and Repairing the Economic and Monetary Union”. Yes, you read that right—a VP of the ECB. Apparently at least some at the ECB have finally recognized what is wrong with the set-up of the EMU. His assessment of the problems comes mighty close to what MMTers have been saying for the past decade. His solutions are timid, but I suppose there are constraints on what he can say. Still, I recommend that you take a look at his talk (at the Levy site). I’ll draw on some of his points below.

The second was The Return of Full Employment Policy Conference in Finland that I’ve mentioned previously. ( This one focused narrowly on the “deficit owl”, functional finance, MMT approach to using public policy to achieve full employment. It provided a frontal attack on EU austerity. One of the more interesting (albeit brief) presentations was by Lena Sommestad, an MP in Sweden (you can watch the video of the panel discussion here: While Sweden is not in the EMU, she was concerned that this drumbeat for austerity has also gripped her government.

Both conferences raised some hope that there are outposts of sanity in Europe. However, that hope was dashed as I returned to the US and was inundated with media reports of the latest policy moves—from the UK to Ireland and to Germany, every government is calling for more blood-letting. Britain is planning to cut a million jobs from the public sector, and Chancellor of the Exchequer Osborne says austerity will continue through 2018! Remember that the global downturn began in 2008, so he’s planning to prolong the Great Recession to a 1930s style Great Depression length of at least a decade.

Here’s the logic: so far the cut-your-way to prosperity has generated only more suffering, so greater and more prolonged cuts will be needed to achieve the elusive prosperity. ( Yep, the patient is weakening, so we’ve got to drain more blood to restore health.

Over in Ireland, things are even more desperate. Since five rounds of blood-letting have failed so far to revive the patient, the government is imposing yet a sixth austerity plan. ( We know that those Irish are tough, but this is getting a bit ridiculous. The remedy to famine is now thought to be more famine.

And, finally, Chancellor Merkel has held out the hope of some consideration of debt relief for troubled member nations—but not before 2014 and only if they agree to impose more suffering on their starving people first. You see, the patient is not dead enough to stop the bleeding just yet.

(And not to be outdone, our own resident comedy relief team—University of Chicago economists—is demanding more suffering in the US. Not merely content with general statements about the need for austerity programs, Casey Mulligan is arguing that we need more poverty (“Poverty Rates Should Have Risen”, . He insists that it is terrible, just terrible!, that poverty rates have not risen higher in the downturn. I, for one, wish we could find a way to let all the “Chicago Boys” experience some homelessness for a few weeks this January.)

Let’s think back to the formation of the EMU. Back then, Europe had a standard of living that was the envy of the world, or at least of most of the world. There were, to be sure, big differences across Europe in terms of material living standards, but in many cases that difference was tolerably well compensated by a pleasant social environment. Even a visit to the relatively poorer Mediterranean periphery nations could produce envy—at least in me.

There were three laudable goals of unification: convergence of living standards (poorer nations enjoying improvements); social/cultural/political/economic unification; and creation of a huge internal market. I want to focus in this blog on the last goal.

Let’s recall the economic theory that reigned during the final push to unification because it had a lot to do with the way the monetary union was formulated. And note that it was largely our Chicago Boys who dominated the creation of this pathologically false doctrine.

First, individuals and markets were presumed to be rational in a very specific sense: they know how the economy works and form expectations in such a way that only random errors are made. There is no uncertainty, although mistakes are made (you know a fair coin will come up heads fifty percent of the time in repeated tosses, but there’s a risk you could lose five times in a row). Financial markets are “efficient”, with prices reflecting fundamental values. Importantly, these models do not allow for default. So speculative bubbles and crashes that generate defaults are ruled out by assumption. Essentially, neither money nor finance really matters—with no default risk and no uncertainty, underwriting is unnecessary. Money’s role in the economy comes down to determining inflation.

Second, the reigning orthodoxy abstracts away from institutions; to the extent that institutions are considered at all, they are seen as obstructions to the efficient operation of free markets. Governmental institutions, in particular, are mostly bad, interfering with equilibrating forces. Likewise labor unions and consumer protection—these necessarily lead to suboptimal results.

Third, market forces are strongly equilibrating. While exogenous shocks might momentarily move markets away from equilibrium, unregulated markets will quickly restore equilibrium.

Fourth, monetary policy is potent but should be limited to fighting inflation. As markets are naturally stable, there is no need to use policy to nudge the economy back to equilibrium. In the short run, inflation is dangerous because it fools people into acting against their own self-interest as they mistake nominal price changes for “real” (relative) changes. (In the long run, money doesn’t matter at all.) Hence it is important for the central bank to target inflation.

Fifth, fiscal policy is completely impotent; for every dollar spent by government, the private sector reduces its spending by a dollar—or even more. This is true even if the government deficit spends—the extra dollars do not call forth extra production because everyone knows that deficits today mean higher taxes in the future. So people today set aside more savings in order to meet the bigger tax bill tomorrow.

Sorry for all the esoteric theory, but it helps to frame our understanding of the set-up of the EMU. The idea was that adoption of the single currency would result in lower transactions costs of trade across borders. Opening those borders to financial institutions would similarly lower the costs of financial transactions by increasing competition. With free markets and open borders, the euro would lubricate trade in goods and services so that it would flow as freely as grass through a goose.

Monetary policy was moved to the ECB which pursued a single inflation-fighting mandate. By contrast, fiscal policy would be retained at the individual member level—reflecting its subordinated function. Maastricht’s “growth and stability pact” would constrain national fiscal policy by imposing deficit and debt limits. By constraining those governments, the vaunted market forces would be free to pursue growth. Importantly, financial regulation and responsibility for crisis resolution were left in the hands of the severely fiscally constrained individual member states.

In truth, there was almost no regulation—reflecting the belief that financial markets are efficient—and there was no real planning for crisis resolution. After all, unregulated and unsupervised banks would never do anything stupid!

Various other barriers—especially labor market regulation by unions and governments—were reduced or removed. The social safety net was under constant attack—who needs a net if nothing can ever go wrong up on the trapeze?

As VP Constâncio argued in Berlin, for this set-up to work, three (at least) conditions would need to be met.

A) Business cycles in the member nations would need to be synchronized. This is because with the centralization of monetary policy, all members would face the same interest rate set by the ECB. If, say, Germany was growing very vast, that would dictate on conventional thinking a high interest rate; but if Portugal was growing slowly it would need a low rate.

B) Flexible and competitive internal markets would be needed to ensure a quick rebalancing after a shock. This is based on the belief that “free” markets would move economies back to equilibrium.

C) There would be in place shock absorbers of sufficient size in each member state to deal with any idiosyncratic problems. It was believed that “fiscal capacity” to deal with a shock would be ensured by running tight fiscal policy in normal times, so that deficits and debt could expand when a shock hit. That was part of the thinking behind setting maximum ratios in the Maastricht agreement (to maintain policy space to manage a crisis).

In my view all three of these conditions are problematic because they rely on the conventional macroeconomic model described above. First, they presume that central banks can and should fight inflationary pressures through interest rate setting. I cannot get into it here, but there is neither evidence nor sound theory to justify this; a more accurate characterization of central bank omnipotence is the Wizard of Oz spinning dials and pulling levers that are not attached to anything.

Second, they presume that markets are equilibrium-seeking, and that disequilibrium is caused by external shocks. In reality, markets are highly unstable and it is the existence of constraining institutions that keep markets from flying off toward Pluto. After the Global Financial Crisis, if anyone still believes in the equilibrating forces of markets, I suppose they are already living on some virtual Pluto.

Or at the University of Chicago. (Same thing.)

Finally, it should always have been clear that if you deregulate financial institutions, allow them to cross borders, and permit them to layer on debt upon debt upon debt, they would blow up any of the member states in the first serious financial crisis. There was no way that any member would have the fiscal capacity to deal with such a crisis no matter whether it had always run budget surpluses.

Indeed, the countries that had the “best” fiscal policy (budget surpluses)—Ireland and Spain—were the ones with the worst problems in the financial sector. Anyone who understands the three sector balances approach of Wynne Godley knows why: if the government runs a surplus then the private sector will run a deficit (unless there is a large enough current account surplus—see below; that was made impossible by Germany’s economic strategy).

And so the banks blew up Ireland, and in its attempt to fall on the sword to protect French and German banks, the Irish government blew up its budget. With no central authority concerned with financial crisis, and with the banks highly interconnected (debts on debts!), the crisis spread like a deadly viral contagion across Euroland.

Again, the problem was that neither macroeconomic theorists nor Euroland policy makers understood that financial flows are mostly related to ownership of financial assets rather than to trade flows. That’s what “financialization” or what Minsky called “money manager capitalism” is all about. Even now most analysts point their fingers to current account deficits of some of the members and claim that the financial crisis was caused by profligate consumption of imports by overindulging Mediterraneans.


Recall that one of the arguments for the creation of the EMU was to develop a large internal market, something on the order of the size of the USA. With a large internal market, Euroland’s producers would not have to rely on export sales. That was a good idea; and if they could rely on internal markets, they would not have to slash wages to reduce labor costs to Asian levels in order to compete for global trade outside the EU.

Following the USA, they could ignore internal current account deficits, since, after all, they all use the same currency. They have a single payments system, run through the ECB—which clears accounts of the national central banks. Internal current account deficits don’t matter, at least with respect to the financing.

Unfortunately, the EU made one big mistake that we did not make in America. When the Fed was created in 1913, we made sure that the borders of the regional central banks did not coincide with state lines (indeed, Missouri is home to two regional central banks—it’s nice to have an influential representative in Washington to send the pork home!). That means that the payment-clearing does not coincide with states.

In the USA we do not know or care which states run current account deficits. Payments clear whether or not Mississippi runs a current account deficit forever. It is sustainable. The Fed makes it so. And it does not matter if the Federal Reserve of Kansas City always runs a clearing deficit with the Federal Reserve of St. Louis. It is sustainable. The Fed makes it so.

In Euroland, the Target 2 system accomplishes the same thing for national central banks: accounts clear. But here’s the problem. The little accounting elves keep track by national borders. They report that the naughty Greeks import more from the other member states than they export to them. Profligate consumers! Shame, shame. Tighten your belts!

Rather than creating one great big economy, the EMU was set up to foster competition among the member states to see who could export the most to neighbors. Germany won. How? Through painful deflationary policies to keep wages in check, assisted by the fortune of the fall of the Berlin Wall that brought in waves of low wage and high skilled East Germans to the labor force.

And so now Germany chastises the hapless Greeks, Italians, Spanish and Portuguese for losing the Hobbesian dog-eat-dog Mercantilist battle for internal export markets. The proposed solution is austerity everywhere. The inevitable outcome will be race-to-the-bottom dynamics to slash wages and living standards.

We’ve been there before. Remember the 1930’s? Made worse by trade policies such as the  Smoot-Hawley Tariff Act of 1930. The EU has the Maastricht No-Growth and InStability Pact.

European leaders are seeking déjà vu all over again.

What should they have done differently? First they should have prohibited a member state from purposely deflating to gain competitive advantage. Germany’s strategy sucked jobs out of the periphery and should have been penalized as anti-EMU behavior. Second, they should have ignored current account deficits arising from internal trade. And third, they should have created jobs in those nations losing them to internal trade.

What happened, instead, is that as nations lost jobs to German imports, their unemployment rates rose. In some cases, their households tried to maintain living standards through borrowing, and their economies relied on asset speculation (especially real estate) to create income and jobs. In other cases they tried to compete by adopting austerity—which of course could never work for the EU as a whole precisely because it destroyed the big internal market the EU was trying to create.

Here’s the most important conclusion. If you want to create a monetary union, you need to forget the internal current account outcomes and focus instead on employment. The trade flows all take place in the same currency and can always be financed. Internal deficits are sustainable. But unemployment is not.

Euroland needs jobs, not austerity.


Alexander KarvoshDecember 6th, 2012 at 10:40 pm

Very interesting professor!
I just want to make sure I understand two points that you made.
FIrst, what impact does it have that markets know of the current account position of a particular Euro-country? It is that this create pressure on deficit nations to become more competitive via deflation? Thereby creating an argument for austerity.
Also, holding all else constant in the current structure, what would the difference have been if trade balances weren't reported? Is the point you're trying to make that, it shouldnt have mattered who was in deficit or surplus because (1) payments would always clear (2) in the long term movements of labor should have created balance?
Thanks in advance.

kevin_globalDecember 7th, 2012 at 1:23 am

Internal deficits within monetary union are natural. All states cannot be in current a/c surplus or deficits at the same time. The idea of punishing Greece or Spain for consuming too much is ridiculous. And to make monetary union function efficiently, it needs is Surplus recycling mechanism as described by Prof. Yanis Varoufakis. EMU made two mistakes (apart from many other mistakes). First they, in theory, believed that all EZ states should tend towards surplus, which can't happen. And chastised states that ran deficits. Secondly, they did not built a Surplus Recycling Mechanism (or they just left it on markets to take care of it).

Mark MangerDecember 7th, 2012 at 4:35 am

"Through painful deflationary policies to keep wages in check, assisted by the fortune of the fall of the Berlin Wall that brought in waves of low wage and high skilled East Germans to the labor force."

Sorry, but that's factually incorrect and has things backwards. During the political bargaining over reunification, West German unions made sure that East German wages approximated West German levels, even though productivity was a fraction of the West. East German Marks were exchanged 1:1 to Deutschmarks. East Germans were promised "blooming landscapes" by Helmut Kohl and voted from him in droves.

Reunification then gave a short-term artificial demand boost to all of Germany through a sudden increase in the money supply, and led to considerable wage increases in collective bargaining agreements, because supposedly the economy was doing well. The Bundesbank reacted (as it always did) by raising the interest rates. By the time of the introduction of the € (as a fixed exchange rate, not as coins yet), Germany had a seriously overvalued exchange rate, mass unemployment and deindustrialization in the East, and was unable to compete with its European neighbors. There was no sudden entry of low-wage and high-skilled East Germans into the labor market because collective bargaining agreements prevented that.

German companies and unions reacted to this by negotiating real wage freezes over many years, but this was not a matter of government policy. Rather it demonstrated the ability of German industry unions to set wages below productivity gains when necessary for the benefit of the export industry. Swedish and Dutch unions have been able to do the same (David Soskice has written about this at length).

The only important change in government policy was to reduce unemployment benefits, creating a lot of hand-wringing, but not much downward pressure on wages – only about half a million people moved from welfare into work, hardly enough to affect wages in Germany as a whole.

German politicians just extrapolated that experience to the Eurozone: you have an overvalued exchange rate, so you need to internally devalue. German real wages didn't grow for over a decade, so there's an expectation that other countries can do the same.

lkofenglishDecember 8th, 2012 at 2:25 am

"shoulda coulda woulda." Germany is the clear winner…and the rest of Europe looks more and more like her satrapy by the day. France of course is the big exception…and she has an awesome amount of diplomatic power on the Continent because the bottom line is Germany has screwed this euro thing up IMMENSELY. Instead of bailing out their own banks while throwing Greece under the bus they should have simply cut the check and "let it go." Instead there now is the worst of all worlds where Greece is more destitute than she could be possibly fathom but without any stake in the existing economic order. "go ahead…stay in the euro." once she returns to the drachma…sure, the inflation and loss of GDP will be staggering…but she will have a powerful friend in Paris. And so it would appear will everyone else unless Berlin can figure out a way to "share the wealth." the irony that the whole system is predicated on RIDDING inequality should be lost on no one.

DiranMDecember 8th, 2012 at 9:34 am

Nice piece, Randall. Very concise and to the point. Sort of echoes many of the things that Michael Pettis writes about the EU and the trade policy issues. So why is Nouriel suddenly reversing his position on Greece? There is no sight yet of Germany reversing their mercantilist trade policies, not even any real action on debt relief for Greece but vague promises. The Greek government is planning a new barrage of taxes for next year. So on the one hand, they do some EU infrastructure projects and sell off assets – the old EU yadi ya that greases the pockets of the same old Euroweenie crowd – but most of the Greek population suffers…. Needless to say, debt relief is not the same thing as a transfer union or reversing mechantilist trade polcies. A debt relief target of 120% GDP for Greece is absurd with 60% a proper level….

DiranMDecember 8th, 2012 at 9:34 am

Seems to me Yanis Varoufakis is more on the ball than Nouriel when he sees the risk of Greece become another Kosovo-like protectorate. Remember how the Germans played a key role in the Yugoslav mess…. With prolonged weak economic conditions locked into Eurohell, young Greeks will emigate, Greeks will become a minority in their own space with others like the Albanians becoming the majority. Already Albania is opening old territorial claims. Greeks letting the Germans speak for them at the Balkan Conference. Smells an awful lot like a brewing Kosovo….

Philip PilkingtonDecember 8th, 2012 at 1:22 pm

In Ireland during the boom years the government obsessively told us that our budget surpluses were "savings" to be spent on the future — and everyone, regardless of their political orientation, believe it (just like in Australia right now… *hint*…). This was always nonsense because the surpluses were just running down pre-existing government sector debt. The mainstream story didn't even make sense on its own terms: because Ireland never retired all its government debt it was never truly "saving" at all.

I must say that as tragic I find what happened to my country I get infinite amusement out of saying to people calling for austerity: "Whatever happened to that pot of gold that the government were saving during the boom years. Can't we just spend that?" They inevitably get completely bewildered. Very amusing.

jerryDecember 8th, 2012 at 4:04 pm

Dr. Wray – lot of great material from you lately.. thanks!

I've been reading your new book and found it very helpful. It seems as though you (and MMT in general) does not have much to say regarding private sector bank debts. You seem to allude to it towards the end of the book and I understand it is probably a larger topic to address, but how do you fit in the creation of debt/money through the banking system within the sectoral balances approach? Especially given the 250+% of GDP that private debt now amounts to even 4 years after the crash.. Is there no net surplus to the private sector because one person getting the money from a loan means someone else owes the money?

BarrettDecember 8th, 2012 at 6:02 pm

I'm from Finland but due to work couldn't make it to the conference. I've watched the videos and was glad to see that your visit got a good amount of media attention here.

Ordinary people are really interested about the MMT ideas as long as you take the time to explain them.

HepionDecember 10th, 2012 at 5:01 am

There should not be debt relief for indebted countries. After all debts can be paid back: polations are growing and so is productivity. Only guestion is the interest-rate question, would compounding interest outstrip growth in ability to pay?

Therefore all debts should be refinanced to long term, low interest-rate debts. I would suggest interest-rate that only compensates for inflation, so that real value of debts would not change, and paypack times closer to one century.

These debts are result of pension savings in trade surplus countries and are meant to pay for consumption once population retires. We have to recognize that debt cancellations are morally wrong. And that there is no need for them.