A T-shirt model of savings, debt, and private spending

As long as the Euro area enforces balanced budget constraints at ALL levels of government, the Euro area will not be sustainable.

I have summarized here the argument behind the statement above.

What follows is a simple model that shows the logic of the argument.

1. In a monetary economy where the private sector demands financial assets as a vehicle to store wealth (aka ‘financial savings’), spending (by the private sector) can be assumed to depend on saving desires. Specifically, in any given period of reference, the change in total spending (ΔE) is a function (α) of the difference between the available stock of financial assets (FA) and the desired stock of financial savings (FAd):


The intuition is that if the value of available financial assets exceeds the desired stock, spending will increase, and vice versa.

2. In this simple model, FA(= the desired stock of financial savings) is taken as a given:


3. The nominal value of available financial assets to private residents must equal the sum of all liabilities outstanding, including those issued by the private resident sector (DP), the domestic public sector (DG), and the foreign sector (DF). DP is the outstanding value of private debt. Dis the oustanding value of public debt. DF is the net position with foreigners (when positive, it is the value of residents’ claims on foreign entities). This means:eq3

4. This model explains spending with saving desires (FAd) and the available stock of financial assets (FA) which depends on the existing liabilities issued by private, public, and foreign entities.

Thus, an increase in spending requires that:eq4

Taking the desired stock of financial savings (FAd) as given, when the private sector is unwilling to expand its debt (DP), an increase in spending can only be the outcome of an increase in net exports (DF), or an increase in government deficit (DG). While an increase in DG is financially viable as long as the ECB supports it, and it is also economically desirable as long as unemployment remains high, an increase in DF can hardly be large enough to restore nominal income growth, entails rising risk on foreign assets, makes the euro area dependent on foreign demand conditions, and is not economically desirable as net exports reduce the output per capita below what the economy can produce.

European fiscal rules violate the savings-debt constraint

In a forthcoming article (‘A T-shirt model of savings, debt, and private spending: lessons for the euro area’, European Journal of Economics and Economic Policies: Intervention, Vol. 13 No. 1, 2016, pp. 39–56), I have discussed the relevance of the savings-debt constraint in macroeconomics, and have argued that EU policies violate the savings–debt constraint. As long as this continues, the euro area will continue to live dangerously and will remain vulnerable to political disintegration.

The EU has always stressed that euro area’s national government budget must be consistent with the budget constraint set by fiscal rules, while offering no other channel for fiscal flexibility at the euro area level. This approach is inconsistent with a key constraint in macroeconomics that I call the savings-debt constraint.

In a nutshell, the savings-debt constraint says that any policy that inhibits debt also inhibits financial savings, spending, and jobs. Evidence that the EU policy framework is inconsistent with the savings-debt constraint is offered by the first priority in the list offered online by Jean-Claude Juncker, President of the European Commission: ‘Creating jobs and boosting growth – without creating new debt.’ As long as EU policymakers believe or assert this principle, the euro is in unsafe political hands.

A more detailed discussion of the savings-debt constraint can be found in my article cited above. This is a short summary of what the savings-debt constraint is about.

1. In any monetary economy, the savings–debt identity defines a fundamental financial constraint: any increase in financial assets must correspond to (or ‘be validated by’) an equivalent amount of new liabilities coming into existence. When we hold currency, or bank deposits, or government securities, or corporate debt, we hold a liability issued by the central bank, a commercial bank, the government, or a private business, respectively.

2. A number of entities of the private sector have a desire to accumulate and hold financial assets (i.e., financial savings), with an important share sitting in institutional portfolios, such as pension funds. For this desire to be fulfilled, it must be matched by an equivalent amount of private and public liabilities.

3. To adequately validate the demand for savings, however, debt must be sustainable, and this is where the difference between private and public debt matters.

4. Private debt is only as good as the borrower’s ability to make contractual payments when they come due, and this ultimately depends on the borrower’s income. So private debt may become unsustainable, or grow above the debtor’s target level of indebtedness, or the lenders’ risk perceptions may ratchet higher.

5. Public debt is always sustainable provided it is denominated in domestic units and the central bank is authorized to use its floating currency to purchase securities issued by governments in unlimited amounts, unconditionally. It only becomes unsustainable under specific institutional arrangements. Notice that since 2012 the European Central Bank (through the introduction of the Outright Monetary Transactions program) has made national government’s debt that meets EU conditions sustainable. Essentially, by placing a cap on public debt, the EU is defining politically what is a tolerable, ‘sustainable’ debt of national governments.

6. If private debt becomes unsustainable, the private sector begins deleveraging, cutting spending to pay off debt. With an increasing number of entities competing for existing financial assets, and fewer entities willing to issue new debt, the disparity between actual and desired savings grows quickly, with a potentially disruptive impact on spending. The savings-debt constraint generates a powerful contractionary effect.

7. By offering no other channel for fiscal flexibility, the EU effectively removes the most powerful remedy to the contractionary effects of deleveraging. And it effectively leaves open only one channel, namely a current account surplus.

8. This means that the EU is handing over its responsibility of providing an internal policy response to the recession. Counting on the support provided by debt issued by foreigners is no solution: a) In a serious stagnation, even a large current account surplus may not be sufficient to help support desired savings; b) The current account surplus depends on foreigners issuing debt and makes the euro area dependent on foreign policies; c) An appreciation of the euro may reduce the size of the current account surplus; d) Net exports tend to be correlated with an increasingly uneven income distribution; e) Net exports lower output per capita.

Economic prosperity depends on government policy dealing effectively with a decline in demand caused by a disparity between desired savings and sustainable indebtedness. Stressing fiscal rules at all levels of the EU means violating the savings-debt constraint. The required ammunitions to restore prosperity are well in the hands of the EU.

The (asymmetrical) negative side of negative rates

Commenting on the last Japanese move, Lisa Abramowicz (The Negative Side of Negative Rates) rightly argues that the only positive effect on spending that one can expect from negative rates is through a depreciation of the yen (at least, as long as it lasts). She writes that negative rates is an idea that “sounds good in theory”, but she clearly acknowledges that the effect on bank lending is likely to be dampening, not stimulative. That negative rates do not have an expansionary, and have probably a deflationary effect has been maintained by some economists, including this blog here and here and also the Q&A here. It should be clear by now to an increasingly number of people that what we call a negative interest rate (on banks’ excess reserves) is actually a positive tax rate!

I suspect that those who believe that negative rates stimulate lending have a view of central bank interest rates that does not fit the reality of a monetary system. They seem to think there is a symmetry between positive and negative rates. They seem to think that because lower interest rates mean lower cost of borrowing, an interest that gets so low to turn negative is an even more powerful borrowing (and spending) stimulus. Equivalently, at negative rates lenders will get encouraged to lend less (and spend) more.


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More Target2 divergence: This time is different

In the midst of the Eurozone “sovereign debt” crisis and increasing spreads in 2010-11, interbank lending came to a halt. At the same time, bank clients were moving funds from the banks of the countries “in trouble” to the banks based in “safe countries”. Because “core” banks were not willing to lend liquidity back to them, “periphery” banks borrowed from the Eurosystem to settle their payments, and Target2 balances diverged. This ended with Draghi’s “whatever it takes” announcement in the Summer of 2012 and the introduction of OMT in the ECB’s toolbox.

What is happening today (SEE CHART) is very different, and does not reflect a “flight to safety” as it did back then. Today’s divergence is a consequence of the ECB asset purchase program (QE), as well as of the current levels of policy interest rates set by the ECB.


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Mario Monti defends the austerity fortress

I have known Mario Monti since the time he was my professor of Monetary Economics in the late 70s. An excellent teacher, he opened his course by teaching financial accounting and balance sheets, explaining that every financial asset has a corresponding liability and demonstrating the importance of net sectors’ financial positions.

Today, Mario Monti chairs the EU “high-level group on own resources”, working on a reform of the EU budget. In an interview by Federico Fubini (Corriere della Sera, 18 October 2015), he discusses the current state of public finances in the EU and shares his concerns that the tight fiscal policy enforced in highly indebted EU countries is now being relaxed prematurely.

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