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.