Juan Laborda – The European Model is Exhausted

Fiscal expansion and a Green New Deal, keys to tackling Europe’s economic problems

Juan Laborda teaches Financial Economics at the University of Carlos III and Money and Banking, Syracuse University (Madrid)

Originally published in Spanish at vozpopuli

Translated and edited by BRAVE NEW EUROPE

El presidente del BCE, Mario Draghi.

The certainties that have guided fiscal and monetary policies in recent years are being shattered, and critical voices are emerging from the same orthodoxy. The current intersection of money, ideas and power is unstable, and an inclusive change of rudder is needed to incorporate the majority of citizens. The future will no longer be the same. The aim is to anticipate where the main lines of tomorrow’s economic policy may move.

Without a doubt this process should involve reconsidering what has been assumed; economists intoning the mea culpa; rethinking the role of money; understanding the hidden face of the financial system and source of systemic risk, shadow banking; and defining what needs to be done, rescuing fiscal activism, via modern monetary theory, and incorporating a new key mission of central banks, combating climate change, ensuring that money will not be an obstacle in this battle. In other articles by me on BRAVE NEW EUROPE we have dealt extensively with many of these issues, but let me focus on two very specific ones: the limits of central banks; and the shadow banking system.

The limits of the Central Banks

In a world of hyper-exporters, where domestic demand was consciously restricted – see Europe – the role of central banks was key, giving the authorities, including the superclass, the helm of the economic policy ship. Today, however, it is clear, even to someone not at all suspected of being a dangerous Bolshevik, such as Mario Draghi, that the state must rediscover fiscal policies. The toolbox available to a central bank today, including quantitative expansion, no longer works. The technocracy has failed.

Let us begin by stressing the obvious, the double panacea of central bank operation (here the Banco de España remains uninterested) is fading away. Modern central banks operate under a double false premise. On the one hand, the dominance of supply in the economy. On the other, inflation understood as the real and imminent danger. The long-term damage that the euro crisis has inflicted on the growth prospects of many economies, and the failure of austerity policies, invalidates the claim that supply should dominate the economy.

ECB economists recently demonstrated the overwhelming dominance of the principle of effective demand, in a highly recommended article, “On the sources of business cycles”: implications for DSGE (Dynamic stochastic general equilibrium) models, and with which you are familiar because I have already explained their most relevant conclusions in previous articles. The key point is very simple: the business cycle dynamics of key macroeconomic data can be explained to a large extent by a single source of variation: aggregate demand, i.e. expenditure. The implications are brutal because the dynamic stochastic general equilibrium models, the famous DGSE, which are dear to orthodoxy, do not pass the litmus test. The authors explain this as follows: “The most prominent DSGE models today are not compatible with our empirical findings about the number of factors and the nature of joint movement in macroeconomic data.” It is grotesque that at this point some relevant patriotic economists, to the delight of our superclass, are making judgments and opinions based on these models.

But the fact is that the control of interest rates and the amount of money provided by central banks are no longer reliable tools for governing the economy. Yet another falsehood: In reality, money is endogenous (see Bank of England research: “Modern Creation in the modern economy”; “Banks are not Intermediaries of loanable funds-and why this matters!”) As you know, the amount of money cannot be fixed arbitrarily by central banks. The supply of money is determined by the demand for credit and the preferences of the public. Loans produce deposits, not the other way around.

The inflation of the 1970s, which forced the neoliberal paradigm, was an anomaly. The Golden Age, 50-70, was characterized by high rates of employment, economic growth and equitable distribution of income and wealth. In the mid-1970s, however, these policies were abandoned because they were thought to be causing inflation. This was an incorrect assessment, since inflation was actually generated by the oil crises imposed by the OPEC cartel in response to US foreign policy in the Middle East, combined with poor labour relations in English-speaking countries, which led to class conflict and strikes over who should bear the brunt of these higher oil prices.

But the economic profession of that time, and of today, did not realise this. Their theories told them that it was full employment policies that were generating inflation, so they encouraged policy makers to abandon these policies and instead tried to control inflation through the use of monetary policy. In today’s world, however, as a result of the application of the neoliberal toolkit, it is not so much inflation as deflation that poses the most problems for central banks. There is a hypothesis, still a minority one, that is beginning to be detected among some economists: the drop in interest rates is deflationary, except for the inflation of assets that it generates (due to the predominance of the income effect); the rise in interest rates would be inflationary.

Growth based on export surpluses vis-à-vis the rest of the world is fading. I have already detailed the alternative, fiscal expansion, following Modern Monetary Theory, relying on guaranteed work and a green New Deal. The European model is running out of energy and time. A sound fiscal policy would compensate for the damage done. This response, which is necessary, would initially undermine the very important European external sector, by increasing salaries and decreasing competitiveness, which should be compensated for by increases in productivity, via investments in capital, which many sectors have not implemented over the last two decades.

However, in addition to the reactivation of expenditure, it would have a very positive side effect. The rise in interest rates, via the income effect, would additionally increase consumer demand in exporting and saving countries, reducing their excessive current account surpluses, which are not due to their good economic performance. Meanwhile, the inflation that would be generated by all these policies would reduce the burden of the debtor countries. If this is not done, the European Union will be diluted in a conflict between debtors and creditors that will end up disintegrating it.

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