Seeing “It” Coming: An Interview on the Global Financial Crisis and Euroland’s Fatal Flaw

L. Randall Wray | February 20, 2014

I recently did an interview for the magazine “Synchrona Themata” (“Contemporary Issues”). The interview, which will appear in Greek, was conducted by Christos Pierros, doctoral student at the University of Athens Doctoral Program in Economics (UADPhilEcon). What follows is the English transcript:

What do you think went wrong in 2008? Why was standard macro theory unable to predict such an event?

This was a collapse of what Hyman Minsky called “Money Manager Capitalism.” In many ways it was similar to the 1929 collapse of “Finance Capitalism” that led to the Great Depression. MMC and FC share several common characteristics. First, the dominant approach of economists and policy makers in the 1920s and in the 2000s was one of “laissez faire”—that is, a worship of free markets. Importantly, that meant that finance was “freed” from regulation and supervision. Second, in both cases we lived in an era of globalization—with both goods and finance crossing borders fairly freely. That ensured that when crisis hit, it would spread around the world. Third, finance dominated over industry. Our economy in both cases was “financialized”—with finance sucking 40 percent of all corporate profits out of the economy. To say that “finance ran amuck” is an understatement. To say that our economies were completely taken over by “blood sucking vampire squids of Wall Street” is only a slight exaggeration.

Standard macro theory either thinks all these are “good” trends, or ignores them. That is why—as the Queen of England remarked—none of these economists saw the crisis coming.

Do you believe that by using other tools of analysis (another methodology) one could have seen it coming? If yes, which type of analysis would that be?

Certainly. Many of us saw the crisis coming. The three approaches that made it possible to understand what was going on were: a) Minsky’s financial instability approach; b) Wynne Godley’s sectoral balance approach; and c) Modern Money Theory—which actually builds upon the approaches of Minsky and Godley. All of those working in these approaches “saw it coming.”

Just very briefly, those following Minsky could see that financial institutions were engaged in highly risky practices that would eventually cause liquidity and solvency problems. Those following Godley knew that government budgets were too tight—including the governments of the USA, Spain, and Ireland. By the same token, private sector households and firms had taken on far too much debt. That was particularly true of homebuyers in the USA, in the UK, and in Spain. And those following MMT knew that Euroland was designed to fail; by disconnecting fiscal policy from currency sovereignty, the EMU ensured that the first serious downturn or financial crisis would threaten the very existence of the European Union.

Do you see any shift in the paradigm of economics taking place? If yes, towards which direction?

Definitely not in academics, and not so much in policy-making, either. Those are almost completely oblivious to the problems. However, across the internet, bloggers have discovered Minsky, Godley, and MMT. This will be a revolution of ideas that begins from the bottom.

Recently, you mentioned the need to place our focus on reducing unemployment. Which are according to you the optimal policies for reducing unemployment in US and the eurozone?

We have two unemployment problems—short run and long run. In the short run, we have not recovered from the Global Financial Crash of 2008. Even if we do not slip back into recession, it will take years and years to recover those lost jobs. But even if we were to get back to the employment levels of 2007, we still would be tens of millions of jobs short in both the EU and the USA. The long term problem is jobless growth. It is a global problem. It will not be resolved by recovery. We need to create millions and millions of new jobs. I do not see an alternative to the Job Guarantee—direct job creation by sovereign governments.

What are your thoughts regarding the impact of the globalized financial system on real economy? Do we need to regulate the financial sector? How can we do that considering its globalized nature?

The mistake everyone makes is to equate finance to scarce resources, and to argue we need to “free” finance so it could increase the supply. False. Finance actually amounts to “key strokes” that create credit. It is potentially infinite in supply. What is scarce is the supply of good borrowers. We lived through a fantasy period in which financial institutions thought it did not matter whether the borrowers were good—because all risks would be pushed onto someone else’s balance sheets through securitization and other derivatives. Again, false. The delinquencies and bankruptcies all came back to the financial institutions. The job of finance is to do good underwriting to find the good borrowers. And we need good supervision and regulation of bankers to make them do that job. We do not have “too little finance”; rather, we have far too much unregulated and unsupervised finance.

How do you evaluate US monetary policy (QE) and the corresponding European (LTRO)?

QE is vastly over-rated. Once you lower the overnight policy rate toward zero (called ZIRP) there’s little else a central bank can do. After that, it is up to Uncle Sam to spend more, using fiscal policy. We are not doing that in the US, so we do not have a good recovery. QE will not do the trick—it is an impotent handwave that will not encourage Americans to spend.

The EMU is in a different situation since fiscal policy is constrained because countries adopted a foreign currency—the euro. In that case the only thing available is “monetary policy” broadly defined, in the hands of the ECB. Near-zero ECB rates don’t do much good because Greece, for example, cannot borrow at those rates in markets. What is needed is a guarantee by the ECB that it stands ready to support Greek government debt at some maximum interest rate—say, 3 percent. The ECB would either directly buy the debt, or lend to any bank that would buy the debt at that rate. That is the way the ECB can support fiscal policy. But this must come without conditions—it does no good to allow governments to borrow but then to tell them they must adopt austerity. I won’t go into the Godley sectoral balance approach, but countries like Greece and Portugal need to run government budget deficits well above the Maastricht criteria. And that is perfectly sustainable with ECB support.

How about Obama’s fiscal policy compared to European austerity?

Not much different. We had two years of fiscal stimulus and once that ran out, Washington embarked on austerity. The main difference is that we have our own currency—so “bond vigilantes” cannot increase interest rates on Uncle Sam’s debt. Still, government in the US is doing very little to help recovery—the budget is far too tight and getting tighter. I think we are slowing down, and could be back in recession before the end of the year.

In the EMU, countries gave up their currencies and so the bond vigilantes price everything off German government debt. If you are not Germany, you get higher rates; and the less you are like Germany, the higher the rates you get.

In your speech at Levy’s Conference in Athens, last November, you focused on the fatal flaws of the euro. Could you briefly explain the main drawback of the euro?

Again, it was giving up the drachma, the lira, the Irish pound and adopting the foreign currency called the Euro. While most economists focused on the unification of monetary policy under the ECB, what really mattered was delinking fiscal policy from the currency. Trying to implement your domestic fiscal policy in a foreign currency is effectively equivalent to colonization of your economy by foreigners. The Euro set-up was sure to make the dominant economic power (which turned out to be Germany) the “foreigner” that would colonize the other nations. Godley actually said precisely that before the unification. He was right. Germany has colonized Greece.

How do you evaluate ECB’s obsession against inflation? In your view, does it enhance or reduce depression?

It is of course a German obsession that from the beginning infected the ECB. In truth, I don’t think that the inflation focus of monetary policy matters much. Some time ago Claudio Sardoni and I showed that there really has not been much difference between interest rate setting by the Fed versus the rate setting of the ECB. While the ECB is more fanatical about inflation, the actual policy adopted has not been much different. Again, what matters is the constraint on fiscal policy—not the monetary policy constraints.

Which are, according to you, the optimal policies for the eurozone to recover? Any thoughts particularly on Greece?

Sorry to be pessimistic, but there is no recovery in view under the current arrangements. Europe is too big to be pulled out of its slump even if the USA were to recover (which is not at all certain). The EU as a whole only runs a small trade surplus, anyway, so exporting its way to recovery will not happen. Germany might do OK through exports, but it will do what it can to maintain advantages within the EU so that it is unlikely any other big economy in Europe can follow Germany’s mercantilist strategy. Hence there are 2 possible paths. One is an exit from the EMU. That will be costly, painful, and divisive.

The better path is to reform the set-up. That requires significant loosening of the fiscal constraints—by perhaps 10 percent of the EMU’s GDP. The “money” must come from the center—either allocations by a better-funded European Parliament (whose budget is now under 1 percent of GDP—so we are talking about more than a ten-fold increase of its spending), or by ECB purchases of member government debt at very low interest rates. To be fair and to ensure all members benefit, it should be based on population. And to ensure decentralized political decision making, it should come with few strings attached.

Letting each member nation spend more (by issuing debt to the ECB or through grants from Parliament), the economies can recover. It also reduces the imperative to “beggar thy neighbors” through attempting to gain competitive advantage over fellow members. While I might have sounded very critical of Germany earlier, we must understand that the set-up of the EMU practically ensured the outcome. From Germany’s perspective, it did everything “right”—holding wages down and increasing productivity. Germany tightened its belt so that it could compete. Now Germany enjoys the benefits. The problem is that for Germany to win, many had to lose. But that is precisely how the EMU was set up. You need to change the rules of the game if you do not like that outcome.

For further reading:

short one: Euroland’s Original Sin
medium length: Fiddling in Euroland as the Global Meltdown Nears
Ireland and JG: The Euro Crisis and the Job Guarantee: A Proposal for Ireland
older but more thorough and prescient: Endgame for the Euro?


3 Responses to “Seeing “It” Coming: An Interview on the Global Financial Crisis and Euroland’s Fatal Flaw”

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  1. Comment by Giacomo — February 21, 2014 at 5:08 am   Reply

    I really like this article. I’m dubious, though, about the suggested solution to maintain and reform the eurozone.
    The whole set-up and the treaties are clearly conceived like that on purpose. It’s not a mistake.
    But assuming eurozone countries managed to reform the system as suggested, I think we still would have two big issues.

    The revenues from ECB purchases of govt bonds are given back to EU countries proportionally to their size.
    This results in a significant fiscal advantage to countries with lower debt/gdp ratios and lower interest rates on their debt.

    The Euro is overvalued for most EZ countries and undervalued for Germany and other core countries.
    The price difference is often estimated in the range of 20-30%. Given this, if you raise govt deficit spending, a great deal of this will go into excessive imports thus resulting in dramatic CA imbalances and further deindustrialization of peripheral countries.

    How do you cope with this?


  2. Comment by Jordan — February 21, 2014 at 1:26 pm   Reply

    Your point number 1 is important. What next after initial purchase of government bonds?
    Those revenues should be employed for more developement of south economies. Just give money for projects.

    Point 2 is also an issue but not expressed in the right way.
    Euro is not under or overvalued but perifery’s wages and social benefits are too low.
    Prices throughout the EU are relatively similar on average. It is the debt that is overly costly in the perifery, especially comparing it to the wages.

    In Croatia here we have a widespread belief that we can not give good enough social benefits and wages because Croatia is a poor country, I believe that it is the same case all over the south.
    Truth is that we are poor only because we give low wages and low social benefits, not other way around as widely believed.
    It is the false ideology that rules southern countries, untill we loose them we will not understand the problems we ourselves create.

  3. Comment by Giacomo — February 25, 2014 at 4:58 am   Reply

    On point 1,
    when you say “give money for projects” are you talking about lending or transfer?
    Lending would burden those economies with even more debt. I believe transfer, or reforming the ECB to achieve the same result, is the only way.

    On point 2,
    EU is not Eurozone. The point I’m making is on fixed exchange rates.
    while I agree with you that in some peripheral countries wages and social benefits were or now are too low, this is not what I’m talking about.
    Currency undervaluation and overvaluation in the Eurozone is a matter of fact.
    If you entered the Euro 15 years ago and you accumulated a 20% inflation differential during this time, then the Euro is overvalued by 20% for your country. All goods and services produced by you cost more than they should and would with floating exchange rates.
    Then you import too much and export too little, your current account goes more and more off balance… and you blow up.
    The way they’ve managed to bring this back under control till now is with austerity.
    They don’t tell you that of course, they blame public debt and tell the cure is austerity. While the problem is current account imbalance and foreign private debt.
    Austerity solves this problem, by destroying income and internal demand you bring the CA back into balance. Austerity in the Eurozone is required.
    Monti did this in Italy and openly admitted he did so. It was a perfect success (in this regard, dreadful otherwise).

    Furthermore, since what you want to achieve is economic recovery, this implies at least moderate inflation which will make the price differential grow even greater.
    So, I would ask again, how do you avoid current account imbalances while keeping the exchange rate fixed and having accumulated a significant price differential?

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