The Euro, the surrender of monetary sovereignty and the two lost decades (Part 3 of 3)

If in the 90's most of the governments in the Eurozone were partially constrained in their use of monetary and fiscal policies, during the Eurozone crisis they felt even more restrained as now they have completely forfeited their monetary sovereignty by adopting the Euro. By doing so, they have given up their fiscal, monetary and exchange rate policies and in effect became little more than local authorities. Now markets, not politicians dictate the rules. The Maastricht criteria became redundant, if they ever mattered at all, as the inventor of the 3% budget deficit concept, Guy Abeille, a former senior French Budget Ministry official has recently acknowledge:

"We came up with the 3% figure in less than an hour. It was a back of an envelope calculation, without any theoretical reflection. Mitterrand needed an easy rule that he could deploy in his discussions with ministers who kept coming into his office to demand money. [...] We needed something simple. 3%? It was a good number that had stood the test of time, somewhat reminiscent of the Trinity." (original version: French)

Contrary to the early 90's recession, in the present slump, monetary policy has been more accommodative because this is now the responsibility of only one Central Bank- ECB- and not several as back then. Nonetheless, the ECB has been slower than other central banks in cutting interest rates as can be seen below. This is mainly the result of its single mandate at it seems to work like a handcuff that prevents the ECB from being proactive during swings in the economic cycle. The problem now was that the rates were already low to start with and even if the ECB had acted more swiftly, there was only so much it can do as nominal interest rates cannot go below zero-the zero lower bound problem- therefore, the room for conventional monetary policy to stimulate the economy is more limited now than in the early 90's recession. However, once again, other central banks have been more proactive and have been experimenting with unconventional measures to stimulate the economy while the ECB has been more timid.

In a recession, when unemployment is increasing and monetary policy has lost traction, only deficit-spending fiscal policy can effectively lead the economy out of recession as Keynes explained a long time ago (audio recording). In this situation, the difference between the Euro economies (non-sovereign) and other major economies (sovereign) becomes all the more evident. While initially both groups let their budget deficits increase, it is clear that in the sovereign countries the increase was greater and longer. In the Euro economies the increases were not only smaller but by 2010 this countries were already reducing their budget deficits while unemployment was still rising. 

In France and Italy this is quite obvious, the more their unemployment increased the more they cutted. Keynes must be turning over in his grave. No surprise then that unemployment kept on rising in the Eurozone while it started to fall in the other sovereign countries. When comparing the deficits of the sovereign and nonsovereign countries for the year 2009, when this were at their highest, we can easily see that the US and UK were able to run deficits of 13% and 11.2%, respectively, whereas France and Italy just 7.5% and 5.4%, respectively. Certainly this difference translated into a couple of p.p. difference in the unemployment rate. By 2011, when the unemployment rate was going down or at least levelling off in most sovereign countries, in the Euro area it just gathered pace and at the end of 2013 it rose above 12%. Like the early 90's recession this countries started to cut the deficit before unemployment started to decrease. When it comes to recessions, both the US and UK are quite Keynesians despite their reputation as neoliberals, while the Euro Area countries seem to have forgotten about the "We are all Keynesians now".

Again, while in the 90's the Euro area countries had to cut their deficits because of the Maastricht treaty limits, so they could join the Euro, in the Great Recession they had to do so because of the limits established by the markets. As Randall Wray notes, interest rates on government bonds for non-sovereign governments depend on market assessment of default risk: 

"the interest rate on the nonsovereign, dollarized/euro-ized, government’s liabilities is not exogenously set (whether it is a US state, a Eurostate or an Argentina). Since it is borrowing dollars/euros, the rate it pays is determined by two factors. First there is the base rate on dollars/euros set by the monetary policy of the US government (the issuer of the dollar) or the ECB (issuer of the euro). On top of that is the market’s assessment of the nonsovereign government’s credit worthiness. A large number of factors may go into determining this assessment. The important point, however, is that the nonsovereign government, as user (not issuer) of a currency cannot exogenously set the interest rate. Rather, market forces determine the interest rate at which it borrows."

This was the cause at the epicentre of the Eurozone crisis. Back in 2001 when the paper was written, Randall Wray defended that rates were converging because markets were not pricing default correctly following the introduction of the Euro:

"Markets, likewise, have not yet fully recognized the regime shift that has eliminated currency sovereignty for the nation states. While interest rates have not fully converged (and will not), they are typically more similar than they had been before union. This is because while currency risk has been eliminated, markets have not yet begun to fully price- in default risk. Rating agencies are still treating the individual nations as if they were sovereign, with eyes focused on the Maastricht criteria (most importantly, the 3% deficit ratio limits)."

  

Although rates never fully converged, as predicted, they came quite close to it. However, this came to an end in 2007 with the onset of the recession when markets started to realize that not all sovereign bonds were equal. Given the severity of the recession, deficits ballooned, in particular those of Greece and Ireland, and the markets started pricing the default risk, demanding a premium to hold debt from countries they believed were less creditworthy, making their situation even worst. These countries would later lose access to the markets, which led to the intervention of the troika, and this would be known as the Eurozone crisis (timeline). All of a sudden markets views started to matter more than the Maastricht criteria. This is an important change from the recent past because these countries are now subjected to the more subjective appreciation of the market than to the more objective Maastricht criteria. Moreover, markets are prone to have mood swings and although these can happen at any time, they are more likely to happen when financing is more urgently needed. 

The implications for this now non-sovereign states is that their ability to spent is now pro-cyclically biased. This is because during expansions not only taxes revenues tend to increase but market will also lend at more favourable terms, as their assessment of creditworthiness will certainly be more positive. The problem is that during recessions the opposite is true. Not only will tax receipts fall, but market assessment of creditworthiness will necessarily be more negative and as a result, governments will find it increasingly difficult to finance their borrowings or will do so at more unfavorable terms, making a bad situation worse as Randall Wray predicted:

"Meanwhile, the fiscal situation of member states could deteriorate rapidly—with rising market-determined interest rates absorbing ever- larger portions of the budget, forcing spending cuts, driving growth further into negative territory, destroying tax revenue, and leading to further downgrading of debt."

This was exactly what happened to the Eurozone peripheral countries: Portugal, Ireland and Greece. Having increased their budget deficits sharply following the onset of recession, in some cases to rescue their banks, soon the markets started to doubt the sustainability of their debts, resulting in higher yields, which in turn made their debt even more unsustainable. They rushed austerity budgets in a last effort to please the markets but they would eventually lose market access and had to be bailed out by the Troika. The loans came with very strict goals in terms of budget deficit reduction, therefore, these countries had to implement measures to reduce their deficits, either by increasing taxation, reducing spending or both. Other countries, namely Spain and Italy, feeling the heat of the markets embarked on their own austerity measures, as did France, to a lesser extent.

  

Germany did not increase its deficit much with the crisis and it's now even back to a balance budget. In this case, unlike the other Euro area members, unemployment has been falling since 2005 and so there's no pressure whatsoever to increase the budget on account of unemployment.  However, this fall in unemployment has little to do with its economic situation and more to do with its demographic nightmare. Germany has passed the point of no return and thus, bar any major recession that affects its major trading partners, it will suffer from permanent shortages of labour and unemployment should continue to fall for the foreseeable future. This must be the case; otherwise, how can it be understood that an economy whose growth has averaged 1% in the last decade and whose GDP shrunk more than 5% in 2009 has anyway halved its unemployment since 2006? On the contrary, in the other countries of the Euro area unemployment has more than doubled from already high levels.

If in Spain and Ireland the unemployment accelerated clearly from 2007 onwards with the burst of their property bubbles, in Portugal, Greece and Italy it went up more markedly at the time governments started to implement austerity measures. Even though part of the initial increase in the deficit resulted from the slowdown of the economy and subsequent unemployment - fall in tax revenue and increase in unemployment benefits -, a big part of it was directed to supporting financial institutions. If this was more evident in Ireland and Spain, it was nonetheless the case for Portugal and Greece, where part of their bailouts were destined to prop up financial institutions as well. The problem being that this spending had no direct impact on the real economy or employment. If part of that money had been direct into a stimulus package, like the one approved in the US in 2009, the unemployment situation wouldn't be as bad as it is. However, instead of stimulus packages, these countries were soon implementing austerity measures, making a bad situation worse, with unemployment reaching levels only seen during the Great Depression. In Ireland, Spain and Greece unemployment increased threefold from its pre-recession levels.

The markets effectively forced these countries to cut theirs deficits, which constitutes a clear departure from the previous status quo that had governed these countries for decades. If in the 90's they had abdicated part of their monetary sovereignty when joining the EMS, now they have clearly surrendered the rest of their monetary sovereignty as they have abdicated their national currencies and have become effectively non-sovereign countries, similar to US states. In fact, in monetary terms, one should not think of these countries as similar to the US or the UK but the equivalent to US states (See rankings). Just like them, Euro Area countries are now exhibiting a pro-cyclical behaviour that is common to non-sovereign states or local authorities.

While for Europe it’s normal to look at the economic indicators at the country level, for the US there's a tendency to look exclusively at the federal level, as a result, there's a predisposition to overlook how diverse the picture is at the state level. Although in the Great Recession unemployment rose across all states, the size of that increase was very different among the states. It affected in particular states with bigger decreases in housing prices and with larger households in-immigration rates, namely Florida and Nevada. This is exactly the same situation as Spain and Ireland in the Eurozone, which not only experienced the biggest fall in house prices since the recession but whose growth prior to the recession was for the most part driven by immigration.  If unemployment, at least initially, rose more steeply and across the board in the US, it peaked in 2010 and has since started to fall steadily; Nevada with 13.8% had the highest rate of unemployment among all states. On the contrary, in Europe it increased more slowly and only in the countries affected by the housing burst before 2010; however, with the onset of the Eurozone crisis, unemployment started to surge in Portugal and Italy; and to shot up in Greece where, together with Spain, it peaked in 2014 above 25%.

In the US all State governments, with the exception of Vermont, are required to balance their budgets every year regardless of the economic situation. In actual fact, it is practically impossible for revenues and expenditures to get out of balance, since expenditures are controlled by available funds. This are enforced mainly through prohibitions to carry forward deficits to the next fiscal year and by restricting the financing of deficits through borrowing. Current expenses are rarely financed through the issuance of new debt which is mainly used to finance capital spending. This necessarily makes state spending pro-cyclically biased: in economic expansions, revenues increase more rapidly and the ability to borrow is increased as well because markets will tend to have a more favourable view regarding state’s repayment ability, as a result, spending is likely to increase fuelling economic expansions. On the other hand, when the economy slows revenues decline, as states are required to balance the budget, they have to cut spending, increase taxes or a combination of both. Depending on the severity of the recession and the fall of tax revenues, fiscal consolidation might act as a further drag on the economy and ultimately drag the economy into a downward spiral, with less revenue being followed by more cuts that in turn make the economic situation worse, resulting in weak tax collection and a new cycle of cuts in expenditure.

Most of the times the recession is short and job cuts are hardly necessary. However, the Great Recession was different, not only because of its severity and length, but also because it came after a housing boom that had ballooned budgets on account of property taxes; and when this evaporated, revenues collapsed and states and other local authorities had no other choice than to balance their budgets in the midst of a recession, as they can't borrow to replace the lost revenue as Paul Krugman explained:

"The answer, of course, is that state and local government revenues are plunging along with the economy — and unlike the federal government, lower-level governments can’t borrow their way through the crisis. Partly that’s because these governments, unlike the feds, are subject to balanced-budget rules. But even if they weren't, running temporary deficits would be difficult. Investors, driven by fear, are refusing to buy anything except federal debt, and those states that can borrow at all are being forced to pay punitive interest rates."

Contrary to most Euro area countries, US States and Local governments had large surpluses before the crisis but when the recession came revenues plummeted. States and local governments didn't rush to close their budgets deficits as for the most part they increased or maintained their expenditure up until 2010. Nevertheless, even without reducing expenditure, deficits started to improve markedly from 2009 onwards on the back of increased revenues. In some cases the increase in revenue was more than 50%. This was the result of transfers from the fiscal stimulus whose main purpose, as Obama has stated, was precisely to plug the hole in state budgets:

 "When I came into office and budgets were hemorrhaging at the state level, part of the Recovery Act was giving states help so they wouldn't have to lay off teachers, police officers, firefighters. As we've seen that federal support for states diminishes, you've seen the biggest job losses in the public sector -- teachers, police officers, firefighters losing their jobs."

The fiscal stimulus package, known as the American Recovery and Reinvestment Act and estimated to be $787 billion when it was signed into law in February 2009, disbursed part of the money by making transfers to state budgets. This allowed many states to close their budget deficits even when they were increasing their expenditure. It is estimated that in Texas, where expenditure increased significantly from 2008 to 2010, the stimulus funds received plugged nearly 97% of its shortfall for fiscal 2010. However, by the middle of 2011 stimulus money started to run out and, with the exception of California, all other states below started to cut their expenditure for the first time since the onset of the recession. By 2012 more than 44 states were reporting fiscal year shortfalls.

In the US, contrary to most countries in Europe, states and local governments can lay off their employees to balance their budgets; and this was exactly what they did in the current recession and that is why employment in the US has not yet returned to pre-recession levels. Although initially state and local employment, which together represent more than 87% of the more than 21 million public-sector jobs in the US, rose when the private sector was already shedding jobs and peaked around August 2008 but, has since been declining. If the stimulus package has not increased state and local employment it certainly avoided that many state and local employees were laid off, but as it started to die out, state and local governments started to shed employment at a faster rate, as Matthew O'Brien noted, state and local governments went on a cops-and-teachers firing spree the likes of which we've never seen before.  (See this report for state variations).

  

While Greece has become the poster child of "fiscal irresponsibility" in the Euro Area, it is hard to say the same of Ireland and Spain, both of which maintained budget surpluses for several years before the crisis, resulting in lower debt stocks. In fact, on the eve of the Great Recession, both countries had one of the lowest, if not the lowest, debts stock of any OECD countries. One can even argue that Ireland and Spain were as fiscally responsible as Nevada or Florida were. Yet, when the housing bubble burst, the effects were quite different in the two groups. The subsequent slowdown resulted in higher levels of unemployment, but while in Spain and Ireland the unemployment benefits had to come out of their national budgets, in Nevada and Florida this came out of the Federal Budget. In addition, in the absence of a true banking union and a more fragmented baking sector in Europe, Ireland and Spain had to bail out their respective banking sectors at a great cost, whereas in the US the Federal government once again pick up the tab (TARP program). With falling revenues and increased expenditure, budget deficits increased significantly more in the European countries than the US states. In Ireland, deficits ballooned from a balanced budget in 2007 to 30% of GDP in 2010 and debt jumped from 25% to more than 100% of GDP; much of it a result of the once-off bank bailout. In Spain the increase was more steady but it has nonetheless increased significantly. On the contrary, in the US states of Florida and Nevada budgets deficits increased briefly and in 2010 were already balanced.

Increase in expenditure should result in increased economic growth but here the quality of that expenditure was certainly a major factor in the reversal of fortunes. Even if part of that increase in expenditure in Ireland and Spain was the result of the increase in unemployment benefits, the lion share was certainly directed to prop up financial institutions. If unemployment benefits undoubtedly help sustain economic activity it is not clear that bailing out banks has the same effect. While one can understand that failing banks might worsen economic activity if it results in drying up of credit it is not certain that alternative uses of the same money would not have resulted in a better outcome. If Ireland had spent 30% of its GDP(some estimates put the total cost of saving the banks at 50% of GDP) in a multi year stimulus package, US style, rather than propping up banks it surely would have been enough to bring the economy back to life. It could even have engineered a boom. The US stimulus at 7% of GDP would pale in comparison. Anyway, it could have something to show for in much needed infrastructure. On the contrary, US states used the stimulus money to start shovel ready projects that certainly helped to stimulate the economy and increase employment.

Euro states and US states responded very different to their fading fortunes. To start with, with the onset of recession and the subsequent increase in unemployment, the automatic stabilisers - like unemployment benefits- kicked in, but whereas in the Euro Area individual countries have to foot the bill, in the US this is the responsibility of the Federal government. In addition, many Euro Area states had to bail out their national banks (IMF estimates), while in the US this is clearly the responsibility the Federal government. If Nevada or Florida had to bail out their banks, they would more than likely go bankrupt. The result was that in the Euro States most affected by the crisis deficits and debt rose more sharply than US states, to the point where markets started to see some of the Euro states as default risks, demanding higher rates, and in the case of Ireland refusing to finance it altogether. Ireland and Spain had to adopt austerity budgets when the recession was gaining speed while Florida and Nevada only had to do so when the economy was already recovering. So it should not come as a surprise that unemployment exploded in Ireland and Spain while it started to decrease in Florida and Nevada. But in the end, the main difference in the response to the crisis was that when the States and local governments in the US were in need, the Federal government stepped in with significant transfers to their budgets, while in the Euro area, in the lack of an established mechanism of transfers, Euro states, to avoid bankruptcy, had to cut spending or increase taxes in the middle of a recession and ultimately, as that did not work, they had to be bailed out by other EU countries.

 The Federal Government not only paid for the increase in unemployment insurance, bailed out banks and assisted State and local governments, measures that helped to sustain and create many employments, but it also created jobs directly. Federal government employment, with 2,736 million jobs represents 13% of all public employment in the US, increased steadily the during the recession when the private sector was destroying jobs and it only began to decrease when the private sector was already increasing employment. More than 600 thousand federal jobs were created until May 2010 as a result of the stimulus package and the once off decennial census. Despite helping to save or create an estimated 1.6 million jobs a year for four years, the stimulus package came under attack and was deemed a failure, which has in effect shut down the opportunity for further stimulus measures. The immediate consequence of the scale down of the stimulus programme is that public employment began a long decline and it's now even below its pre-recession levels. As Matthew O'Brien demonstrates in the following graph, the Great Recession recovery has the worst record for government job added since the post war.

Note. From "Our Historic Austerity—in 1 Crazy Chart" by Matthew O'Brien, 2013, The Atlantic.

Despite that fact, the US unemployment situation, like that of the UK and Japan, compares favourably to that of the Euro area countries. Unemployment did not rise as high as in the Euro Area and it started to came down sooner as well.  This was ultimately the result of better monetary and fiscal policy implemented in the US vs Euro Area. If on the monetary side there were some differences in the response to the crises, with the Fed responding quicker and more aggressively than the ECB, it is unlikely that this accounts for the difference as lower rates don't necessarily translate into higher demand and lower unemployment. On the other hand, the increase in government spending, increased demand when it was faltering and in that way sustaining employment in the US. 

 

While in the Euro Area the deficit of the Euro countries taken as a whole reached 6 % of GDP in 2009, in the US it surged at 13% for the same year, more than the double, and by 2012 when the Euro area deficit had been reduced to below 4%, in the US it still remained above 8%. Certainly this made a big difference in terms of growth and unemployment.

It's here that the flaws of the European arrangement became evident. While the ability of the Europeans nations to implement counter-cyclical measures to smooth the business cycle has been curtailed in the same way of US states, no supra-national or Federal government has been created to take on the responsibility to pursue growth and full employment policies as is the case in the US. This is a fundamental difference as Randall Wray explains:

"In the US it is the federal government (the sovereign) that ultimately has the responsibility and the means to maintain full employment—not the individual, nonsovereign, states. Logically, this is a necessity implied by the fiscal arrangements. As the sovereign issuer of the currency, only the national government is able to spend without regard to revenue. Fiscal transfers (mostly from the US Treasury, although the Fed can also play a role) from Washington to the states can help counter the pro-cyclical behavior of states."

The fundamental problem with the Euro Economic and Monetary union is that nobody has the responsibility and the means to maintain full employment; i.e. the one who has the means has no responsibility and the one who has the responsibility has no means. In practice, given that there's no de facto government, just the ECB, the sovereign issuer of the currency, has the means but by no means has it the responsibility or even the legitimacy to maintain full employment. On the other hand, the national governments of the Euro states have the responsibility but limited means. Before the Eurozone crisis many governments behaved like they still have the means, and that was part of the problem, but have since began to realize that they are not sovereign, even if they don't fully comprehend the implications. The problem is that now many have started to believe that they were always nonsovereign. More worryingly still, is that the electorate still sees the national governments as sovereign, even if they nowadays resemble more local authorities, as a result, they believe that government have the same responsibilities and means they had before joining the Euro. By holding them accountable for their incapacity to improve the economic situation, in particular unemployment, they are wrecking havoc to the traditional party system in Europe with unforeseen consequences.

Therefore, if this countries are ever going to get out of the present economic malaise, there must be a marriage or remarriage of responsibilities with the means to maintain full-employment. This can be achieved either by creating a Central government for the Euro area or the Euro nations must reclaim their powers to issue their national currencies. The fact that this has not happen or is not even discussed just shows how little is understood about the causes of the Euro crisis. Otherwise, by keeping the current status quo, the countries in difficulty in the Eurozone will suffer from never-ending austerity. Eventually they will arrive to the conclusion that the problem with the Eurozone is the Euro and break free from the its straitjacket.

Sadly, this is not a guarantee, as Wynne Godley's conclusions 22 years ago in the article Maastricht and All That, can attest:

"I sympathise with the position of those (like Margaret Thatcher) who, faced with the loss of sovereignty, wish to get off the EMU train altogether. I also sympathise with those who seek integration under the jurisdiction of some kind of federal constitution with a federal budget very much larger than that of the Community budget. What I find totally baffling is the position of those who are aiming for economic and monetary union without the creation of new political institutions (apart from a new central bank), and who raise their hands in horror at the words ‘federal’ or ‘federalism’. This is the position currently adopted by the Government and by most of those who take part in the public discussion."

The Euro, the surrender of monetary sovereignty and the two lost decades (Part 2 of 3)

So much talk about the ailments that have left Europe lagging behind for more two decades now, when precisely the opposite was expect when the treaty of Maastricht was signed in 1992. The first decade of the Economic and Monetary Union (EMU) was marked by low growth and high unemployment; This was followed by another period of low growth but a slightly better unemployment outlook, which coincided with the introduction of the Euro. But it all came crashing down with the great recession (2007) and a new period of ultra-low economic growth and even higher unemployment seems to have become the norm in the third decade under the single currency.

Euro area countries started to surrender their monetary sovereignty in 1990 when following the presentation of the Delors report it was decided to start the first stage (out of three) of the monetary union that would culminate in 2002 with the physical introduction of Euro currency. A major step was taken in 1992 with the signature of the Maastricht Treaty (Treaty on European Union) that formally introduced the prohibition of the central banks "financing” the government as is made clear by article 104:

 "1.Overdraft facilities or any other type of credit facility with the ECB or with the central banks of the Member States (hereinafter referred to as “national central banks”) in favour of Community institutions or bodies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments."

 (Council Regulation (EC) No 3603/93 of 13 December 1993 that came into force at the same time as the Article 104 to clarify some definition above)

Monetary sovereignty was further severed with the establishment of the European and Monetary Institute, forerunner of the European Central Bank (ECB) and the process of surrender of monetary sovereignty would culminate with the introduction of the single currency- the Euro- and the conduit of a single monetary policy by the ECB. With the introduction of the Euro, the countries that adhered to it, surrendered completely their monetary sovereignty  by transferring the power of issuance of currency to a supranational authority, the ECB, but contrary to other monetary unions where a single currency was adopted,  Us or Swiss,  no Central (or Federal) Government was created, as such the Eurozone is a particular case of monetary union "one money, (too) many governments".

For the countries themselves it is as if they became users of a foreign currency, akin to a dollarization, but contrary to this, they gave up their own currency for good. This raises two types of problems: first, by surrendering their monetary sovereignty or the power to create money, they have become effectively non-sovereign states, similar to a local authority; second, by separating their fiscal and monetary authorities, they have given up their power to pursue policies to achieve full employment. The European nations effectively become non-sovereign nations. similar to US states, but with no Federal government to back them.

The implications of this particular arrangement must not have been completely understood at the time, at least by the countries that adhered to it, though others, namely the UK, Sweden and Denmark, if they didn't understand it back then they seem to get it quite well now, as they decided to stay out of the monetary union. But even today, when the flaws have been exposed, the implications of such a unique construction are not fully comprehended.  Wynne Godley, on the contrary, understood quite well the implications of having a monetary union with an independent Central Bank and no Central government when he wrote his article " Maastricht and all that" in 1992. In it, he starts by expressing the view that modern economies are not self-adjusting systems and as such they need some management:

 "I think that the central government of any sovereign state ought to be striving all the time to determine the optimum overall level of public provision, the correct overall burden of taxation, the correct allocation of total expenditures between competing requirements and the just distribution of the tax burden. It must also determine the extent to which any gap between expenditure and taxation is financed by making a draft on the central bank and how much it is financed by borrowing and on what terms. The way in which governments decide all these (and some other) issues, and the quality of leadership which they can deploy, will, in interaction with the decisions of individuals, corporations and foreigners, determine such things as interest rates, the exchange rate, the inflation rate, the growth rate and the unemployment rate."

However, precisely the opposite view, one that sees government intervention as the "source of all evil, had gained prominence following the "troubled" decade of the 80's and this vision was undoubtedly behind the construction of the European Monetary Union as Wynne Godley rightly observed:

"I am driven to the conclusion that such a view – that economies are self-righting organisms which never under any circumstances need management at all – did indeed determine the way in which the Maastricht Treaty was framed. It is a crude and extreme version of the view which for some time now has constituted Europe’s conventional wisdom (though not that of the US or Japan) that governments are unable, and therefore should not try, to achieve any of the traditional goals of economic policy, such as growth and full employment. All that can legitimately be done, according to this view, is to control the money supply and balance the budget."

This view is clearly expressed further in the single mandate of the ECB and the Maastricht Criteria that had to be met by the European countries that joined the Euro. While the Federal Reserve has a dual mandate: (1) maximum employment; and (2) stable prices; The ECB single mandate is to maintain price stability within the Eurozone, which at times might be at odds with more important economic goals, like reducing unemployment. However, it is mainly in the Maastricht criteria that this view was enunciated with the "sound" and "sustainable" public finances criteria that translate into the  prohibition of government deficits exceeding 3% of GDP and government debt exceed 60% of GDP.

If during periods of economic expansions the differences between sovereign and non-sovereign governments are not always evident, during periods of recession this are made clear. While the sovereign government can spend without regard of revenue, the non- sovereign government ability to spend is dependent on tax revenues and its ability to borrow, both of which tend to fall during recessions and increase during expansions as such leading non-sovereign governments to act pro-cyclically. i.e increasing spending during expansions and cutting during recessions as pointed out by Randall Wray:

Sovereign governments are able to deficit spend as necessary to climb out of recession and to restore full employment. Lack of will, not lack of financial where-with-al, is the constraint. Nonsovereign governments are constrained by revenues and ability to borrow, the latter of which is a function of market assessment of credit risk. They can provide a more favorable environment for private spenders (“structural adjustment”—including reduction of labor market “frictions” such as minimum wage laws) in the hope that this might increase nongovernmental demand, but they may not be able to increase demand directly as needed should this fail. Their own ability to spend will necessarily be pro-cyclically biased: not only does their tax revenue rise in good times, but market assessment of their credit-worthiness will also improve in expansion.

The outcome of this particular institutional arrangement is all too evident as it has resulted in two decades of low or ultra-low economic growth and high levels of unemployment. It all started with the establishment of the  the European Monetary System (EMS)  in 1979, whereby the countries of the European Economic Community (EEC) decided to link their currencies to avoid large fluctuations of the exchange rate. Even though no currency was officially designated as the anchor of the system, soon the Deutsche Mark would emerge as the reference and with it the Bundesbank as the principal Central Bank of the system. Given the anchor status of the Deutsche Mark only Germany was able to set monetary policy freely, with all the other countries having to follow its lead in order to keep the peg. The EMS was in part responsible for the severity of the early 90's recession in Europe, as this was certainly more severe there than in other developed countries, but it is the response to this crisis that started to set apart sovereign from non-sovereign nations.

Following Germany's reunification, inflationary pressures started to build up in Germany and this led the Bundesbank to hike interest rates from a low of 2.5% in the middle of 1998 to 6% at the end of 1989 and a further increase to 8.5% at the end of 1992. In the context of the reunification and the slowdown of the global economy, the interest rate hike by the Bundesbank seems an overreaction. The economy had grown more than 5% in 1990 and 1991 but the rest of the world was in recession or at least slowing down; as such, a slowdown should have been expected. Inflation running around 3%, hardly out of control. Even unemployment, that rose from 5% in 1990 to 5.5% in 1991, could hardly be said to be high when compared to most of its neighbours. The budget deficit running at 3% was remarkably low for a country that had taken on a poorer country.

Nevertheless, in order to keep the deficit under control in the face of the increased expenditure with the reunification, some fiscal consolidation had to be made. And so, as a paper by Jörg Bibow defends, the German government under the command of the Bundesbank embarked on fiscal consolidation in a pro-cyclical and inexplicably aggressive way, which was not only in conflict with economic theory but also with the best practices observed in other more successful countries. In addition, the Bundesbank imposed tight money of an exceptional length and degree, magnifying rather than compensating the depressive effects of fiscal policy.

The paper goes even further to challenge the assumed view that the relative underperformance of the German economy in the period that followed the reunification was a direct result of it, to advance that the poor performance was rather a result of the monetary and fiscal policies implemented by the German government and the Bundesbank in the period:

"This paper challenges the view that the marked deterioration in public finances since unification, and western Germany's exceptionally poor performance more generally, might be largely attributed to unification. Specifically, this paper challenges the view, implicit in the Bundesbank's above assessment, that the rise in public indebtedness reflects that the virtuous course of fiscal consolidation might have been adopted either belatedly or not firmly enough. Instead, it is argued here that ill-timed and inexplicably tight fiscal policies in conjunction with tight monetary policies of an exceptional length and degree caused the severe and protracted de-stabilization of western Germany in the first place. The key result is that Germany's dismal recent record must not be seen as a direct and apparently inevitable result of unification, but as the perfectly unnecessary consequence of stability-oriented macro policies conducted under the Bundesbank's dictate."

The result was a recession in 1993 and a rise in unemployment that would only start to decline in 1997. But the Bundesbank "fanaticism" had implications well beyond its borders, due to the anchor position of the Deutsche Mark in the European Exchange Rate Mechanism (ERM). While Germany was free to set its monetary policy and for that matter its fiscal policy, the other countries had limited control over their monetary policy as it was used mainly to control the exchange rate. This effectively prohibited the other participating countries to react by cutting interest rates to counter the deteriorating economic conditions.

Wynne Godley highlighted the need for cooperation at the height of the crisis:

"The political implications of this are becoming frightening. Yet the interdependence of the European economies is already so great that no individual country, with the theoretical exception of Germany, feels able to pursue expansionary policies on its own, because any country that did try to expand on its own would soon encounter a balance-of-payments constraint. The present situation is screaming aloud for co-ordinated reflation, but there exist neither the institutions nor an agreed framework of thought which will bring about this obviously desirable result."

Without coordination each country was to fend for itself and this was the main cause of the European Currency Crisis of 1992- 1993. The short lived experience of the UK in the ERM is illustrative of the problems with the mechanism. To counter inflation pressures in 1988 the UK started to increase its interest rate from a low of 8% in 1988 to a high of 14.8% in 1990 when it joined the European Exchange Rate Mechanism (ERM).  Initially rates fell steadily to 10% but on 16 September 1992 as the pound came under attack by speculators, the British government increased the rates to 12% and promised to raise them to 15% in order to maintain the exchange rate. But as speculators, chief among them George Soros, kept on selling the pound the government eventually decided to abandon the ERM and regain its monetary sovereignty again on what would later be known as the Black Wednesday.

By the end of the year interest rates had been set below 6% but more important the budget deficit was allowed to increase up to 7.5% of GDP in 1993 and it wasn't until 1997 that it went below 3%.  Not surprisingly, the economy started to rebound and in 1993 it grew at a rate of 3.5%. It would peak at an astonishing 5% in the next year and kept on growing above 2% until the Great Recession in 2008. Good news didn't stop there as unemployment peaked in 1993 and went all the way down to 5%, levels not seen since the 70's. By regaining it economic sovereignty, the UK unleashed one of the more extraordinary periods of growth, 16 years non-stop, accompanied by 15 years of decreasing or low unemployment. One can even speculate what would have happen if the government instead of having balanced budgets from 1998 to 2001 had embarked on a programme of infrastructure spending, probably the economic growth would have been higher and more balanced and the recent recession wouldn't have been so serious; But surely the UK could have first class infrastructure, a far cry from today’s crumbling and overcrowded roads, railways and airports . Anyway, no wonder that "Black Wednesday" is now dubbed "Bright Wednesday". Probably these golden years owe more to George Soros and a lot less to the supply-side economic reforms of the Thatcher years.

On the other side of the channel, on the other hand, things haven't looked bright for a long time. After the attack on the British Pound the speculators went after the Italian Lira, the Portuguese Escudo and the Spanish Peseta until eventually they pulled out of the ERM (lira) or devalued their currencies. Last but not least they went after the French Franc, but here the fight was different as the Banque de France had the help of the Bundesbank. Initially they were successful with the intervention in the forex market by buying Francs and selling Marks but this just bought some time as the French economic situation deteriorated further.

With the economy decelerating and unemployment rising, France needed to lower interest rates to stimulate the economy but precisely the opposite happened as France had to increase rates to defend the Franc (see spike in rates from 1992 to 1993 in the graph Interest Rates, discount rates above).  Between 1992 and 1993 rates were increased several times and remained above 10% until they eventually gave up defending the exchange rate which would then lead to the Brussels Compromise which relaxed the fluctuations band to 15%. After regaining part of its monetary sovereignty, France immediately cut its rates and by the end of the year they had fallen below 7%. Although the economy got out of recession to grow 2.2% in 1994 it decelerated in the following years to 2.0% and 1.1% as interest rates were increased in 1995 again.  On the unemployment side, however, the things never really rebounded.  After the small decrease in 1995 it started to increase again and it has never really recovered until today.

Contrary to the UK, France started to consolidate its budget before unemployment had started to fall. This happened because at the time a major change was taking place; The Maastricht treaty entered into force on 1 November 1993 and with it the Maastricht criteria, in particular the prohibition of government deficits exceeding 3% of GDP and government debt exceeding 60% of GDP. For France that in 1993 had a deficit of 6.2% of GDP, this meant that it had to start consolidating its budget in the middle of a recession with very high unemployment as such, effectively, "locking in" its unemployment rate. While it kept on reducing the deficit until it reached 1.7% in 1999 when the Euro was introduced, its unemployment rate kept on rising  until 1998. From 1998 to 2001 it decreased slightly but resumed its path after the introduction of the Euro.The same can be said for Italy, just add that the consolidation started even sooner and was more severe than in France, but this was compensated by a great decrease in interest rates.

No wonder then that unemployment in the main Euro Area economies was not only higher during the early 90's recession but remained significantly higher than the European Economies that decided to stay out of the monetary union until today.  United Kingdom and Denmark have opt-out clauses while Sweden has decided to stay out even though it has committed to join. Denmark, however, has decided to join the ERM II in 1999 and as such its currency is pegged to the Euro with a floating margin of 2.25% either way. While unemployment in Denmark and the UK went down steeply from 1993, when monetary sovereignty was regained,  in the Euro Area it continued to increase until 1994, where it stood more or less unchangeable until 1997. It started to come down then, albeit very slowly. The unemployment in Sweden, who was at the time dealing with the aftermath of its own banking crisis, took a little longer to start to fall but once it was under way the fall was abrupt. Most of all it seems that the golden age of global growth that started in the mid-to-late 1990s just passed by the Euro Area and there's nothing to show for it. It was supposed to have been a time of prosperity but it all ended up in disappointment. The Eternal Recession Mechanism seems to be a more appropriate label for the ERM.  High unemployment was the price to pay for the loss of sovereignty.

The IMF recognized that unemployment was particularly high in the Eurozone in a paper dated 1999 under the title of Chronic unemployment in the Euro area: causes and cures

"Despite some modest improvement since 1997, persistently high unemployment remains a major problem in Europe, especially among most of the economies that entered monetary union on January 1, 1999." But surprisingly (or not) they were not able to put two and two together as they defended  that unemployment was the result of labor market rigidities and a series of adverse shocks since the early 1970s- the denominated "dominant view": " The "dominant view" outlined above appears consistent with the observed developments. The secular rise of unemployment in Europe has been concentrated in periods of slow growth or recession when output and demand fell below potential. The failure of employment to increase symmetrically during the subsequent recoveries - in contrast to the experience of the United States- coincided with real wage increases picking up well before unemployment had returned to its previous trough"

This view has ushered more than a decade of useless papers and recommendations under the label of “structural reforms". However, in Japan, arguably one of the most rigid labour markets in the developed world, unemployment has been kept low despite the explosion of a massive asset price bubble in the early 90's and weak growth for more than two decades now. Japan responded by aggressively cutting the interest rates and steadily increasing its deficit as growth faltered.  From 1991 to 1996 rates were cut from 6% to less than 1% while budget deficit as percentage of GDP increased from less than 1% in 1992 to 8% in 2000 as unemployment increased.

Certainly Japan has had lacklustre growth since the burst of its bubble - the famous lost decade -  but surely other causes, chief among them population decline, have combined to bring about a very challenging situation. Nevertheless, Japan has fared better than other countries in the same situation; at least no one can blame the government for not acting decisively in supporting its economy. The Japanese Central Bank even went to the extreme of experimenting with unconventional monetary policies - quantitative easing- to stimulate the economy. Above all it has kept unemployment low, which by itself is extraordinary achievement in a time where high unemployed has become a new normal.