Depression in the Eurozone’s Periphery and how to restore Aggregate Demand without creating new bubbles: My reply to Kantoos Economics

Preamble: Kantoos Economics recently posted an article discussing points of agreement and points of disagreement between us regarding the restoration of growth in Greece, both in the short and in the long run. Here is my reply.

The problem with any Crisis is that it eliminates the type of scarcity which helps two crucial markets function properly (the market for labour and the market for money/capital) and replaces it with another kind of scarcity that causes these two markets to cease up: severe scarcity of aggregate demand. This is what happened in the 1930s in the USA and Europe. And it is happening today in countries like Greece and Spain with, however, a hideous twist. Can the depressed Eurozone Periphery be refloated, aggregate demand-wise, without new bubbles being formed? What would a New Deal for the Eurozone look like?

From aggregate demand scarcity to depression

Once in the clasps of demand scarcity, a macroeconomy enters a depression which means that wages reductions fuel unemployment and zero official interest rates do nothing to stimulate investment. If the government introduces austerity and helps employers bargain for lower wages, the result is a further reduction in aggregate demand and a boost to the recession. Still, the said macroeconomy may be lucky to escape a depression if one of the following two conditions is met:

(a) the external environment is buoyant, and thus the economy is helped along by increasing demand for its exports; and/or

(b) some bubble begins to grow (e.g. in the financial markets and real estate) that spearheads a boost in consumption which then pushes investment up which, in the end, restores demand.

A good example of (a) was Canada in the 1990s. As for (b), I can think of no better example than the so-called ‘anglosaxon model’; i.e. the manner in which, under the ideological cover of neoliberal nonsense, the UK and the US exited the 1979-1982 recession by means of cultivating massive bubbles in their real estate and financial markets.

Of course, not all drops in aggregate demand spell a depression. Rises and declines in aggregate demand are part and parcel of a normal business cycle. What is it that turns a normal recession into a depression? Historically, this happens when large bubbles have set in within the financial and real estate markets (these two always developing bubbles in unison), causing massive capital inflows in an economy, and then bursting at the height of the economic growth that they fuelled. With the bubbles gone, suddenly there is a vast debt overhang. In John Lanchester’s apt words, everyone owes to everyone and no one can pay. When, at that point, the government tries to rein in its burgeoining deficits via austerity, deleveraging dries up credit, businesses collapse, trust melts, unemployment explodes and a triple-crisis erupts (debt-deflation-banking failures) that brings the depression on.

Depression in the Eurozone’s Periphery: the cases of Greece, Spain etc.

In the case of the Eurozone’s depressed economies, there is another sad wrinkle to the picture above: unable to devalue their currencies, and bereft of a lender of last resort, countries like Greece and Spain are caught in an impossible death trap. With an ECB that ensures that no banks ever die, however sick they might get, a zombified, undead, network of disparate banking systems goes on ‘living’ without however having the capacity to perform its normal banking duties. Forced periodically to re-capitalise these zombie banks (since the ECB only offers them liquidity), the Eurozone’s stressed sovereigns find themselves tied to a sinking megalith. The more they try to resuscitate the banks, in order to give businesses a lifeline, the more they sink into insolvency; a fact that the money markets know (thus desisting from lending to these banks) and the local depositors fear (thus sending their money abroad). Thus, gradually, the circuits of credit die with the banks playing the sole role of funneling whatever capital is left in these god forsaken countries to the surplus countries. In a never ending circle of doom and destruction, the fact that the surplus countries are now experiencing unprecedentedly low interest rates (courtesy of the capital flight from the hapless deficit nations) reduces the incentives of the surplus countries’ politicians to act in order to help the depressed nations exit their death trap.

In this state of being, talking in conventional terms of aggregate demand is something between a tautology and a… luxury. Aggregate demand is the sum of G+I+(X-M), where G=government expenditure, I=investment, and X-M is net exports. For countries like Greece and Spain, troika conditionalities squeeze G into the ground and the collapse of the circuits of credit ensure that I is negative. The only tiny fillip comes from X-M, as imports (M) fall precipitously and firms that still produce something turn abroad for customers (thus pushing X up, as much as conditions abroad permit). In short, aggregate demand is on the floor in our countries, and digging a hole toward… China – as the troika is implementing its remit and the banks sink deeper into zombie-hood.

In short, Kantoos’ point that Greece, Spain et al are facing a dearth of aggregate demand is undoubtedly, almost tautologically, true. It is like saying that a terminal cancer patient is experiencing a mountain of pain. True but not particularly helpful, from an analytical point of view. The question is: What will it take to restore aggregate demand without rebuilding the bubbles that burst asunder, thus creating the problem in the first place.

The Modest Proposal

As Stuart Holland and I have been arguing for more than two years now, Europe’s task ought to be to restore aggregate demand without forming new bubbles of public and private debt. To effect this, Europe needs three things (for a detailed analysis of our proposal, click here):

1. Restore the circuits of credit

The bank run in deficit countries will not stop until and unless a euro in a Spanish bank account has, once again, the same present value as a euro in a Dutch or German bank account. For that to happen, the probability of a Eurozone breakup must be driven back down to zero, something that can no longer be achieved by means of brave declarations by Mrs Merkel or Mr Draghi: it requires a full integration of Eurozone banking systems into a single system to be supervised by the ECB and recapitalised/rationalised by the ESM-EBA.

2. Centralise part of the Eurozone debt

A currency union requires a common debt. Not only because this reduces the borrowing costs of countries like Spain and Italy, at a time when they are facing insolvency in the face, but because common debt acts as a buffer that prevents the evolution of a domino effect after a financial panic. Moreover, a common debt acts as a signal to markets that the Eurozone cannot be broken. Our proposal for ECB-bonds was intended to provide a simple method of creating this common debt without Treaty changes, without guarantees by Germany of other member-states’ debt, and without moral hazard concerns.

3. Convert idle savings into profitable investment

As intimated above, we do not want a new bubble to create the missing aggregate demand. Europe should not repeat the gross error of the Thatcher era, when the losses of aggregate demand due to crumbling industrial capacity and public sector cuts were replaced by huge aggregate demand generated from the twin bubbles of the City’s Bing Bang and the effervescence of the real estate sector. No, what Europe needs to do is to find a way of channelling the mountains of idle cash (both of the corporations that are stashing cash away and of the banks which, currently, prefer to park mountains of euros at the ECB at zero interest rates) into potentially profitably investments. Our suggestion of how to do this is to energise the European Investment Bank (EIB) in conjunction with the European Investment Fund (EIF), and with the ECB (which could issue ECB-bonds in conjunction with the EIB and EIF issued bonds) in a supporting role. And how would this help depressed economies like that of Greece and Spain? By ensuring that the aggregate flow of investments to these countries are proportional to the scarcity of aggregate demand in the various Eurozone member-states (while the distribution of these investments within a country, like e.g. Spain, is left to the EIB-EIF to decide along standard banking principles).


Certain Eurozone economies remain depressed and with a level of aggregate demand that is falling daily. Their depression increases the probability of a Eurozone breakup while the increases in the probability of a Eurozone breakup boost their depression. Something has to give. If Spain’s, Greece’s, Portugal’s depression is not addressed by policy makers, the Eurozone will simply shrivel and die. Alas, due to the Eurozone’s faulty underpinnings, the Periphery’s Depression cannot be addressed by standard macroeconomic aggregate demand management. Unless a euro is ‘forced’ to have the same value across the Eurozone, the Periphery’s Depression will get worse and the Eurozone will perish. Unless some debt mutualisation is effected, without asking German taxpayers to guarantee others’ debts, the Periphery’s Depression will conspire with the Euro Crisis to end the European Union. Lastly, the last thing Europe needs is another bubble to restore aggregate demand. No, we need to eradicate not only the Crisis’ symptoms but also its underlying causes (i.e. the imbalance in productive investments). In short, we need a cleverly designed New Deal for Europe, with the EIB at its forefront.

Appendix: Some comments on Kantoos Economics’ (KE) points

1. KE: “Channelling more aggregate demand towards Greece, however, is a difficult process. Banks need to be recapitalised… But equally important is that investors (and depositors) need to be convinced that Greece will stay in the euro. How do you go about that? Maybe by forcing Greek deposits back to Greece, as a sort of committment device? Legally challenging to say the least.”

Not just challenging but impossible within a liberal society and a single market. Also, unnecessary. Investors will only become convinced that the Eurozone will hold if banking sectors are unified. Pure and simple. (See Policy 1 of our Modest Proposal)

2. KE: “[T]he people of Greece need to send a strong and credible signal that their committment to the euro is final. European investment funds do not serve that purpose directly, just indirectly by making the situation less bad. I think this aspect is under-appreciated, but important.”

The people of Greece never fail to send such a signal. In the last election the top three parties (including Syriza) made an unequivocal commitment to staying in the Eurozone. Moreover, opinion polls show more than 80% support for staying in the Eurozone. Thus, the Greeks’ commitment to the Eurozone was never in question. It was Mrs Merkel who suggested that any Greek dissent on the terms and conditions of the bailout would be translated to a Greek No to the Eurozone. Can you imagine what would have happened if the Irish or French No to the Lisbon Treaty was interpreted by Berlin as a No to the EU? What right does one have to say that a European people’s objection to a particular Treaty or agreement equates with a rejection of Europe or of the Eurozone? No, I repeat, the problem is not a lack of commitment by Greek to the Eurozone. The problem, rather, is the lack of a European plan that makes the Eurozone sustainable.

4. Regarding our EIB-EIF administered New Deal for Europe proposal (see Policy 3 of the Modest Proposal), KE says: “[T]he EIB bonds should, according to Yanis, be serviced by the country that benefits from the investment. How should Greece do that? And what happens, if the benefiting country doesn’t or can’t service them?”

This is precisely NOT what we propose. We, instead, propose that the EIB-EIF fund directly profitable projects in Greece and elsewhere. Who repays the EIB-EIF bonds that are issued to carry out these investments? The investment projects themselves. Not Greece, Spain, the UK etc. E.g. suppose that the EIB funds a fast railway line from Patras to Munich, thus linking the fast train network of Western Europe with South Eastern Europe (a much needed infra-structural project which will, by the bye, benefit German and French companies enormously). Our proposal is that the EIB funds this without involving the Greek. Slovenian or Austrian states. That it funds it as a private investment bank on pure banking principles, by issuing EIB-bonds as it has been doing for 20 years now (and with the possible backing of a net issue of ECB-bonds). The only involvement of states that is necessary concerns the licensing of the project and the expropriation of the land. And how are these bonds to be repaid? By the revenues of the railway that go directly into EIB-ECB escrow accounts. It is up to the EIB-EIF (perhaps in collaboration with the ECB) to pick and choose projects that have a high expected return.

5. KE: “Investment is a risky business, and someone needs to be willing to take it on.”

Sure. The EIB has been doing this for decades. And has a sterling record of turning a profit from them. All Europe needs do is harness its capacity for profitable investments and unshackle it from the requirement of co-funding from insolvent sovereigns.

6. KE: “Yanis’ ECB bonds do not circumvent this problem. This is (in expectation!) a transfer if it is done below reasonable rates that take the risk appropriately into account (note: I did not say market rates). It is fine to argue that Germany needs to bear some of that risk, and I agree. But let’s be honest about those risks first.”

OK, let’s (be honest about the risks)! I submit that, under our ECB-bonds proposal, Germany will bear very much less risk (if any) than it will under the ill-designed ESM.

7. KE: I think we should not put too much faith into political institutions to manage these investments well. I don’t think the track record of similar efforts in East Germany is encouraging in that respect, or European structural funds in Greece or Spain for that matter. Projects like the common agricultural policy (CAP) are another European example of wasted taxpayer money, which to this day remains largely uncontested, despite the crisis.”

I agree. East Germany is a good example of what we need to avoid. Similarly the Brussel’s administered structural funds. This is why we are proposing the EIB as the pillar of EU investment policies. Not Brussels! As for the CAP, its purpose, from the beginning, was not to effect efficiency or justice but to ‘buy’ the support of Franco-German farmers for the customs union that would cause them problems while bestowing huge benefits to heavy industry. It was never more than a permanent side payment from oligopolistic industrial capital to landed rentiers.

8. KE: “The EIB may have an excellent track record so far (any evidence for that?), but in part because it could conduct its business unmolested by European politics.”

Quite so. So, let’s keep the EIB a politics-free zone. But let’s also unshackle it from a silly political constraint that stops it from delivering to Europe many potential benefits.

9. KE: The silly over-investment before the crisis… should also make Yanis cautious: yes, we have an aggregate demand problem (aka under-investment problem) … but we need to make sure that any European investment fund is smart, and unmolested by the domestic forces that in part brought Greece to the point where it is now.”

Could not agree more. In the terms of my preferred narrative we do not need another series of bubbles. What we need is to eradicate the causes of Eurozone disintegration and to shift idle savings into profitable, real, investment.

10. KE: “Exports are another way to direct AD towards Greece. How did countries in Asia manage to become such successful exporters?”

Greece must improve its export performance. This is indubitably true. But it won’t do so before (a) profitable, export-oriented Greek companies regain access to credit, and (b) investment into such companies re-starts. The three policies of the Modest Proposal are a prerequisite for both (a) and (b). All three? Yes. Consider Spain, for instance. Its export potential is excellent. Yet, without a functioning credit system and while state and banks are in a deadly embrace, export potential does not help restore aggregate demand.

11. KE writes that long term growth requires “…an efficient public sector, sensible regulation, occasionally even industrial policies like export zones. It requires local knowledge, local initiatives, and local policies that focus on growth. Outside investment funds can help, but as long as Greece ranks 155th in protecting investors out of 183 countries, 90th in enforcing contracts, and is last according to the overall business index in the OECD, I have no idea how long-run growth can take hold with EIB investment alone.”

It can’t. Until and unless the Greek state reforms itself and investors feel that there are simple, sensible, functioning rules, long term growth will not pick up. But let me make one thing clear: The belief (that is prominent in some German circles) that further austerity will ‘force’ Greeks (and their state) to adopt such important reforms is patently erroneous. Just like Yeltsin gave democracy a bad name in Russia in the early 1990s (allowing Putin later to trample important democratic rights in view of a lack of public support for defending these rights), the word ‘reform’ is now being associated in Greece with misery, loss of hope, indignity. The more the depression continues, and the deeper it goes, the less reformable Greece becomes. Spain is about to go the same way. And Italy.