MMT, The Euro and The Greatest Prediction of the Last 20 Years

By L. Randall Wray

Lest you think NEP is tooting its own hyperbolic horn a bit too much, I borrowed the title of this post from a 2011 piece written by someone who is currently hostile to MMT even though he acknowledges its predictive accuracy.

(I’ll send 5 Buckaroos to the first person who can identify the author! Sorry, UMKC students are not eligible—they have to work an hour for each Buckaroo to pay their taxes.)

The author of that original piece went on to provide some proof for the case he was trying to make.

Being right matters.  This isn’t emphasized quite enough in the finance world and in economics in general.  Too often, bad theory has led to bad predictions which has helped contribute to bad policy.  While MMT remains a heterodox economic school that has been largely shunned by mainstream economists, the modern proponents have an awfully good track record in predicting highly complex economic events… In the last few years, the Euro crisis has proven a remarkably complex and persistent event.  And no school of thought so succinctly predicted the precise cause and effect, as the MMT school did.  These predictions were not vague or general in any manner.  In reading the research from MMTers at the time of the Euro’s inception, their predictions are almost eerily prescient.  They broke down an entire monetary system and described exactly why its construction would lead to financial crisis if the union did not evolve.

You see, he tooted the NEP horn for us. As evidence he selected some juicy quotes:

In his must read book “Understanding Modern Money” Randall Wray described (in 1998) the same dynamic that led to the crisis in the EMU: ‘Under the EMU, monetary policy is supposed to be divorced from fiscal policy, with a great degree of monetary policy independence in order to focus on the primary objective of price stability.  Fiscal policy, in turn will be tightly constrained by criteria which dictate maximum deficit to GDP and debt to deficit ratios.  Most importantly, as Goodhart recognizes, this will be the world’s first modern experiment on a wide scale that would attempt to break the link between a government and its currency. …As currently designed, the EMU will have a central bank (the ECB) but it will not have any fiscal branch.  This would be much like a US which operated with a Fed, but with only individual state treasuries.  It will be as if each EMU member country were to attempt to operate fiscal policy in a foreign currency; deficit spending will require borrowing in that foreign currency according to the dictates of private markets.’

In 2002, Stephanie Kelton (then Stephanie Bell) was even more specific in describing the funding crisis that would inevitably ensue in the region: ‘Countries that wish to compete for benchmark status, or to improve the terms on which they borrow, will have an incentive to reduce fiscal deficits or strive for budget surpluses. In countries where this becomes the overriding policy objective, we should not be surprised to find relatively little attention paid to the stabilization of output and employment. In contrast, countries that attempt to eschew the principles of “sound” finance may find that they are unable to run large, counter-cyclical deficits, as lenders refuse to provide sufficient credit on desirable terms. Until something is done to enable member states to avert these financial constraints (e.g. political union and the establishment of a federal (EU) budget or the establishment of a new lending institution, designed to aid member states in pursuing a broad set of policy objectives), the prospects for stabilization in the Eurozone appear grim.’” (emphasis in the original blog)

In 2001 Warren Mosler described the liquidity crisis that the Euro would lead to: ‘Water freezes at 0 degrees C.  But very still water can be cooled well below that and stay liquid until a catalyst, such as a sudden breeze, causes it to instantly solidify.  Likewise, the conditions for a national liquidity crisis that will shut down the euro-12’s monetary system are firmly in place.  All that is required is an economic slowdown that threatens either tax revenues or the capital of the banking system… A prosperous financial future belongs to those who respect the dynamics and are prepared for the day of reckoning.  History and logic dictate that the credit sensitive euro-12 national governments and banking system will be tested.  The market’s arrows will inflict an initially narrow liquidity crisis, which will immediately infect and rapidly arrest the entire euro payments system.  Only the inevitable, currently prohibited, direct intervention of the ECB will be capable of performing the resurrection, and from the ashes of that fallen flaming star an immortal sovereign currency will no doubt emerge.’

Wow. Pretty much hit that nail on the head. For completeness let me add a few more comments. MMT got its start as “Soft Currency Economics”, the title of Warren Mosler’s 1995 monograph, and what could be called the first Modern Money conference was held at Bretton Woods in 1996, sponsored and organized by Warren with assistance from Pavlina Tcherneva (who was Mat Forstater’s undergrad at the time).

Shortly thereafter we created the Center for Full Employment and Price Stability headquartered at the Levy Economics Institute and funded by Warren. I had already started writing Understanding Modern Money (in 1995 as I recall) but was finishing it up at Levy in 1997 and circulating it among Warren, Mat Forstater, Stephanie Kelton (then Bell), Pavlina Tcherneva, and Wynne Godley (among others) for discussion (Scott Fullwiler soon also got a copy of the draft). To be sure, my book mostly concerned a sovereign currency-issuing government but at the time we were of course aware of the soon-to-be-launched Euro experiment.  The first paper devoted to the problems with the Euro that we read was by Charles Goodhart (who was at that first meeting at Bretton Woods); we read a draft in 1996 (“The Two Concepts of Money and the Future of Europe”) and a version was published in 1997 (“One Government, One Money” appeared in The Prospect in March 1997).

At Levy we discussed these problems and Wynne wrote an excellent editorial, in 1997 after we had all settled at Levy: “Curried Emu: the meal that fails to nourish”. (Interesting tidbit: the author whose title I stole for this essay quotes Wynne’s article but inaccurately dates it as 1992. A footnote then says the date was “corrected” to 1992. But the actual date was 1997 so presumably the author “corrected” the correct date to an incorrect prior date. To be sure, Wynne did write an amazingly prescient piece in 1992, titled “Maastricht and All That“. However, the 1992 criticism of the Euro project is not as specific as the argument Wynne made in the quote from the 1997 article. That is not surprising since the details were not well-understood about a project that would not launch until the end of the decade. Why the author has got the dates all mixed up is unknown.)

Here’s another great quote, from Mat Forstater, written in 1998 and published a year later:

Under the EMU, if investors are at all hesitant about any one member’s debt, they can buy another member’s debt without incurring currency risk, since there is no exchange rate variability among the currencies of member countries. Because member nations are now dependent on investors for funding their expenditure, failure to attract investors results in an inability to spend. Furthermore, should a member’s revenues fail to keep pace with expenditures due to an economic slowdown, investors will likely demand a budget that is balanced, most likely through spending cuts. In other words, market forces can demand pro-cyclical fiscal policy during a recession, compounding recessionary influences…. Even if there were no imposed limits on countries’ deficits and national debts, the structure of the EMU makes it nearly impossible for a country to enact a counter-cyclical fiscal policy even if there were the political will. This is because, by giving up their national monetary sovereignty, countries are no longer able to conduct coordinated fiscal and monetary policy, essential for a comprehensive and effective remedy to periodic demand crises. Why would countries voluntarily sacrifice the ability to conduct a coordinated macroeconomic policy, especially at a time when official unemployment rates are in double digits and there are clear deflationary pressures?

This is from a symposium Mat organized in 1998 (published in 1999 in the Eastern Economic Journal) that included a paper by Jan Kregel and a co-authored paper by Goodhart. Warren then organized a London conference in 1998 and Bard College published a collection of papers to coincide with the “launch” of the Euro. Here are a couple of quotes from that 1999 book (The Launching of the Euro, Proceedings of “A Conference on the European Economic and Monetary Union,” Annandale-on-Hudson, N.Y.: The Bard Center, 1999). First, from Warren:

…market forces can demand procyclical fiscal policy during a recession.  Without a higher fiscal authority such as the European Central Bank standing by with counter-cyclical capability and not subject to investor preferences, a severe downward spiral can result, with member nation insolvency at least a technical possibility. At that point, and probably much sooner, I’m certain that the ECB would step out of its Maastricht constraints and take action…. The question today is, if France wants to bail out Credit Lyonnais, or if Italy decides to run a higher budget up, it can’t just do it by decree. You actually have to go out and have investors buy your debts and fund them.

Here’s Jan Kregel from the same book:

Germany appears to have adopted a policy of controlling the growth of nominal wages at a rate that is below its domestic productivity growth. German unit labor costs have been falling …. If Germany does in fact manage, as it seems to have been doing for about two years, to continue to decrease its unit labor costs at 5 percent — that is, at rates that are substantially below those in the other European countries, with no longer a possibility, as has been the case in the past, for the deutschemark to revalue relative to the other currencies — this means that if I am a manufacturer or a government in a non-German European country, I am going to experience declining profit margins until I also manage to compress my unit labor costs. Therefore, if there is a risk associated with the EMU’s introduction of a single currency under conditions in which Germany is practicing a policy based on a belief that in absolute terms their wage costs are too high relative to Asia and the United States — not internally, relative to Europe — there will be very strong deflationary pressures on wages in the other European countries, which will produce a risk that is, I would say, now roughly balanced between zero inflation and outright deflation.

Well, that is precisely what Germany did for the next half dozen years—helping to fuel current account deficits on the periphery. And, finally, here’s how Warren concluded the book:

We happen to think that there should be a contingency plan for the ECB should a crisis happen. . . should a crisis occur, we’ll have this little book on the shelf with which to come up with some ideas. Meanwhile, I’m not going to buy any German, French, Italian or Spanish bonds with your money…

It is now no secret that the EMU had no contingency plan, so for the past 5 years has been making up responses as it goes along—always too little, too late, and too ill-informed to resolve the problems created by delinking nations from their currencies.

Finally, Stephanie and Ed Nell teamed up to publish a series of scholarly papers all focused around a 1998 paper by Goodhart that continued his Chartalist critique of the Euro project in his paper titled “The Two Concepts of Money: Implications for the Analysis of Optimal Currency Areas”.  You can still obtain a copy of the Bell/Nell edited volume here. And if that is not yet enough evidence, take a look at Stephanie’s paper from 2002 that correctly foresaw problems with credit default risk.

In order to judge how correct MMT was in its predictions, of course, we have to understand what went wrong in the Eurozone. Our argument was that separating fiscal policy from currency sovereignty would raise questions of solvency that would constrain ability of fiscal policy to expand when necessary. That was the basis of all these arguments: Godley, Goodhart, Bell/Kelton, Forstater, and Wray. But there was an additional angle: how would the crisis begin? Would it be a recession that no individual government could resolve by fiscal stimulus? Would it be chronic current account deficits of some member states (to the benefit of Mercantilists like Germany or the Netherlands)? Or would it be a financial crisis? Well, how about a Trifecta: all three at once?

I think all readers of NEP understand the problems raised by recession—so there is no need to go into that one in detail. As individual nations faced a downturn, their budgets would move sharply to deficits that would rise further above Maastricht criteria; markets would react with higher interest rates that would in turn raise deficits further in a vicious cycle. OK, that happened. And then, of course, we also found out that (Surprise! Surprise!) governments had already been manipulating accounting so their deficits had always been higher than supposed.

NEP readers are also familiar with the current account story—easily understood through the lens of Godley’s sectoral balance approach. The best work in this area has been done by Eric Tymoigne, Daniel Negreiros Conceição, Scott Fullwiler, and especially Rob Parenteau (who has enriched a model introduced by Paul Krugman). I won’t expand on that right now—but a current account deficit must be offset by a combination of a domestic private sector deficit and/or a government deficit. Since these are not sovereign currency issuing governments, private and government deficits can both lead to problems. (To be clear, it is much more than a current account problem, as Rob shows. Any EMU nation can be blown up by its banks even while running a current account surplus. This is the “financialization” or “Money Manager Capitalism” story—probably more than 90% of cross-border finance has nothing to do with the current account, and it was that part of finance that blew up countries like Ireland and Spain. I’ll explain that elsewhere in a response to an entirely confused and specious anti-MMT diatribe by Sergio Cessarato.)

Finally there was the financial crisis angle. So far as I know, Warren Mosler was the first to fully understand this. He was harping on it for as long as I can remember—long before the 2001 article quoted above.

(I have recently become aware of a 1998 paper by P.M. Garber (1998. “Notes on the Role of TARGET in a Stage III Crisis.” Working Paper 6619, Cambridge, Mass.: National Bureau of Economic Research. June.) that explicated the problems created by the clearing mechanism. I covered that over in my GLF blog two weeks ago. A troll responded that MMT had never before paid any attention to the EMU, and (wrongly) cited the “1992” article by Godley as evidence that we simply stole the idea from him.)

But Warren had long argued that a very likely path to crisis would come from a bank failure. With no equivalent to Washington to come to the rescue, each individual nation would have to bail out its own banks. That would add to government debt, cause interest rates to spike, and lead to a run out of banks that could not be stopped. Except by the center—the ECB—which was not supposed to do anything of the sort.

Hello!?! That’s where we are, folks.

Judge for yourselves. Greatest prediction of the past 20 years? Probably not. But certainly our understanding of how “modern money” works helped us to see the underlying problems. Our main claim is now commonplace—almost no commentator now fails to refer to the problems created by separating fiscal policy from the currency. When we wrote this back in 1997-99 at the launch of the misguided experiment, we were ridiculed as fringe nay-sayers. We’re still ridiculed as fringe, of course, even though our main argument is now as mainstream as it can get.

Here are just a few of the mainstream predictions about the Euro also from that little 1999 book, The Launching of the Euro. We knew they were wrong at the time; they are hilarious in retrospect. One wonders where these people are now? Do rotten predictions by mainstreamers ever get punished, or are all their pronouncements—no matter how silly—always one way bets to success?

Let me come to grips with the problem of a debt crisis. A debt crisis may happen, but the EMU does not make it more likely to occur than before. I am even inclined to think that the EMU makes a debt crisis less likely.(Cesar Molinas, First Vice President and Head of European Fixed Income and Research, Merrill Lynch)

What if there is an unusually strong downturn? In that case, the stability pact allows deficits above 3 percent. So there is an escape clause in the stability pact….In such a case, I think spreads would probably widen…However, I think the main market impact probably is an under performance of EMU-bloc governments as a whole, rather than a dramatic intra-EMU spread widening. (Gunther Thurman, Managing Director, Salomon Smith Barney)

Certainly, among most of the major countries in Euroland, there is a very great similarity of economic structures, and the economic cycles are in most cases remarkably coexistent. This suggests that one size fits all. It won’t create a serious problem as has sometimes been suggested.  (Norman Williams, European Economist, Barclays Capital)

It is not that the whole fiscal picture in Europe is going to collapse.  We can “short” something and “long” something and have lots of up-and-down movements. What’s going to go wrong is indeed that nothing is going to go wrong from our point of view.  (Jan Loeys, Managing Director, JPMorgan)

Nothing wrong, indeed! 

4 responses to “MMT, The Euro and The Greatest Prediction of the Last 20 Years

  1. Permit me to offer the following:

    “5.3 Will capital still be able to veto policy?

    …First, financial capital may still be able to discipline governments through the bond market. Thus, if financial capital dislikes the stance of national fiscal policy, there could be a sell-off of government bonds and a shift into bonds of other countries. This would drive up the cost of government borrowing, thereby putting a break on fiscal policy (Palley, 1997, p.155-156).”

    Palley, T.I., “European Monetary Union: An Old Keynesian Guide to the Issues,” Banco Nazionale del Lavoro Quarterly Review, vol. L, no. 201 (June 1997), 147-164.


    The above quote from my 1997 paper shows two things:

    (1) MMT’ers were not the first to predict the structural flaw in the euro’s design regarding possibilities for conduct of fiscal policy.

    (2) Old Keynesians fully understood that if you remove the national central bank, national government is reduced to the status of a province and may be unable to run deficit based fiscal policy if bond markets refuse to finance it.

  3. Pingback: Renzi dalla Merkel non mi pare il nuovo che avanza | Carlo Costantini