European economic policies, stock-flow relations and the great double crisis.

• Author: Valli, Vittorio
• Position: Report

1. Introduction

   In this paper we will try to show how stock-flow relations can badly influence a great economic depression as the one that struck the United States and Europe since 2007-8. Several countries, both in North America and in Europe, had a double crisis, financial and real. Some of them, as the United States, Germany and the United Kingdom, could begin the recovery after a couple of years. Other Eurozone countries, which had in 2007-8 some severe structural problems, as a chronic weakness in the balance of payments and a great net external debt; a structural housing bubble or a very high public debt/GDP ratio, had a much deeper and longer depression. These countries will be here named financially vulnerable countries. Changes in stock concepts as wealth or debt, and their feed-backs with flow concepts, as investment, consumption and GDP, had a great impact on the difficulties encountered by these countries to cope with the crisis. The economic policies adopted proved to be very weak and in several cases they badly backfired. Moreover, the idea that the same kind of medicine (austerity policies), could be applied to patients with very different diseases, has proved to be disastrous. In the last section we try to outline some elements for alternative economic policies.

2. Four original sins

   There are four original sins in EU's institutions and policies that have heavily affected the depth and duration of the double crisis, the 2008-2015 financial and real crises.

1. The executive power in the EU is mainly given to the councils of prime ministers and of treasury ministers, with the support of the Commission. So, national interests are usually prevailing and all controversial economic decisions require months or years of difficult compromises. The measures are often tardive and ineffective while a financial crisis would need very rapid and vigorous actions. Moreover, since during the crises the financially stronger countries get more power, if nationalism prevails, a solidarity approach is usually banned.

2. There is no treasury or economics minister In the European Union (EU) and the EU's budget is only about 1% of EU's total GDP. So, the budget of the European Union is completely insufficient to make effective anti-cyclical and development policies. It ought to be at least around 10% (1). Moreover, the euro was created without any kind of protective devices. In 2007-8 there were no EU institutions devoted to face major financial crises and the statute of the European Central Bank (ECB) makes it extremely difficult to pursue effective monetary expansionary policies (2). For example, quantitative easing policies have been introduced in the Eurozone about six years later than in the United States, after a tough confrontation with the Bundesbank, and it was possible, with several constraints, only in the presence of a very dangerous deflation.

3. The EU political leaders and their main economic advisers are often inspired by the monetarist--neoclassic--anti-keynesian approach prevailing in the last four decades in most Western countries.

4. As a consequence, in the 1990s there was the adoption of "Maastricht parameters" including the Public deficit/GDP ratio and the Public debt/GDP ratios (3), and years later the "Stability Pact" and then the "fiscal compact". All this, in cases of severe and prolonged crises, can lead to harsh restrictive fiscal measures and disastrous and fully anti-keynesian "austerity policies", as it happened in the 2008-2015 years.

   Even IMF's chief economist Oliver Blanchard had to admit that the there was an under-estimation of fiscal multipliers, i. e the impact of fiscal austerity measures on economies during a severe and prolonged depression (4). Paul De Grauwe in various contributions has also criticized the imposition of "violent austerity fiscal policies to Southern European countries", while they ".. .should be spread on a longer time" (5) and should be accompanied by a reduction in the surplus in current accounts of Germany and other North European countries and an expansion of their public deficits; by an active expansionary monetary policy of the European Central bank, and, finally, by a banking union and a budgetary union.

3. The relations between stocks and flows and the double crisis

   In order to better understand why the 2008-2015 great financial crisis had such severe consequences on real economies and on public finance in the United States and in most European countries, it is essential to study the relationships between stock concepts, as wealth and debt, and flow concepts, as GDP, consumption and investment.

   From the analytical point of view, both main-stream and critical economists have heavily overlooked the importance of the relations between stocks andflows, which consist in a complex series of dynamic feedbacks.

   The analyses of most economists have been principally based on flow-variables (6). However, the size of stock variables, such as wealth, accumulated in a number of years, are much larger than the one of flow variables, such as income.

   As table 1 shows, in 2006 net national wealth was, for example, in Spain 8.6 times the net national income, in Japan 6.2 times, while in in the US, Greece and Germany the ratios were respectively 5.4, 5.2 and 3.8. As a consequence, an abrupt and substantial fall in the values of wealth, as it happened in the US, Spain and Greece since 2007 and in most other countries since 2008 or 2009, did swiftly determine catastrophic falls in income, investment, consumption and GDP.

   We give here some examples of the importance of the values of stocks in determining the passage from financial to real crises and then to public debt crises.

   These relations can contribute to a better comprehension of the great world crisis of the 2008-2015 period.

   Since 2007-2008 there has been ten vicious circles (7), at first occurring in the U.S. and then rapidly spreading to most other industrialized countries.

   The first three negative feedbacks are mainly associated to the sub-prime crisis and the consequent financial crisis begun in the United States and then spread to European countries, while the other ones have been also widely influenced by EU austerity policies and government's responses to the outbreak of structural bubbles and to worsening economic conditions.

1. a negative wealth effect: a sharp fall in the prices of housing leads to a severe financial crisis and then to a fall in the price of shares. There is thus a fall in private total wealth (both real wealth and financial wealth) and consequently a reduction in consumption, investment and aggregate demand. All this leads to a fall in GDP and income. Soon there will be a new reduction in wealth due the weaker demand for housing and financial assets, a further fall in consumption, etc.

2. a collaterals effect: the initial reduction in wealth leads to a fall in the value of collaterals (housing subject to mortgages, or shares) and consequently to a fall in the volume of loans conceded by banks. There are thus a fall in investment, possible failures of weaker enterprises, a sharp rise in nonperforming loans. and crises of several banks. All this leads to a reduction in GDP and income, further reduction in wealth, etc.

3. a financial effect: a fall in the prices of housing leads to a severe reduction in the values of toxic assets incorporating sub-prime loans, thereby to the crisis of several financial institutions and to the failure of some banks, if not rescued by the governments. In general, there follows a crisis in the confidence in most banks and in the inter-bank liquidity market, thus a liquidity crunch and a sharp fall in the stock exchange index. There is also a strict rationing of banks' loans to firms and thus a fall in real investment. All this leads to a decrease in GDP and income, further reductions in the value of real and financial wealth, etc. All this was greatly amplified by the "ex-post unnecessary" bankruptcy of Lehman brothers in 2008 and by the failure of a few European banks, like Northern Rock.

4. the total wage effect. In the United States and in several other countries there was, before the crisis, the deliberate policy of pumping up consumption and the building sector in a period of real wage restraint. This led to over-indebtedness of households and of some firms and to the fuelling of structural bubbles in housing and the stock exchange market. When, in 2007-8, there was the outbreak of the crisis, there was in most country a heavy fall in wealth, and then in real GDP, consumption and investment, and this determined a stagnation in real unit wages and, with a certain delay, a sharp reduction in employment. All this led to a fall in total real wages, a further...