A SIMPLE MODEL OF THREE ECONOMIES WITH TWO CURRENCIES: THE “EUROZONE” AND “THE USA” W. Godley & M. Lavoie

1. A SIMPLE MODEL OF THREE ECONOMIES WITH TWO CURRENCIES:THE “EUROZONE” AND “THE USA”W. Godley & M. Lavoie

2. Goals of the model • An exemplar of the stock-flow consistency method, as prescribed by Wynne Godley • To illustrate the evolution of a world economy, Euroland and the USA, describing the whole complex of financial flows, including interest payments, starting from a stationary equilibrium, following an increase in the propensity to import of one of the Euroland countries.

3. A complex, but still elementary model • The simplifying assumptions are enormous. • There is no domestic or foreign investment in fixed or working capital • No holdings of financial assets by firms; • No wage inflation • No commercial banking • No “hot money”. • The treatment of expectations is elementary. Yet the model contains nearly 80 equations!

4. A three-country model … • The euro zone is in a flexible exchange rate regime with the USA (the Rest of the world) • The Federal Reserve holds no foreign reserves • The ECB is the central bank of both European countries, each with its own government, but with a unique currency, the euro • Households hold foreign securities but hold cash only in their own currency • Imports depend on foreign income and on the exchange rate

5. Main endogenous variables of the main closure of the model • In all three countries: • GDP, disposable income, taxes, sales, consumption • Capital gains, household wealth and its allocation between cash and securities • Central bank assets and liabilities • Exports, imports, and hence, the trade account, the current account and the capital account

6. Main exogenous variables of the main closure • In all three countries: • Pure government expenditures (excluding debt servicing) • The tax rate • The interest rates set by central banks • Propensities to consume and the parameters of portfolio behaviour • Import elasticities

7. Main results of the main closure • The twin deficit principle (which occurs in a stationary or semi-stationary state in the two-country case) does not hold anymore for individual countries of the eurozone. • Flexible exchange rates do not bring back anymore the current account towards equilibrium (zero). • Interest rates can remain constant, but the ECB must accept a transformation of the composition of its assets (it will hold more assets issued by the deficit eurozone country). • Eurozone countries cannot all converge towards balanced or surplus budget positions, unless deficit countries decide to self-impose fiscal austerity measures (or unless surplus countries decide to give up fiscal austerity).

8. Notations • # represents Germany in the eurozone • & represents Italy or Greece in the eurozone • $ represents the USA

9. USA Balance sheet The net worth of the Fed is zero (all profits are distributed to government). Assets with plus (+) sign, liabilities with a minus (-) sign.

10. Eurozone balance sheet The BCE net worth could be positive because of capital gains or losses on foreign exchange reserves. We are cheating: ECB cannot buy T-bills directly.

11. The transactions flow matrix • Too big to be shown ! • The matrix includes standard NIPA but also flows of funds

12. Behavioural equations • Standard Keynesian equations wrt to: • Consumption equations • Import equations (and hence exports) • Tobin portfolio equations • Production supply responds to demand • Taxation • Central banks set interest rates and the supply of cash money is endogenous

13. An experiment using the main closure • Starting from a full stationary state (constant wealth, balanced budget, balanced current account) we impose an increase in the propensity of the & country (Italy, Greece) to import goods from the $ country (the USA).

14. Figure1.1: Effect on the domestic product of each country of an increase in the propensity of the ‘&’ (Greece) country to import products from the ‘$’ country (main closure).

15. Figure 1.2: The euro (measured in dollars) depreciates, following the increase in the propensity of the & country (Greece, Italy) to import goods from the $ country (USA)

16. Figure 1.3: Effect on various balances of an increase in the propensity of the ‘&’ country to import products from the ‘$’ country (main closure).

17. Figure 1.4: Evolution of the assets and liabilities of the European Central Bank following an increase in the propensity of the ‘&’ country to import products from the ‘$’ country (main closure, with rates of interest remaining constant in both countries

18. Figure 1.5: Relative evolution of the debt to GDP ratios, in a world where pure government expenditures grow at an exogenous rate

19. Variant 2: • The interest rate of country & (Italy, Greece) becomes endogenous. • To get this variant, a series of equations must be inverted. • Here it must be supposed that the ECB refuses to purchase additional Italian or Greek Treasury bills, (BECB&d is a constant). As a result, the interest rate on Italian or Greek bills or bonds becomes endogenous, to clear the financial markets.

20. Figure 2.1: Effect of an increase in the propensity of country & (Italy) to import goods from the USA ($), when the interest rate & on Italian or Greek securities is endogenous.

21. Figure 2.2: Effect of an increase in the propensity of country & (Italy, Greece) to import goods from the USA ($), when the interest rate & on Italian or Greek securities is endogenous.

22. Variant 2: The adjustment through interest rates leads to instability. • The adjustment through interest rates brings the asset market to equilibrium for a single period. A continuous readjustment is needed, pushing up the interest rate for countries with a deficit current account. • The model explodes.

23. Variant 3: Alternative closure: endogenous government expenditures by deficit country • If the ECB does not want to take on more assets issued by the deficit country (Italy, Greece), or if the deficit country does not want to let its debt to GDP ratio drift upwards, then the deficit country may decide to impose fiscal austerity, having endogenously falling government expenditures. • The Italian government then acts as if it were facing a loanable funds constraint: the supply of bills must adapt to the demand for bills by households.

24. Figure 3.1: Effect on GDP of an increase in the propensity of the ‘&’ country to import products from the ‘$’ country, when government expenditures of deficit country are endogenous

25. Figure3.2: Effect on current account balances of an increase in the propensity of the ‘&’ country to import products from the ‘$’ country, when government expenditures of deficit country are endogenous

26. Figure3.3: Effect on debt/GDP ratios of an increase in the propensity of the ‘&’ country to import products from the ‘$’ country, when government expenditures of the deficit country are endogenous #

27. Conclusion • Eurozone countries cannot all converge towards balanced or surplus budget positions, unless deficit countries decide to self-impose fiscal austerity measures • But then fiscal austerity is incompatible with full employment goals