EuropeanDebtCrisisandDebtSustainabilityintheNewMonetaryEra

EftychiaPsarra,AristotleUniversityofThessaloniki

VasilisPsarras,AristotleUniversityofThessaloniki

Abstract

ThispaperexaminestheseverityofEuropeanDebtCrisisanditseffectsto Eurozone member states alongside the policies implemented toovercome recession and rescue overindebted countries from default.UnconventionalmonetarypoliciessuchasQuantitativeEasing(QE)andNegativeinterestrates(NIR)weremajortoolsusedbyEUinstitutionstoenhance growth to the economy signalling the beginning of the NewMonetaryEra.Weusearobustpolicyruletoforecasthowinterestrateswill perform in coming years and we stimulate a model of debtsustainability for different Eurozone countries based on our estimation.Different debt-to GDP ratios, fiscal priorities and monetary conditionshighlyaffecthowdebtwillperforminthefuture.

Key words: European Debt Crisis, unconventional, public debt,sustainability, austerity, negative interest rates,growth,debtmonetisation,ModernMonetaryTheory(MMT),secularstagnation,inertialTaylorrule

JELClassification:C2,C3,C5,E52,E58,E62,H6

1. Introduction

Thisyearwecommemorate20yearssincetheofficialintroductionoftheeuroandnomatterhowmucheconomics’ “HerculePoirot” has tried tosolve the mystery of Eurozone collapse our case, as Gourinchas,PhilliponandVayanos(2016)putit,israthersimilartothe“MurderontheOrientExpress”.Manyforcescontributedtothe“murder”ofEUeconomyandmany have started the blame game since day one. For the mostpowerfulonesthe“PIGS”-anacronymforPortugal,Ireland/Italy,GreeceandSpain-andtheirreluctancetoreformtheirfiscalstructureswerethecauseofthecrisis.Foreveryoneelse,Brusselsasthe“capital”oftheEUturned into scapegoat and ordinary people around the Union startedblaming EU institutions as a whole for their problems and the eurosuddenlybecame“thewhip”todisciplinethoseneedingconsolidation.

Manyeconomists,especiallyUSbasedandeducated,haveforeseenthecollapseof theeurobefore ithasevenstarted.MiltonFriedman (1997)twoyearsbeforetheeurowasputintocirculationdescribedthemonetaryunion as an attempt deriving from political, rather than economic,incentiveswhichwilleventuallyleadtointernalpoliticaldisunity.TheEU20 years agowas consisted only by 15members and right now it hasalmost double that number, this sudden expansion of the EU gavepolicymakers a great opportunity to broaden their goals and theirhorizons, but at the same time it also raised serious doubts over thesocial,politicalandeconomicconvergenceofEUmemberstates.

Post-communistcountriesenforcednecessarylabourmarketreformsonearly90’sdue to thecollapseof theSovietUnionandGermanyduringthoseyearswaslabelledasthesickmanofEurope.AftertheunificationEastGermanyhad to convergewith theWestandcircumstanceswere

no favourable at all. The determination of three consecutive Germanchancellorstomodernisetheeconomyandsynchroniseproductivityratesbetween East and West cured the sick patient of Europe. SouthernEuropean countries never took those difficult decisions, so when theGreatRecessioneruptedandmostofthemwerebailed-outafewyearslatertheywereforcedtotakeallrequiredremediesavailabletocuretheneo-sickmenofEurope.

European debt crisis provedmany US economists right. Although, thevastmajorityofpolicymakersandpoliticiansintheEUbelievedthattheircountries were immune to political and economic disruption the crisisshowed how distorted the reality was. The collapse of Eurozoneeconomies triggered mass unemployment, with an average of doubledigitsforseveralyearsafterthecrisis,anoutstandingdecreaseofoutputand most importantly the rebirth and rise of nationalism and populismamongEurozonecountries.

Expertstriedreallyhard20yearsago,tocreateamonetaryunionunderthecriteriaofMundell(1961)buttheyhavefailedmiserablytoovercomethe difficulties of such an ambitious plan. Our aim in this paper is toexamineboththecausesoftheEuropeanDebtCrisisanditspoliticalandalsoeconomicconsequences. Inaddition,wewillemphasisetotheuseofunconventionalmonetarypoliciesasavaluabletooltoovercomecrisisandexaminehowtheconsequencesof thecrisisandmonetarypoliciescanaffectpublicdebtsustainabilityinthefuture.

2. EuropeanDebtCrisis:Overview

Economists all over the Eurozone were extremely confident thatcountries would eventually comply with the rules of the “Growth andStabilityPact”concerningpublicdeficitsanddebts.Unfortunately,manymemberstateswereunwillingtoadjusttheirfiscalbudgetsand in 2010Ireland’sdeficitskyrocketedto32percentofGDP, justmonthsafter theIrish government had agreed on a bail-out deal. Other bailed-outcountrieshadsimilarbudgetperformance like Irelandonlywithamuchmore moderate level of around 10 percent, still very high from the 3percenttargetoftheMaastrichtTreaty.

Eurozone countries faced an external debt crisis since they were

borrowinginanexternalcurrency,theeuro.Arellano,AtkesonandWright(2016)presentevidencethatexternaldebtcrisisaffectedseriouslybothpublic and private borrowers with dramatic reduction in net volume ofcapital flows.GreecewasthefirstEurozonecountrywhichdefaultedonitsdebtonMay2010whentheGreekPrimeMinisterhadaskedfortheassistancefromtheIMF.Ireland,onthecontrary,hasnotcollapsedduenational sovereignsbut becauseof thebust in its “irrational exuberant”bankingsector.CyprusaskedforassistancehavingsimilarproblemsasIrelandwhileSpanishandPortuguesecaseswereclosertoGreece.

The common currencymade it easier for countries to be rescuedwithhuge loans-Greecehas receivedaround€200bn from theESM/EFSF-but at the same time made countries more vulnerable to financialexternalities. Rajan and Zingales (2003) acknowledged that althoughcontinental Europe has a financial system more based on banks andinstitutionalrelationshipsthantheUS,Eurozonedevelopedarm’s-lengthfinancial system endorsing free market economy. Unfortunately,Eurozone financial system incrementally increased derivativesoutstandingonthesecondarymarket,with$2.4tn in2001while in1986theywereonly$2.7bn.Derivativeswere theprimarycauseof the2008collapseandalthoughthefinancialsystemworldwidehadevolvedrapidlyduringtheGreatModerationeratheevolutionledtoevengreaterdistressandfragility.DiamondandRajan(2009a)describedthemisallocationofresources as the primary cause of the crisis, alongside investmentslargely financed with short-term debt. Irish and Spanish banks wereamong those misallocating investment, endorsing this culture ofexcessive risk taking, leading to even higher housing prices to bothcountries.

Mortgage-backed securities (MBS) became the newnormof borrowingandbanksallaroundtheUSwereissuingthemintheearly2000’s.Manyeurozonegovernmentstookadvantageof the lowinterestratesthat theEuropean Monetary Union (EMU) offered them and started issuingsovereigns irrationally andwith no supervision. Those sovereignsweremostly sold to non-Eurozone investors creating an even larger bubblethan this of the MBS deriving from toxic sovereign-backed securities.Lowerinterestratesledtoincreasedbondpricesandvalue.Sovereignsand mortgages are extremely illiquid loans and the financial collapse

deteriorated even further because these illiquid assets were spread tofinancial markets. Diamond and Rajan (2009b) describe how the post2000 environment of exuberance pressured for current consumption,which the economy was too illiquid to provide and how illiquidity andultra-lowinterestratesencompassedeconomicdestruction.

TheArellano,AtkesonandWright(2016)papermadeacleardistinctionbetween the US and European case describing the debt crisis of USfederal states as public debt crisis while Eurozone’s member statesdefaultedonexternaldebt.Theothermajordifferencebetween theUSand European case comes from Romer and Romer (2016) paper inwhich theyevaluate theaftermathof financialcrisesofmanyadvancedeconomies based on credit disruption. All European economies facedminor or moderate crises under their evaluation, similar to the 1990’srecessionof theUSor thecurrencycollapseof theUKandSweden in1992-1993. In their sample the worst performing countries are the USand Iceland with extreme crisis in 2008 and also Japan in early 1998afterthecollapseofotherAsiantigers.RomerandRomer(2016)provideusefulevidenceadmittingthatthesituationcouldhaveeasilybeenmuchworse once credit was not secularly affected thanks to the bail-outprograms.

Nonetheless, the stabilisation of credit was not enough to stabilise EUeconomy in general. Strict austerity measures were implemented tomany Eurozone countries and the economy was, in many cases,unprepared topay thisprice.Fiscalconsolidationwasseenas theonlyalternative – or to be preciseEU institutions alleged that therewas noalternative-andsimpleKeynesianeconomicswereutterly rejected.Thecost for thebailed-out economieswere intolerable not only political butalsoeconomicalandsocial.ReinhartandRogoff(2014),despitetheroletheyplayedtothecrisiswith“GrowthinaTimeofDebt”paperwhichwewill comment in another section of this paper, examined the recoveryfromfinancialcrisesfor100differentepisodes.Onaveragethebailed-outeconomiesinthesamplelost10percentoftheirGDP-Greecelostmorethan20percentofitsGDPfrompeaktotrough-andtheywouldneed12yearstofullyrecoverfromcrisis.The12-yearperiodendsnextyear,andwearenotyetsurehowfullyrecoveredthesecountriesare.

ThemoststrikingfactonReinhartandRogoff(2014)paperistheuseofa “severity index” todescribe financial crises.Thecrisis inGreecewasalmostassevereastheGreatDepressionintheUS,withtheindexbeing36forGreeceand38.6 for theUS. It isalsoastonishingthat inEuropetherewereonly threecasesofmoreseverecrises, Italy in1921beforetheformalprevailofMussolini,Spainin1931duringthecivilwarandtheNetherland in1939 justmonthsbefore theNazi invasionto thecountry.ThemodelofGourinchas,PhilliponandVayanos(2016)whenstimulatedwith an emerging market sudden stop and also initial debt levels(government,private,external)ofanadvancedeconomy, theresult isaGreekcrisis.ParaphrasingReinhartandRogoff“magnumopus”,thetimeoftheGreekcrisiswasdefinitelydifferent.

The common sense of old and simple economics was replaced byintellectual failingmodelsand theneed topromote internaldevaluation.Governmentshadtoenforceadjustmentconcerningtheirfiscalposition,but at the same time the entire economic system had to adjust to“pioneering”andessentialneoliberaldoctrinesaswell.Thesimplewaytoovercomerecessionisexchangeratedevaluation,enhancinggrowthandincreasingcompetitiveness.Mundell(1961)acceptsthatcountriesshouldstill focus on devaluation but when there is a currency union under aflexibleexchangerateregime,countriescannotcontrolthedevaluationoftheir currency,so theonlypossiblealternative is forwages toadjust tothis downward trend. Several Eurozone member-states have liberatedtheir labour markets in the 90’s constructing flexible wage regimesinstead of flexible exchange rate regime. The countries more severelyaffectedbythecrisiswereobligedtoreformtheireconomicstructuressoastocreateafavourableenvironmentforefficientinternaldevaluation.

The conditions in the Eurozone were no favourable at all. Firstly,countrieshaddelayedformanyyearsthosereformssothepeoplewereunwillingtorisksomuchfortheoreticalbenefitstheycouldnotsee.Theyhaveonly seen lowerwages, higher taxes, rising lending interest ratesandhigherprices to theirdailyproducts.Secondly, themonetaryunion,as itwasmentionedbefore is flawed in itscore.Althoughpolicymakerstried tomakeabumblebeeable to fly,asMarioDraghioncedescribedthe common currency, the circumstances have only gottenworse oncetheyhaveneglectedbasictheoreticalbackground.Evenifourbumblebee

eventuallygraduates intoabee themonetaryunionwill bemuchmorevulnerable and Krugman (2013)findsevidencethattheEurozonehasneitherincreasedlabourandcapitalmobilitynorintegratedfiscally.

Thosefiscalimbalancesamongmemberstateswouldnotraiseseriousconcernsduringasymmetricshocks,butwhen theentireEurozonewason the verge of collapse the variance of deficits and current accountbalances among the countries could not simply be underestimated.Policymakers haveurged for the creationof fiscal union, but therehasbeen no constructive resolution and popular demands on governmentsforsocialserviceshavecausedat theendof the lastcenturyasecularincrease in public debt-to-GDP ratios in a variety of countries inconjunctionnotwithwarsandcrisesasitwasnormallydoneinthepastas Eichengreen et al. (2019) find out. It’s very interesting that despiteausteritymeasures inmanyG20countries,suchasSpain, Italy,Franceand the UK, in order to reduce deficits and debts, debt-to-GDP ratioincreasedby40percentintheGreatRecessionversus24percentintheGreat Depression while advanced economies in the 30’s dealt withmedianunemploymentratesof25percent.

Eurozonegovernmentshad tobedisciplinedandEU institutionsshouldhave made an example of them so as to prevent irrational fiscalbehaviour in the future. Fiscal consolidation should not be seen as apoison,Stiglitz(2016)describesthecombinationofthestraitjacketruleoftheeuro, the complete rejectionofKeynesianeconomicsand the strictpolicymeasuresthatcountriesimplementedgraduallypoisonedthesickpatients of Europe. The problem is, that every time the system breaksdown, people doubt its effectiveness with a backlash against thesystemicnormsof liberaldemocracyandglobalisation.Feinman (2016)testedthesimilaritiesoftheGreatRecessionbacklashwiththepost-WWIeraandtheGreatDepressionwhencountrieshadenjoyedthebenefitsoffreetradeforalmost40yearsbeforethebeginningofWWIandwhentheworldendedandtheglobalfinancialsystemcollapsedpeoplesupportednationalists and fascists while “liberal” governments had raised thebarriersofprotectionism.

People in an abundance of EU member states endorsed nationalistparties focusing on a xenophobic and racist anti-EU agenda. Those

leaders, in thewordsofDonaldTrump,wantedtomaketheir “countriesgreatagain”and theonlyway todoso isbyreviving the ideaofnationstate. Rodrik (2011) in his attempt to explain the paradoxes ofglobalisation he issued a trilemma of democratic policies, economicintegration and nation state. Countries in the EU, especially after theintroduction of the euro, have abolished to some extent their nationalsovereignty and it’s true that they have endorsed for many years,economic federalism and the norms of liberal democracy. Since theEuropeandebtcrisiseruptedpeoplestartedtofeelangryattheEUandtheyfeltabandonedbytheirconventionalgovernmentsandnationalism,anunconventionalideaofthepast,simplybecamethenewconventionalform of parliamentary democracy. It was either the case of governingconservative parties endorsing extreme right-wing ideology as it hashappened in Hungary, Spain and Greece or ultra nationalist partiesgaining unprecedented popularity and parliamentary support as it hashappenedinGermany,France,ItalyandtoalmostanyotherEUmemberstate.

FrancisFukuyama (2007)describedtheEUastheutopiainwhichtheworldwillliveaftertheendofhistory.Unfortunately,thisutopiahascollapsedbothpoliticallyandeconomicallycreatingwhatFukuyamadescribesas“identitypolitics”.Onesocialorracialgroupbelievesinitssuperiorityoveranyothercreatinginthiswayitscommon“identity”whichwilleventuallydeterminethisgroup’spoliticaldecisions.Fromourperspective,andfranklyfromhistoricalperspective,thisistheexactbeliefcoordinatingnationalists all over Europe and the world, butpoliticianshavedemonisedwordsand termsavoiding thedemonizationof obsolete ideas, like nationalism and fascism. People have notsupported these beliefs because they necessarily believed that theirnationissuperioramongothersbutbecausetheyweredissatisfiedwiththeideasofmultilateralismandfederalism.

Many advanced EU economies have asked to regain their nationalsovereigntyonceagainandalthough theyhavenotdoubted free trade,they have mostly emphasised, as Bolle and Zettelmeyer (2019) havemasured, on immigration restrictions, industrial policy andmacroeconomicpopulism.ThedynamicsofGermanindustrialsectorwasavitalaspectofhowtheeconomyfullyrecoveredaftertheunificationand

austerity measures, but countries like Ireland and Cyprus have noindustrialised economies on the contrary they have emphasised onfinancialization of their economies while Greece, Portugal and Spainnever had a powerful and sustainable industrial sector. Itwas the autoindustry that gave Germany this cushion of protection, it’s theindustrialisedNorthofItalythatpreventedItalyfrombeingbailed-outandthe domestic importance of French industry that has restricted Frenchpresidentstotakeallvitalreformstoliberalisetheeconomy.

TheEurozone, undoubtedly, has survived fromoneof themost severeeconomic crises inmodern history. But as Benguria and Taylor (2019)pointed out all financial crises throughout the years are very clearly anegativeshocktodemandandpoliticians’reluctancetoincreasedemandvia expansionary fiscal policies, the extremely low propensity to investandthelackofconsumptionduelowerwagesfuelledanunprecedentedpoliticalcrisismuchworsethanthefinancialcollapse.Inthenextsectionwewilldiscusshowmonetarypolicyplayeditsroleas“theonlygameintown” despite its initial mistakes and how the new monetary era ofunconventionaltoolssupportedeconomicgrowthandhealedthebankingsector.

3. TheNewMonetaryEraoftheEuro

For many years after the Great Depression economists havecharacterisedmonetary policy as irrelevant and the only role it shouldplaywastoretainpegexchangeratesundertheBretton-Woodssystem.In late1940’s,Friedman (1948)publishedapaperdescribing the fiscaland monetary framework necessary to sustain equilibrium in theeconomyandtheimportanceofflexiblenominalvalues,concerningbothexchangeratesandwages.Twentyyearslater,Friedman(1968)returnedin thespotlightwithhispresidentialaddress to theAmericanEconomicAssociation praising Keynes for his valuable contribution to monetaryeconomics, in spite of raising concerns over its long run effectiveness,explainingpastmistakesofmonetaryauthoritiesandprovidingfeedbackon how monetary policy can prevent money itself from being a majorsourceofeconomicdisturbance.Friedman’sspeechchangedeconomicsfundamentallyestablishinganewschoolofthought,monetarism.

Friedman believed that monetary authorities should target to stablemonetary growth to stimulate growth and at the same time guidingthemselvesbymagnitudesthattheycancontrol.Europeanshavealwaysbeen afraid of inflation- they suffer from “inflatiophobia”- because ofhyperinflation phenomena in the 1920’s and in the 1940’s. Thus,Friedman’sproposalsaboutastableandproductivemonetaryauthorityoverwhelmed them with euphoria and when stagflation occurred,monetarist experiment was the pill needed to heal the economy. Ofcourse, the Bundesbank, the German Central Bank, was the first toenforce monetarist theories. Bernanke and Mihov (1996) testedBundesbank’s decisions, and since 1974 Bundesbank has conductedmonetary policy framework that is officially designated as money-targetingalthoughtheyhavenotedthat thesemoneytargetsare tied toprojections of inflation and potential output growth- plainly Taylor rule.Alesina and Summer (1993) a fewmonths after the Maastricht Treatyacknowledgedthecorrelationbetweencentralbank’sindependenceandlow inflation. Under Alesina and Summer’s characterised theBundesbankandtheCentralBankofSwitzerlandarethemostpoliticallyindependent central banks in the world. That widely perceivedassumptionledtothefamousJacquesDelors’phrase“NotallGermansbelieveinGod,buttheyallbelieveintheBundesbank”.

Europeanpolicymakersin1999faceddifficultdecisionsandtheyhadtochosehowtheywantedtoconductmonetarypolicyandfranklyboththeir“inflatiophobia”andtheirneedtocreateapoliticallyindependentECBledthemtotheso-calledDeutschemarkregime.Ilzetzki,ReinhartandRogoff(2017)stimulatedamodelonhow theECBconductedmonetarypolicyandtheyfoundthattheDeutschmarkregimelasteduntil2009,whenthecrisis starts and interest rates enter the Zero-Lower Bound, even if in2014theyturnednegative.

In2011,during thepeakof theEuropeandebt crisis,ECB’sGoverningCouncil completely forgotwhatmonetaristshaveadvocated concerningthe stabilising role of monetary policy and they decided to increaseinterestratestwicethatyear,contractingmonetarypolicyandescalatingthe extent of the recession. Many blame asymmetric shocks for thismistake,but throughouthis lifetimeFriedmanusedtorefer to theGreatDepression as the Great Contraction because of the contractionary

measurestheFedtookduringthecrisisandthoughtthatthesemeasureswhere the reason why the US and consequently the world economycollapsed. Europeans easily forget, they have totally forgotten hownationalismandfascismhasdestroyedourcontinenttwicein1900,andtheGoverningCouncil thought that theonlywaytoavoidrising inflationwas through contractionary decisions even if the crisis furtherdeteriorated.

In2012,MarioDraghias thePresidentof theECBdecided to take thiscrisisseriouslymaking thecommitment that theywoulddo “whatever ittakes” to save the euro. Draghi was prepared to learn the monetaristlesson,butmostimportantlylearnfromothercentralbanks.Japanonlyayearafterthe1997distressoftheAsianTigerssuffersfromanextremelyhazardous banking collapse andKrugman (1998) famouslywrote backthen that the idea of “Liquidity Trap”, a phenomenon first described byHicks (1937), was “baaaack” in the game and Japanese authoritiesshould more both fiscally and monetarily to confront the downturn.Liquidity traprefers toaperiod inwhichnominal interest ratesarenearzero,butpersistentlylowinflationleadstorisingrealinterestrates.Whenan economy enters “Liquidity Trap” the famous LM Hicks’ curve turnshorizontal and conventional monetary policies cannot increase output.Theonlyalternativewasfiscalpolicy,orin1933termsa“NewDeal”.

Japan was afraid to perform such an ambitious fiscal plan in 1998althoughthegovernmentincreasedexpenditures,theUSin2008offereda fiscal packageequals toalmost $600bnwitha largedeficit around8percent of GDP and European leaders, utterly afraid of deficits andcommitted to austerity chose decreased deficits and even budgetsurpluses.TheonlywayfortheEurozonetoescapethistrapwastostartthe experiments of unconventional monetary tools, and Draghi’scommitment to do “whatever it takes” was the first step on rebuildingtrust.Trusthasbeenthedrivingforceofourfinancialsystemandinorderto regain trust policymakers should better understand the “NewAbnormal”describedbyCliffe(2014)asanenvironmentofweakgrowthas a source of volatility and unconventional policies as the tool totransforminvestmentlandscape.

Apart from the commitment the ECB was ready to enter the “New

MonetaryEra”as theFed, theBankofJapanandtheBankofEnglandhave already done. The first step was the introduction of nominalnegativeinterestrates in2014asanattempttosupport investmentanddecreasepeople’spropensitytosaving.Intimesofrecessionpeopletendto consume and invest less, while saving an even bigger amount ofmoneyinordertospendtheminthefuture.RachelandSummers(2019)examine the effects of secular stagnation, the phenomenon thatSummers thought was the result of the Great Recession, causingextremely low interest rates, lower thandesirable inflationandsluggisheconomic growth. The only way to overcome secular stagnation is byusingextraordinarypoliciesandapparentlynegative interest ratesweresuchapolicy. InSeptember,MarioDraghi inhispressconferenceaftertheGoverningCouncilmeetingsaidthatEurozone’scentralbankershadvotedunanimouslyinfavourofdecreasinginterestratesfurther,tominus50bp.

Thatdecisiondefinitelywasnotablast for themarketsonceeverybodywas expecting for lower rates, but those further dovish policies of theECB will eventually doubt the institution’s credibility to performindependently monetary policy. Researcher have not very extensivelytested negative interest rates, mostly because their afraid to makeprojectionstheycannotcontrol,butacrosscountryworkwithmorethan50.000dataconductedbyLopez,RoseandSpiegel (2018)hasshownthatdespitenegativeinterestrates,andtheirextent,bankprofitabilityhasnotbeenharmedinthepast7yearsoncenon-interestincomeimprovedand banks made significant capital gains and gains on securities andinsurance. The banking sector has been regulatedmuchmore closelysinceBaselAccordIIIandmanybanksaremuchmoreresilientnowthan10 years ago.Thenegative interest rates policywasnot enough to letinflation reach its target, although it expanded monetary base offeringindirectlymoremoneytothemarket.

Bernanke (2017) wrote a paper on how monetary policy should beconductedintheneweraandoncehewasthefirsteverChairmanoftheFed introducingQuantitative Easing (QE) programs he emphasised ontheimportanceofQEasanewwaytodo“monetarist”experiments.QEhas operated either via signalling channel, keeping short-term interestrates lower for longer or portfolio balance sheet channel by changing

termandriskpremiums.BernankeadmitsthatQEhasgeneratedassetsbubblesandinevitablytherewillbeadownwardcorrectioninassetpricesbutasKohnandSack(2018)pointedoutontheiranalysisof theGreatRecessionand theeffectivenessofmonetarypolicy, thesituationwouldhavebeenmuchworseabsenttheaggressiveeasing.

Expanding open market operations have been a common strategy formanyCentralBanksduringdownturns,andLaevenandValencia(2018)examining evidence of systemic banking crises worldwide wrote thatadvanced economies had mostly used recapitalisation programs andguarantees on banks’ liabilities and to lesser extent nationalisation-during theGreatRecessiononlya fewBritishbankswerenationalised-andasset purchases.QEchangedall thesewith theamount of assetspurchasedbyCentralBanks,theECBhasquadrupleditsbalance-sheetpurchasing assets of more than €2.5tn, and the vast majority of itsmonthly purchases included government bonds. The extension of ECBbalancesheetwasanattempttospreadliquiditytothemarkets,throughthe famous “helicopter drop” procedure, to reach the inflation target of“below but close” to 2percent andmost vitally reduce the borrowing ofEurozonememberstatesloweringinterestratesandyieldsintonegativeterritory.

Although, policymakers have prevented theECB to uncontrollably printmore money to increase growth and prices, the QE that Eurozoneimplemented and the fact that in November the ECB will restartpurchasing€20bnofassetspermonthisanexampleoftheexpansionaryrole that a Central Bank can play under “Modern Monetary Theory”(MMT).MMT advocates allege thatmonetarily sovereign central bankscanprintmoremoneytofinancefiscaldeficitsonceinflationremainlow.Nonetheless,theEurozonehasnocommonbudget,sotheECBcannotdirectly finance fiscaldeficits,andmembersstateshaveabolishedtheirmonetarysovereignbycreatingtheEMUsoitisquiteinterestingwhenoneofthefoundingfathersofMMT,Wray(2019),describedQEasanindirectimplementationofMMTwithtrillionsaspaymentforlargeassetpurchases.

Policymakers found QE as the only monetary tool that could work inpractice,provingpast theorywrong.Theonly thing thatQEfailed todo

effectivelywastoaffectinflationexpectationsandnameda“toolittle-toolate”measure.TheECB,committedtodo“whateverittakes”,usedalessfamous macroprudential instrument to manage inflation expectations,forward guidance. Credible and independent Central Banks can veryeasily determine the way markets react to their decisions and it isfundamental for theECBtomakedecisionswithin itsmandate focusingon the inflation target. Forward guidance explains how policymakingdecisions now, can determine future performance and frankly the firstexample of forward guidance was Draghi’s 2012 speech and how hisdetermination to overcome “inflatiophobia” and break down pastdoctrines gave the EU economy the opportunity to manage people’sexpectations. When the ECB states clearly that they are ready to do“whatever it takes” to preserve the euro and increase inflation, thenhigher inflation expectations will lead to the need of higher nominalwages and in the end increased supply. That’s how the neoclassicalsynthesisworks.

InertialTaylorRule

it=ρ1it-1+ρ2[r*+πt+0.5(πt-π*)+ŷt],1999Q1-2019Q2(1)

itrt=r*+πt+0.5(πt+π*)+ŷ(2)

Forwardguidancehasbeen themost important tool to increasegrowthandbyallmeanssupport therealeconomy,despite thefact that itonlyrepresents central bank’s trust. Apparently what Eurozone economyneeded was to rebuild trust and Bernanke, Kiley and Roberts (2018)pointed out that lower-for-longer policies work reasonably well even ifthey are not fully credible with the public, but people have modelconsistentexpectations.Lowerforlongermonetarypolicieshaveworkedincrediblywell for the past 10 years in theEurozone but our aim is toexaminehowtheywillperforminthefutureaswell.Forourestimationofour model, we have used the Inertial Taylor Rule as described in theBernanke, Kiley and Roberts (2019) paper. Equation 1, expresses themonetaryrule,withit-1expressingatimelagfornominalinterestrates,r*expressesthenaturalrateofinterestwithdatafromtheFederalReserveBank of New York deriving from the Holston, Laubach and Williams(2017), πt is the four quarter inflation change of the Harmonised

1.291516

ConsumerPriceIndex(HCPI),π*istheinflationtargetof2percentandŷisthecalculatedoutputgapofEurozoneGDP.

Equation2triestosimplifythesecondpartofEquation1puttingitequalstoitr,anacronymusedfor“inertialTaylorrule”.WeusedtheVARmethodtoestimatethemodelwiththeresultsofourestimationshownonTable1.Wehaveaddedasecondlagofnominalinterestratesandalsoalagofitr,writtenasitrt-1,representingthedataofthepreviousquarterandhowtheeconomyperformed thenmostlybecausecalculationsalwayscomewithatleastonequarterlag.

Table1

Coefficients Std.Error t-statitic

it-1

0.09334 13.8373 R-squared0.971803

it-2 -0.354025 0.08816 -4.01550 Akaike-AIC0.125925

itrt 0.168898 0.03285 5.14185 Schwarz-SC0.004169

itrt-1 -0.15791 0.03439 -4.38415 Meandependent0.938312

TheresultsofourestimationcanbediagrammaticallydisplayedbyChart1, in whichwe have also estimated the samemodel not with a vectormethod, but byOLSwith similar resultswith theVARcoefficients.Thismodel can be used as a forecasting tool on how interest rates willperforminthefutureandultimatelythatisouraimsoastoexaminehowtheentireeconomywillperforminthefuture.Wehaveforecastedbasedonthismodelhowinterestrateswill fluctuateinthefutureandwehaveaddedthesefluctuationsintodebtsustainabilityrule,thatwewillexplaininthenextsection.

Chart1

Source:ThedatausedfortheestimationofthismodelderivedfromtheEuropeanCentralBank,theFederalReserveBankofSt.Louis,Holston,Laubach&Williams(2017)andtheOECD

4. DebtSustainabilityintheNewMonetaryEra

TheEuropeanDebtCrisiswasmostlytheresultofirrationalgovernmentborrowingmore than what they could afford, and when their credibilitycollapsed, people doubted the credibility of the entire Eurozone. Thisyear Eurobarometer found that almost 70 percent of Europeans thinkpositively of the euro, but the austerity policies have affected people’severydaylivesdestructively.Keynes(1936/2001)inhis“GeneralTheory”didnotonly specifyhowmoneyand financialmarketsoperatebutalsomadethecaseinfavouroffiscallooseningintimesofrecessionsoastoincrease demand and consequently output. One of Keynes’ closestfriends and colleagues, Joan Robinson, once advocated that theneoclassical synthesis that Hicks, Hansen and Samuelson presentedwas“bastard”Keynesianism.

Hicks and Hansen presented a simplified model of General EconomicEquilibriumandmanyotherNew-Keynesianeconomistshavepresentedthismodelastheonlyoneaccepted.Farmer(2010)explainsthatold-Keynesianmodelexplainsthecrisisasaself-fulfillingdropinconfidence-oranimalspiritsinKeyneswords-andtheymovefromalowtoahigh

unemploymentequilibrium.Onthecontrary,businesscyclesareexplainedbyNew-Keynesiansastheoutcomeofrigidpricesandwages(Farmer(2006),RomerandRomer(2019)andRachelandSummers(2019))andbymonetaristsastheresultoffluctuatingTotalFactorProductivity.EitherwaytheybothagreethatliberatinglabourandinsurancemarketwillhelpEurozonecountriestoovercomethecrisis,becausetheNew-Keynesianswouldagreethatlessrigidandmoreflexiblewageswouldsmoothbusinesscyclesinthefutureandmonetaristsbelievedthatincreasedproductivityandcompetitivenessintimesofcrisiscanonlybeaccompaniedbylowerwages.

Fiscalconsolidation turned intoadogmaandmarkets reformswere thenecessarytooltoimposethisdogmanintherealeconomyastheneedof“internal devaluation”. Suddenly, economics of failed models, fracturedmacroeconomictheoriesandhistoricevidencetransformintoareligioninwhich policymakers only believe in divine doctrines. The Reinhart andRogoff (2010)paperongrowthandpublicdebtbecame the “Bible” thatpolicymakersused.ReinhartandRogoff(2010)usingasampleofmorethan20advancedeconomies-andalmost20developingones-foundoutthat90percentdebt-toGDP ratiowasa thresholdabovewhichgrowthwillbe reducedbyanaverageof1percent.Wedonot really think thatReinhart and Rogoff planned to become Eurozone’s “Gods” but backthen at least half of Eurozone member states government debt hadexceeded theMaastricht threshold of 60percent and a vastmajority ofthemhaddebtshigherorcloseto90percent.

Thepoliciestheyimplementedfailedtoreducedebtintheshort-runandeven their long-run resultsarequitedubious, but the influentialAlesinaandArdagna(2009)paperstatedthattaxbasedpoliciescouldnotworkeffectively,so theonly thing thatpolicymakershad todowas to reducespending.Incrementally,debtsustainabilitybecameafrontrunissue,andeveryonewasreadytofacetheconsequencesofausterityoncethedebtcouldbeonceagainbecalledsustainable.But,frankly,thereisnopaperexplainingwhatsustainabilityreallymeansandhowitcanbeattributedtotherealeconomy.The90percentthresholddoesnotrefertosustainableorunsustainablegrowth,itonlyprojectsthatgrowthwouldbeonaverage1percentlowercomparedtolowerdebtratios.

Themostcurrentworkondebtsustainabilityandtheimportanceoffiscalpolicy was that of Blanchard (2019) on his presidential address of theAmerican Economic Association. In his paper examines how the USpublicdebthadperformedovertheyearssinceWWIIandstatesthataslongasgrowthratesremainhigher than interestrates,or theborrowingcost of public debt, debt can be reduced even without fiscalconsolidation.Ofcourse,asBlanchardstated,debtsshouldnotbeusedwithoutapurposejusttosatisfyvoters,buttheyhavetostimulategrowthandhisfinalremarkwas“debtmaynotbethatbad”.PolicymakersintheEurozoneareequallyafraidofdebtandinflationatthemomentbutasTaylorandWilliams(2010)andKiley(2016)expressedintheirpapers,monetarypolicyaloneinthezerolowerboundcannoteliminatethedeflationarysteadystate-onlyifitisexpectedtolastforafiniteperiodoffuturehelpingmonetarypoliciestocushionadverseshocks-butstillfiscalpolicieshaveamajorroletoplayleadingtheeconomytothedesiredsteadystateinflation.

The era succeeding the European debt crisis established the neweconomic environment of public borrowing, with negative short-terminterestratesandinthecaseofGermanyevennegativeinterestratesoflongtermborrowingandyields.Secularstagnationrefers toaperiodofstagnant economic growth but at the same time of near zero interestrates. In our attempt to examine debt sustainability, we have used therule that Blanchard (2019) used in his paper and we will focus on 6Eurozonememberstates,threebailed-out(Greece,IrelandandPortugal)andthreenon-bailed-out(Belgium,FranceandGermany).

Debtsustainabilityrule

radj,t=αtr1,t+(1-αt)r10,t+prbo(m/9)(3)

αt=(10-averagematurityinyears)/9(4)

sadj,t=radj-i,sadj=αt*s1,t+(1-αt)s10,t+psbo(m/9)(5)

dt=xt+dt-1(1+radj,1)/(1+gt)(6)

Equation3,displaysadjustinginterestratesbasedonbonds’maturitiesinwhichr1,treferstotheshort-terminterestratesandr10,ttothelongterm

ones.Forthebailed-outeconomieswehavealsoaddedthesecondpartof theequationstartingwithpastheratioof theESMloanstothetotalamountofpublicdebt,rborepresentstheinterestratesoftheESMloansandmtheaveragematurityof theESMloans.ForGreece theaveragematurity is 32 years, with p equals to 55percent, interest rate of1.43percentandIrelandandPortugaltheaveragematurityis20.8years,withpequalsto10percentforbothcountrieswithIreland’sinterestrateson1.71percentandPortugal’son1.68percent.WehaveaddedthispartconcerningtheESMloansbecausetheirdecisiontoextendthematurityofpublicdebts,onlyshiftstheburdeninthefutureandeventuallyfuturegenerationswillhavetopayforpastmistakes.

Equation4explainshow factorαdiffers for thecountries inoursampleandequation5 represents thespreadbetween thegovernment interestrates(r)andthenominalinterestratesoftheECB(i).Wehaveusedthemedian spread of the last decade under the adjustingBlanchard’s ruleand we used the estimation of our previous section to stimulate howinterest rateswill fluctuate in the future.Equation6showshowdebt,d,performsundercertaingrowthrate,g,interestratesbasedon(3),radjandfiscal deficit levels, X.Growth and interest rates have been used as aweightingfactorforthealreadyexistingdebtandtheyarethesetwothatcandeterminehowdebtwillfluctuateinthefuture.

Many economists when the Great Recession erupted thought thatsovereign debt problems can be solved by fiscal consolidation and asBuilter(2010)falselypredicted“mostofthefiscally impairednationswilleventuallyoptforthefiscalpainexitfromunsustainablepublicfinances”.Manycountrieswhohadirrationalfiscalbehavioursdidnothavetoconsolidatetheirdeficits,withcountriessuchasPortugal,SpainandItalysecuringdeficitsupto3percent,Franceincreasingitsdeficitabove3percentandtheUS$1tndeficit,whichwasthehighestevernon-recessionpeacetimedeficitofalltimes.Countrieshavesucceededstabilisingtheirfiscalpositionbyretainingborrowingcostsnear-to-zeroandasGalbraith(2011)noted“it’stheinterestratestupid”, describinghowinterestratescanhighlyaffectdebtinthefuture.Inourstimulationswehaveusedapessimistic forecast (dp)and thenwehavestimulatedthemodelwith1percentincreaseingrowth(dg)and1percentdecrease

in deficits (dd) and interest rates (dir). In the case of Germany andIreland-whohadquitesimilarfiscalposition-wehaveexaminedthemostoptimisticstimulationandthenwechangedourforecastingbydecreasinggrowthandincreasingdeficitsandinterestrates.

Chart1

Belgium

France

In chart 1 we have examined how Belgium and France debts willfluctuateintothefutureandtheyhavebothstartedfrom99percentandtheyhadquitesimilarfiscalposition-2percentdeficitforBelgiumand3percent forFrance.By theendofoursample,2050,bothcountrieswillhave increased deficits, but as it is shown reduced interest rates by 1percentfromwhatwehaveforecastedwillcreateaconcavefunctionwitha stagnating path in the future. Increased growth rates today, couldpossiblyhavebetter results in the long runbutonce interestgetsmoreand more expensive the green line would increase constantly with alineartrend.Theleastessential toolwouldbefiscalconsolidationwhichwould end upwithmuch higher debt ratios compared to the other twocases.

Chart2

Greece

Portugal

ContrarytothemostlylinearandconcavetrendofthecountriesinChart1,GreeceandPortugalofferconvexfunctions.Wehavetomakeitclearthat forourestimationsofgrowthwehaveused theOECDprojections,andGreeceby theseprojectionswillonlysecureanaverage1percentannual growth, while the rest of the countries had 2 percent. Bothcountries will have decreased debts in the future- for Greece havepredicted an annual deficit of 1percent while for Portugal we havepredictedonaverageabalancedfiscalbudget.Portugal,inthebeginning

of our forecast had a declined trend for its debt, but after 2030 debtseems to rise again, once we have projected considerably increasedinterest ratesafter thatperiodandall kindsof improvementwill lead toalmost similar resultswith the best one attributed to increased growth.Again, it is important to check the trend of the function once Pr_dirfunction followaconcavepathafter2040withminorchangeswhile theothertwofunctionsfollowanupwardlineartrend.

In Greece, undoubtedly, all results should be worrying for thesustainability of public debt and considering the stagnant projectedgrowth,near1percent, the realeconomycouldbeseriouslydamaged.All four functions followaconvexpath,butGreecewill bebetteroff bysecuring lower interest rates. The current borrowing cost is below 2percent and itmoves downward, andGreece could have very positiveoutcomesbysustainingthisdownwardtrend.Eitherway,ourestimationprojects that interestrateswill remainnearzerofora longtimeandwillonly be increased near toEffective LowerBound levels, and that’s theexact projection that Rogoff (2017) made in his paper, explaining thatabsolutely free interest rates will fluctuate even further to the negativeterritory and incrementally our interest rate policy will enter a constantperiodofmonetaryparalysisandwiththeUpper-ZeroBoundintimesofboom. This chart shows clearly that further austerity could not makethingsworkbetterandtheGreekgovernmentshouldalsoemphasiseongrowthandproductivity.

Chart3

Germany

Ireland

InChart3wehadourfirstcaseofdecreaseddebtinourforecast.BothGermanyandIrelandrepresentanexampleofsustainedandorganisedfiscalpositionandinourforecast,weassumethatthecountrieswillhaveanaveragebudgetsurplusof1percentand1.3and2.4percentgrowthrespectively. Contrary to the two previous cases we have simulatedworseningscenarioswithgrowthandinterestratesfluctuationsresulting

to significantly improved debt ratios for the two countries. The onlydifference comes with fiscal consolidation which pays a much moreimportantroletoreducedebts.

Ireland performs equally in the case of reduced growth and increasedinterest rateswhile forGermanyeven lowergrowth rateswill lead toabetterresultthantheothertwocases,weakeningthedeterminingroleofGDPgrowthtoGermany’spublicdebt.Ourfindingshowsthatincaseofhigher debt, fiscal consolidation cannot support debt restructuring butwhen countries start from a lower debt ratio austerity determined to amuchhigherextentthedebtpaththatthecountrywillfollowinthefuture.Growthand interest ratesaregenerallyusedas theweighting factor, intheformofamultiplier,oflagdebt.Frankly,debtanddeficitareeconomicfundamentals, but as Jayaden and Konczal(2010)expressedintheirpapertherighttimeforausterityisduringeconomicboom,soastosupporttherealeconomywithdeficitsintheslump.Theonlyproblemwithausterityiswhentheeconomicfundamental,turnsintoapoliticalthatitisveryhardtomake.

5. Conclusion

Economists have been blindfolded by non-existing doctrines and nomatterwhattheydo,thelackofpluralityinpolicymakingleadstheworldeconomy to even bigger and deeper crises. The last crisis decreasedrapidly aggregate demand, but the next one will probably affectaggregate supply andeconomists havenot yet discovered if its effectswill be temporary. Summers and Stansbury (2019), quite recentlyexplained how the old-Keynesian economics should be revived- inSkidelsky’s words “the return of the master”- and the new-KeynesiandogmahasfailedmiserablybothforKeynesiansandmonetarists.

The Eurozone has created mechanisms to stabilise and efficientlyregulatethebankingsectorandmemberstatesrightnowaremuchmoreresilient to economic disruption than they were 10 years ago.Unfortunately,ourunionisunderthreatfromapoliticalenemywithinandasPaulKrugmansaidGermany isstill sickand it isdepressing for therest of the Eurozone countries that thisGerman disease is contagiousspreadingallovertheEU.Whenthenextcrisiseruptspeopleshouldnot

beafraid of debt, they have to use it for a productive and constructivepurpose but to do so governments should stop demonising andmonetisingaswell.

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