Category Archives: Uncategorized

More Lemming than Chicken

The US fiscal cliff negotiations are running down to the wire. Surprising? No. Simple models from game theory suggest we’re heading for the edge.

The term “fiscal cliff” refers to a collection of mammoth tax increases and spending cuts that are due to come into effect in early 2013. The measures imply a significant contraction in government spending, which commentators are worried would send the US economy back into recession. A bad thing for the world, not just American’s. Good summary pieces to look at on what exactly the fiscal cliff is include this CFR piece and the BBC Q&A.

The cliff has been likened to a game of chicken, an important model of conflict from game theory. This model captures the idea that neither party wants to be the one to back down, although the worst possible outcome occurs when neither yields. Although “chicken” goes some way towards representing the current situation, it omits some key features that suggest we’re going over the edge.

tumblr_m6qvvmFSWC1rpl1oeo1_500The game of chicken has its origins in a game where two drivers speed towards each other on a collision course destined for death and destruction. This terrible fate can only be averted if one driver swerves and accepts the (socially crippling) shame of being labeled “a chicken”. The simple game alone does not tell us which party will duck out: there are multiple “Nash equilibria”. However, restricting ourselves to consider “pure strategies” only (i.e. as a driver I can either choose to swerve or not serve), then the equilibrium outcome is for one party to backdown and be labeled a chicken. In our case, this would amount to one party conceding to the other’s fiscal demands and crisis being averted at the last minute.

Yet, the chicken analogy, although helpful, does not go far enough. Let’s take the car example. Imagine you’re a driver involved. Before starting the face off, you’d really like to give your opponent a look and say: “Just so you know, there’s no way I’m backing down. So matey, swerve.” However, this threat isn’t credible. You’re opponent would be silly to believe you. Conditional on my opponent staying the course, it’s best for me to duck out and face poultry related stigma.

However, I could take actions before getting into the car to make my not-swerving-claims credible. Take a look at the film “Footloose” to get the idea (no, really do look at this scene: Kevin Bacon driving a tractor with Bonnie Tyler playing in the background). In the film, a dare results in two teenagers playing a game of chicken. The boy played by Kevin Bacon ends up winning, not because of any braveness on his part, but because a tangled shoe lace prevents him from bailing. Knowing that Bacon is unable to get off the tractor, his opponent ducks out. An example that shows greater foresight rather than just lazy shoelace tying, is that of Hernan Cortes, who scuttled his ships during the conquest of Mexico in 1519 to prevent his soldiers deserting. The key idea is that you can limit your action set ex ante to put you in a better bargaining position. Applied to the fiscal cliff, one can argue that the Republican party’s claims regarding inability to compromise are credible. Given the current make up of the House, legislation implying tax rises for the wealthy is a no go here. The fanatical element of the Republican party thus lends their claims weight. Taken alone, this suggests compromise on the Democratic side.

tlav1-21However, another difference between the current situation and the simple model is that falling off the cliff doesn’t necessarily represent the worst outcome for Democrats (although, to be sure it would be bad). If this is true, then off the cliff we go. In fact, they are making parachute/landing preparations. More negotiations will follow if agreement is not reached this weekend. We are operating in a repeated game context, not the “one-shot” scenario in a chicken world. Thus, the cliff metaphor isn’t really accurate. A better one would be a really-difficult mogul-ski-course (although, granted, this isn’t super catchy). Once over the cliff, the “status quo” point will be different: taxes will be higher across the board and spending slashed. On the tax front, Democrats will be in a more favorable bargaining position as they will be rooting for lower taxes for certain portions of society. It is likely to be easier to muster Republican support for such measures. However, to be sure, this strategy is risky. The Republican party will still have the bias towards inflexibility and lack of compromise, but, arguably, the ill that can come of this will be more salient, giving Democrats greater room to poke the pointy stick of public opinion at their opponents in the next round.

Therefore, in my opinion, it looks like the US is going over the cliff. The Republican’s are not going to yield and the Democrats could potentially do worse. A game of lemming rather than chicken seems more apt.

PS Footloose link.

Austerity v Growth: A False Dichotomy

Politicians’ commentary on the state of the UK economy remains frustratingly tendentious and unsophisticated. The rhetoric of both the “austerity”  and “growth” camps is overly simplified and needlessly polarized. Action is needed to stimulate growth. However, this fact doesn’t necessitate adding to the debt burden. The economics of the fiscal multiplier implies greater concern should be given to the composition of spending cuts and tax rises. By designing our austerity strategy to reallocate resources to “high multiplier” activities, growth can be initiated during fiscal consolidation. Elucidating this common ground between the camps is required to move the debate forward and set the stage for the development of a credible and equitable austerity strategy.

Recession? Depression?

More than two years since the UK entered recession, the much anticipated recovery is yet to make its appearance. This week the ONS confirmed that the economy contracted by 0.2% in the last quarter of 2011, a consequence of chronically weak business investment and manufacturing. GDP remains almost 4% below pre-crisis peak. Comparing the current recovery to those following past recessions is chilling. The graph below, taken from Jonathan Portes’ blog, shows that output has already been depressed for longer than that experienced during the Great Depression, and looks set to remain so for the foreseeable future.

The current malaise is the product of weak demand, causing the economy to operate approximately 3% below its potential, and of reduced potential supply. Households and the government are set on consolidating their balance sheets and the Eurozone crisis has effectively foreclosed an export led recovery. There is thus little incentive for investment. The latest negative growth figures therefore come as no surprise.

Ongoing weak demand and reductions in supply capacity are linked, a phenomenon economists call “hysteresis”. If demand for a firm’s output is depressed for a prolonged period, machinery is scrapped and planned investments go unimplemented. Workplace skills and the likelihood of returning to work altogether decline in the length of an unemployment spell, reducing the stock of “human capital” in the economy. Not only has unemployment continued to rise in the UK, but it is increasingly long term and concentrated among the young. Youth unemployment has especially pernicious consequences, affecting the individual and economy for far longer than the spell of joblessness itself. Those experiencing spells of unemployment while young face significant wage penalties and a higher risk of future joblessness compared to their peers for decades, even after controlling for a wide array of individual and family characteristics (see, for example, Gregg and Tominey (2005) and Mroz and Savage (2006)). Thus, the fact that 18% of 16-24year olds are ‘NEETs’ (Not in Employment, Education or Training) should be sending alarm bells ringing through Whitehall. Their current idleness is not just an awful waste of their talents at this particular moment but makes it more likely for them to become trapped in dead-end areas of the labour market for much of their adult life. This is unfair, they did not choose to be born at a time dictating they join the workforce during the worst post-war recession, as well as being highly damaging to the wider economy.

Poor growth prospects ultimately make it harder to finance those dreaded debts. Low economic activity implies lower tax revenues, acting to undermine the UK’s fiscal credibility. In November, the OBR announced that £15bn of tightening is required in addition to what was initially anticipated to meet the deficit reduction targets. Moody’s, the rating agency, put the UK’s AAA credit rating on negative outlook, citing weak growth prospects and Eurozone exposure as justification.

Austerity v. Growth: A False Dichotomy

It seems like an impossible situation. Low growth undermines our fiscal credibility but, so we are told, raising government spending is off the cards as it will add to the national debt, spooking the markets, creating financial turmoil. With both austerity and growth strategies, it seems to be a case of damned if we do, damned if we don’t.

However, all is not lost. First, the downside risks of slowing the pace of fiscal consolidation are overblown and small relative to the costs of continued deficient demand but, leaving this to one side, the situation is not as hopeless as presented. We are not, in fact, faced with the choice of austerity or growth. This dichotomy is false and damaging. Rather than seeing this as a one-or-the-other problem, we should focus on the design of austerity strategy and how fiscal consolidation can be achieved with the lowest impact on growth and demand. It isn’t just a case of “tighten or not” but also “how to tighten”. By reallocating government resources to activities with a high fiscal multiplier, growth can be supported while the budget deficit is reduced. Enacting this principle also implies equitable policy reforms, dictating a transfer of resources from the richest to the poorest in society.

The Fiscal Multiplier

The fiscal multiplier gives the impact that changes in government spending have on overall demand in the economy. With a multiplier of 1, an extra pound of government spending raises total demand in the economy just by a pound. However, we generally expect the size of the multiplier to be greater than 1. Imagine government spending is increased by 1. This additional £1 then represents income which is spent. Let households spend a fraction c of their income. c is defined as the “marginal propensity to consume”. This extra c of spending then represents income for someone else…..who spends c of it….and so on. Thus, one can think of the total increase in demand leading from the £1 of government spending as

1 + c + c2 + c3 + …

Therefore, there can be a more than proportionate increase in demand with increase in government spending.

The actual size of fiscal multipliers is difficult to measure but a moment’s thought suggests they will vary across government activities. Resources should be shifted to high multiplier activities and the burden of cuts should be disproportionately concentrated on those with low propensities to consume. Imagine a balanced budget policy, taking income from one group and transferring it to another. Although fiscally neutral, the policy will boost growth if spending rises by more among the recipients than it falls among the funders. This will be the case if the marginal propensity to consume is higher among the recipients. By redesigning our austerity strategy to shift resources to high multiplier groups and activities, growth can be stimulated without a need to increase the debt burden.

What could this look like?

The analysis above suggests that cuts should be targeted at those with a low marginal propensity to consume, while those with higher MPCs should be protected. We shall also see that enacting this thinking implies equitable policy changes, dictating transfers of wealth to low income groups in society.

Exploiting variation in fiscal multipliers lies behind the Social Market Foundation’s suggestion of cutting high rate income tax relief on pension savings and capping ISA contributions. Such a policy would extract more tax revenue from those in a relatively secure financial position, who are better able to smooth the impact of cuts and tax rises, thereby minimising the impact of consolidation on overall demand. The SMF calculates that halving higher rate tax relief on pension contributions would save £6.7bn annually, while an ISA cap of £15,000 would generate an additional £1bn each year. Tightening should also be done through greater targeting of benefits rather than a reduction in their general level. Families at the bottom of the income distribution, without a savings safety net, are likely to have much higher marginal propensities to consume. Their income levels should thus be protected as far as possible on efficiency, as well as equity, grounds. Therefore, greater means testing of benefits should be enacted. Making child benefit and subsidies such as winter fuel payments and bus passes only available to the most disadvantaged in society will save huge sums but protect those who need it most.

Funds from savings created by efficient, equitable redesigns of the welfare system should be used to instigate a public works programme to facilitate a transition to a new industrial economy and restore the productive capacity of the economy. There are plenty of private sector projects in the pipeline that could be quickly undertaken given government funding. For example, as mentioned by Gerald Holtham, there is a private consortium willing to build the Severn barrage, a multi-billion pound scheme to supply 5 per cent of the UK’s electricity needs, given some guarantee on electricity prices. Investment spending could be rapidly deployed on schemes such as toll roads, that produce a revenue stream, and to support the UK’s broken housing market. We face a chronic shortage of housing in this country. The number of people waiting for social housing rose by 4.5% in 2010/2011, with 1.84million on the list in April 2011. Supporting investment in the housing stock would have huge social value and give a boost to the construction industry.

Further, funds could provide an initial capital injection to a small business bank or increase the scale of the coalition’s green investment bank. A new small business bank could make use of existing agencies to allocate and dispense the loans, offering them to small businesses at low rates, potentially concentrating funds in areas of especially afflicted by unemployment. The focus on small businesses should prove especially affective at job creation given research funded by the Kauffman Foundation showing that all net new private-sector jobs in America were created by companies less than five years old.

A middle ground exists

We need to move beyond the unnecessarily polarised austerity-growth debate. Casting these aims as mutually exclusive is misleading and unhelpful, contributing to policy inertia and unnecessarily limiting debate on how we achieve fiscal consolidation. Action must be taken to improve the UK’s growth prospects. The fact that we simultaneously want to get the public finances under control does not imply nothing can be done. The government’s hands are not fully tied, it must use them.

Incentive Pay in Education

Comment on the podcast by Professor Hanushek for Sense and Sustainability.

Here are some of my thoughts on a podcast on the economics of education given by Professor Hanushek to Sense and Sustainability. They’ll be going up on that site soon but for the moment read on if you’re interested…. Check out the S&S website and podcasts too. There’s some brilliant stuff on there.

In his podcast on Monday, Professor Eric Hanushek extolled the merits of incentive based pay in education. This post critically reviews his claims, arguing that, although raising the quality of teachers is a key challenge for policymakers, performance pay is not the most effective mechanism for achieving this end. The nature of teaching jobs should be transformed, rather than just their pay. Channels for career development within the education system should be created as a means of attracting the most ambitious, able individuals. Employment contracts must also be reformed to remove poor quality teachers from classrooms, quickly.

Teachers matter but how much is not clear. Hanushek starts from the premise that teacher quality matters for educational outcomes. On the face of it, this claim is uncontroversial. However, the quantitative significance of the effect is not as clear as presented. There is debate surrounding the robustness of figures such as those presented by Hanushek. Firstly, defining and measuring teacher quality is hard. The attributes associated with being a great teacher are multidimensional, diffuse and largely unmeasured, which clearly creates difficulty for researchers. Second, good quality teachers are likely to be attracted to the ‘best’ schools, with bright students from supportive backgrounds and other favorable institutional features. Studies thus risk confounding the effect of teacher quality with other “good school” features, overestimating the magnitude of teachers’ impact. Yet, saying this, arguing that outcomes are independent of teacher quality is going too far. Studies that use variation within individual schools still pick up positive impacts of able teachers and common sense tells us that there is going to be some kind of link there. It should be known, however, that the strength of this link, and thus its policy salience, is by no means clear empirically.

Incentive pay to improve selection Taking as given that we should raise the quality of teachers to improve educational standards, how should governments do this? Haunshek argues that incentive pay schemes will help. One can consider two broad mechanisms via which this reform may be beneficial. First, motivational: incentive pay could induce greater effort on the job, making for better teachers. This is a dead-end, as Hanushek concedes. Quality in teaching among those already in the profession is at best negligibly affected by monetary incentives and at worse inversely related. Given that performance in education multidimensional and difficult to measure, tying pay to easily observable indicators such as test scores comes at the risk of distorting energy and attention within the classroom, ultimately making for a less conducive learning environment. Think greater ‘teaching for the test’ as a probable consequence.

Rather, Hanushek argues that the dispersion in rewards induced by incentive pay will induce selection of higher quality teachers into the profession. Incentive pay won’t do much for those already in the job but by paying more, and having greater differentiation in pay levels, it is thought we will attract a different kind of person into teaching. Hanushek states that the independence of pay and performance implies teaching is not thought of as a “profession” in the usual sense. Teachers do not face the same pressures of responsibility and accountability forthcoming in other careers, which puts off the most able candidates. Implicit in his argument is the idea that responsibility and recognition flows from differentiated rewards. It is then these job factors that make it more likely that able individuals will decide to become teachers.

Alternative ways to attract the best. However, pay differentiation is neither a necessary nor a sufficient means of making teaching “a profession” and attracting top people. Rather than focusing on pay, I believe it is more profitable to consider transforming the structure of the job itself, building in more channels for career progression and space for personal responsibility. My perception is that, currently, if you are a teacher the broad nature of what you do day-to-day doesn’t change much over time and it is this that is off putting to top graduates; the idea of career progression is attractive for many. Thinking creatively about how to formally build in opportunities for postgraduate study and develop interactions with government and the development of wider education policy will help to attract the most ambitious. Transforming pay alone cannot turn teaching into a profession in the sense described by Hanushek.

Further, although incentive pay is inappropriate in this context, performance evaluation is still obviously important in education. However, what we are measuring should change. Rather than using output measures, such as test scores, to evaluate teachers, more emphasis should be placed on “input” measures to raise teacher accountability and ‘ownership’ of their job. Moving away from simply looking at attainment to consider classroom atmosphere, pupil feedback and the quality and innovativeness of lesson plans should foster more imaginative teaching and greater responsibility, again making for a job which appeals to more ambitious individuals.

Raising average quality involves removing poor teachers from the classroom, in addition to attracting the best.Thus, employment contracts in teaching must be transformed. As Hanushek notes, evidence suggests that one’s ability as a teacher stays relatively constant over time. Either you’re good, or you’re not. The use of short term employment contracts in the early years of a teacher’s career thus seem like a good way of removing those at the bottom end of the quality distribution from the classroom quickly.

In conclusion, incentive pay in education is neither necessary nor sufficient for raising teacher quality. Rather than focusing on pay, I believe a creative transformation of teaching jobs, to explicitly build in greater responsibility and career progression to other spheres within the education system, is a more direct and profitable approach. More effort should be deployed considering how best to redefine teaching jobs themselves rather than their pay structure.

Something for Nothing? Understanding Executive Pay

Critiques of executive compensation don’t have to center on fairness, although, clearly, this is an important concern. Current remuneration levels are a product of market failure and executive capture of the pay setting process and can be attacked on efficiency, not just equity, grounds. However, direct regulation of wages via maximum rates or restrictions on the ratio of highest to lowest are not the way forward. Radical restructuring of the structure of executive pay and how it’s reported are achievable goals, with potentially far reaching consequences. The government must act to reduce the salience of phony “performance pay” deals and increase the bite of the ‘outrage constraint’.

To infinity and beyond

The staggering level of executive pay hit the headlines last week. Commentators were ablaze at the news that the boss of RBS, a nationalised bank, was awarded a bonus (which he declined yesterday) of just under £1million. Actually, a focus on this bonus somewhat misses the point as it misrepresents the true scale of his salary. The Independent report that Hester’s total remuneration could reach a phenomenal £50million in the next few years conditional on RBS’s share price so, in the grand scheme of things, a £1million bonus isn’t the big issue here.

However, singling out individuals or just focusing on “the bankers” underplays the extent of the issue. Executive and CEO compensation has been hurtling to heaven since the late 1980s. Average CEO compensation for the top 500 firms in the US more than quadrupled over the 1990s. Some UK bosses earn over 1000 times the national median wage. In the last year alone, a time of stagnant growth, executive pay in the FTSE 100 rose on average by 49%, compared with just 2.7% for the average worker.

Yet, such comparisons and figures may be misleading. Firms have got much bigger over the period, many (until recently) performing much better. The structure of our economy has also been transformed.  One needs to correct for these changes to ensure we are comparing ‘like with like’ across time.  However, controlling for factors such as firm size, industry classification and firm performance relative to industry average, still leaves us with staggering rises in average CEO remuneration to account for. For example, Bebchuk and Grinstein (2005) calculate that had the relationship between such factors and CEO compensation stayed constant in the US over the 90s, compensation would have only risen by half as much as what was actually witnessed.

Something for nothing?

How can these rises be explained? Justified? The orthodox view sees pay setting boards operating at “arms length” from executives, setting their pay to maximize shareholder value. Pay is set to attract and retain the best people for the job and provide the right incentives. Under this view, we’d have to look for things like big changes in the added-value of executives, the ‘cost’ they face in doing their job and the size of their ‘outside option’. However, extensive research indicates that none of these factors can account for the scale of growth witnessed. Efficient market mechanisms are not the main engines driving the growth of high pay.

The incorporation of large performance related payments has been a big contributor to the executive pay flood. In 2010, the median bonus for maximum performance of a FTSE 100 executive commanded a bonus worth 150% of basic salary. Stock options have become a central feature of remuneration packages without any offsetting adjustment of cash based compensation.

Linking pay to performance is motivated by what economists call the “principal agent problem” and provides a way of aligning the interests of agents, i.e. executives, to the owners of the company, i.e. the shareholders. However, strong incentive pay is only justified when, among many other factors, executive effort has a strong link to profitability, when high pay actually incentivises high effort and does not crowd out other “intrinsic” motivations or inefficiently distort executive attention. These requirements are not met in reality.

Experimental studies in behavioural economics and psychology highlight that high pay as an incentive mechanism is often counter productive. The link between explicit financial incentives and performance is tenuous at best, and negative at worse. As soon as tasks become complex, or even just marginally more taxing than ‘mindless’, financial rewards are consistently found to have a negative impact on overall performance. And this is the conclusion of studies coming out of Chicago and LSE, the ‘establishment of the establishment’, as Daniel Pink puts it.  Bonus culture has also been cited as a cause of dangerous short termism and unsustainable strategising. Furthermore, qualitative evidence suggests that those at the top are often motivated by things other than money. As the former CEO of Shell puts it:

You have to realize: If I had been paid 50% more, I would not have done it better. If I had been paid 50% less, then I would not have done it worse.

Even if there was a strong case for performance related pay, this wouldn’t justify the size and structure of current pay packages. “Performance” elements in current packages are actually largely independent of individual action. No attempt is made to discriminate between general rises in company value and those arising from the good governance of executives. Executive influence is likely to have played a large part in this. The extreme complexity of schemes and wide freedoms to unload share based incentives have enabled executives to obtain much larger amounts of compensation than more cost-effective plans would have ever provided. Incentive payments have largely been a smoke screen, making it easier for CEOs to justify excessive pay levels even though these performance schemes are fundamentally flawed.

Bloated pay is thus a product of market failure, not the consequence of efficient procedures designed to maximize shareholder vale. Executives have substantial influence over their own pay levels and board members have insufficient incentives to engage in unpleasant haggling over remuneration packages. Complicated compensation packages have been dressed up as well designed incentive schemes to make huge payments more palatable. In general, these schemes are not cost-efficient and overstate the true value of executives to their firms.

Slimming these cats down

Government action is required to get top pay under control. However, direct wage controls, such as specifying some maximum salary, are not the way forward. This instrument is too blunt, so would be grossly inefficient, and would damage the competitiveness of the UK economy given that other countries are not about to follow suit. Further, a maximum salary rate is politically infeasible and so energy is better spent exploring viable options.

The calls to raise shareholder control of the pay setting process are valid, although, unlikely to do enough. Data complied by a leading advisory body, Pirc, demonstrates that shareholders don’t currently exercise the rights they already have to curtail executive pay. Shareholders are increasingly hedge funds and overseas investors who hold shares for such a short time that they have no interest in the inner workings of companies. Their gains are likely to come via speculation.

Raising the diversity of remuneration committees will help to guard against ‘crony capitalism’ and compensate for weak shareholder discipline. The High Pay Commission recommends that employees from lower down the firm structure have an input into the structure of remuneration. I also feel that effort should also be made for other industry professionals, and potentially academics, to play a role in the committee.

In my opinion, radical restructuring of the structure of executive pay and how it is reported are achievable and potentially very effective ways of reigning in top pay. Compensation packages must be made simpler and be presented in a standardized format. Taking first the structure of pay packages, the illusion that bonus payments and complicated incentive plans actually live up to their names must be shattered and salaries restructured accordingly. Studies highlighting the bogus nature of most performance plans should be bought to public attention. Pay packages should be restricted to contain only a single performance related element and that chosen performance measure should be in someway linked to the medium or long term health of the company to try to break the chronic short termism infecting many head offices. Enforcing a simplification of salary structure will also limit the role of compensation consultants, whose advice has been cited as a cause of the increased complexity of modern remuneration packages.

Public outrage and pressure from workers lower down the company structure can only be effectively generated with adequate information. This “outrage constraint” is an important curb on top pay but it has been weak over the last few decades, muted by the smoke screen created by complicated, ineffectual incentive plans and the rising stock market. The stock market boom has provided a convenient justification for pay inflation even though a firm’s stock market value is only weakly (if at all) linked to its earnings and performance and the actions of its executives. Steven Hester’s bonus refusal is evidence that transparency and public pressure can initiate change. The High Pay Commission found attempts to actively “camoflauge” salary packages, with ever more complicated pay arrangements often buried in the depths of impenetrable reports. It has not been easy to find out how much executives actually bring home. Simplifying pay packages as I’ve argued above, combined with a requirement of standardized reporting will make it easier for public outrage to be created and directed at excessive, unjustifiable pay deals. Further, publishing the ratio of median to top incomes should be a legal requirement for publically listed companies. The new economics foundation report covers this consideration in great detail. Making executive pay and its divergence from that of the average company worker will raise the salience of top pay in public discourse, helping to curtail capture at the top.

In conclusion, executive pay is not the product of an efficient market. Performance payments are red herrings, not structured to optimally solve ‘principle agent’ problems but to line individual war chests. The level of pay should not be regulated, but its structure should. Packages must be simplified and their reporting made more transparent. These reforms are achievable and should be swiftly enacted.

Budget and Trade Deficits 101: Two Sides of the Same Coin

The economics behind trade and budget imbalances applied to the Eurozone crisis. 

In my last post I argued that fiscal profligacy is too highly stressed as an underlying cause to the Eurozone crisis. Rather, deep rooted differences in  productivity and competitiveness have resulted in divergent trade balances and public finance disaster zones. Why have trade imbalances contributed to a government debt crisis? What does a single currency have to do with it? Let’s see….

Setting the scene

Many Eurozone countries’ budget deficits are astronomical, incomprehensibly large. Despite all the hype, they aren’t necessarily shrinking. The Greek budget deficit continued to widen throughout 2011, growing to €20.52bn in the first 11 months of 2011 (a 5.5% year-on-year increase), as did Ireland’s, widening to €24.9bn in 2011 from €18.7bn in 2010. Further, it’s not just the problematic PIGS creating trouble: Belgium, Malta, Cyprus, Hungary and Poland are all waiting to hear if they face EU financial penalties to punish for the poor state of their public finances.

Trade figures highlight significant imbalances between Eurozone countries in the run up to the crisis. To talk of a common European trade experience is grossly misleading. The pattern of imbalances across the Eurozone in the period running up to the crisis was dominated by a few outlier countries: Ireland, Italy and Greece on the ‘negative’ front and Germany and the Netherlands on the ‘positive’ (see a relevant IMF paper here). Helping to convey the power of German export machine, the WTO estimated the value of German exports at $1.334tn in 2010, placing them second in the world behind China. This is more than double the value of UK exports and 60 times larger than those of Greeks. (See the following graph from this FT article and this IMF analysis for more data and graphs).

Trade imbalances correctly identify the countries at the heart of the Eurozone crisis. Estonia, Portugal, Greece, Spain, Ireland and Italy had the largest trade deficits over the period 1999-2007. High trade deficits going along with dreadful public finances. A coincidence? No. Exploring the economics behind trade and budget imbalances highlights that the two are intimately related.

Talkin’ the talk: trade terminology

In the global economy, countries interact via trade in goods and saving/borrowing. The “current account” records the net effect of a country’s international trade, constituted of goods and transfer payments. More often than not, commentators simply refer to ‘trade balances’, which don’t incorporate transfer payments. Exports feature as positives, and imports as negatives in these accounts. Thus, a trade deficit denotes a situation where the value of a country’s imports exceeds that of its exports.

The “capital account” records the net effect of international financial flows. Foreign investment, purchases of domestic assets and foreign loans to a country all feature as positives; they represent flows of money into the national economy. Conversely, domestic investment into foreign markets and loans made by domestic institutions abroad features as negatives, representing flows of money out of a country. Thus, a capital account surplus refers to a situation where there is a net flow of funds into a country.

By definition, the balances of the two accounts are inversely related. Given a particular level of total output, any trade deficit must be reflected in inflows of money from outside the country (borrowing basically) to fund that deficit. This is shown most easily by exploring the national accounting framework in a bit of detail. It involves a few equations but there’ll be no more after this, promise!

Total spending in the economy (Y) is made up of what we, consumers, spend (C), investment (I), government spending (G), foreign spending on our goods, i.e. exports (X) minus what is spent on foreign goods, i.e. imports (M).

Y = C + I + G + X – M


Y – C = I + G + X – M

The difference between total income and what households spend, can instead be thought of as what gets taken away in tax (T) and what we choose to save (S). Thus,

S + T = I + G + X – M


X – M = (S – I)  + (T – G)


Current Account Balance = – (Capital Account Balance)

Thus, imagine we have a current account deficit, then the capital account balance must be positive, i.e. foreign funds must be flowing into the economy to fund that deficit.

How does the exchange rate fit into all this?

Take a step back from the Eurozone, to a country like the UK, which has its own currency. The current and capital account balances measure, respectively, the demand for, and supply of, domestic currency.

Take a current account surplus. Foreigners must acquire £s to pay for all the UK exports they are buying. The current account balance is therefore negatively related to the exchange rate. The exchange rate gives the relative ‘price’ of currencies. A depreciated currency (think cheap) boosts exports and limits imports, making for a more positive current account balance.

The negative of the capital account gives the supply of a currency. A capital account deficit represents a situation where money is leaving a country to be invested abroad. To be invested abroad, these funds need to be transferred into the relevant foreign currency. Thus, domestic currency must be supplied to the market in exchange for foreign currency.

So, for a country with its own currency, the net balances of the current and capital accounts determine the net demand and supply of currency and therefore the exchange rate at which its currency trades.

Budget and trade deficits: Two sides of the same coin

How can the build up of large trade deficits cause government finances to go awry? Imagine some country, getting along pretty well by today’s standards, without a government or trade deficit: taxes are just sufficient to cover government spending, and the value of imports equals that of exports. Oh, imagine such a country!

Then, the world changes. Other countries fall into recession, reducing their demand for our country’s exports. Assuming our demand for imports is unchanged, this would cause a trade deficit to develop: exports are now lower than imports. (Alternatively, one could think of imports rising relative to exports if, for example, another country starts producing higher quality goods or invents a new products highly demanded by our own citizens). Unless something changes, this widening of the trade balance will hit total demand in the economy resulting in lower national output and higher unemployment. To prevent this, or at last cushion the blow, the government could prop the economy up by running a budget deficit, pumping money into the economy to make up for the loss of exports, borrowing from abroad to fund this build up of debt (capital account surplus). Thus, a trade deficit can prompt a budget deficit, financed by borrowing from abroad.

If a country has its own currency, exchange rate movements can also occur to stabilize the economy, reducing the extent to which a government has to get embroiled in the situation. A trade deficit implies a fall in demand for domestic currency and thus one would expect an exchange rate depreciation to follow. This depreciation makes exports cheaper, boosting their demand, helping to close the trade gap and support domestic demand and employment.

Applying to the crisis

As stated above, it’s those Eurozone countries that ran sizable trade deficits in the years running up to the crisis who have seen their government debt explode.

Building up imbalances….

There are significant asymmetries in productivity growth across the Eurozone. German real wage growth (wage growth adjusted for inflation) has been much lower than the Eurozone average. In fact, it fell by approximately 20% relative to the Eurozone average in the period 1994-2009. As a result, the labour cost of output rose by a much less in Germany, 5.8% for the period 2000-09, than in its trading partners (equivalent labour costs in Ireland, Spain, Greece and Italy rose by roughly 30% in the same period). Production costs in ultra-efficient Germany are, therefore, much lower than those of its peers.

The Euro accentuated Germany’s competitive advantage. All Eurozone countries trade in the same currency but German goods are cheaper to produce, hurting domestic industries in the other countries that cannot hope to compete with these cheap exports. The trade balances of Eurozone countries have thus been following divergent trajectories: the German trade balance shooting up to the stars, while those of the Club Med descended further into the murky depths of the underworld.

…and funding them

As explained above, trade deficits imply that foreign funds must be flowing into a country and this is what we have observed. The majority of Eurozone governments’ debt is held by nonresidents. In fact, banks and financial institutions in the advanced European economies financed a large part of the build up of debt in the periphery as noted by Blanchard and Giavazzi (2002). BusinessWeek notes that German banks are on the hook for at least $250bn in troubled Eurozone nations’ bonds.

If each country had its own currency, trade deficits and excessive foreign borrowing witnessed would have put pressure on the exchange rate, helping to restore the export-import and borrow-lend balances between European states. For example, we would have expected to see the Greek drachma fall in value relative to the German Deutsche Mark, effectively raising the cost of German goods and helping to rebalance the European economy. This has not happened, allowing imbalances to get out of control and the single currency has also eliminated stabilization mechanisms which would have provided additional routes, other than higher government spending, to prop up the economy.

Missing the heart

Thus, although financial mismanagement and recklessness have had parts to play in the Eurozone crisis, fundamental structural imbalances between Eurozone economies lie at the center of the mess. The singular prescription of harsh fiscal discipline thus does not hit at the heart of the matter. Not even the stomach. Adjustment on the part of creditor nations is also required. At present there is nothing to temper the onset of austerity across Europe. All adjustment is being forced through by depression and default. This is far from efficient. Germany has benefited enormously from Euro membership, taking advantage of an undervalued currency and low trade costs. Others have not been so fortunate, shackled with an over-valued currency and the withering of domestic industries.

Can such adjustment and rebalancing be achieved? Can the Euro be sustained in the long run given the imbalances and limited mobility within its domain? Oh I wonder, I wonder….

To Be or Not To Be?

European leaders face an acute existential migraine this New Year. If only AlcaSeltzer could help them.  

Gone are the days when “greek spread” referred primarily to tzatiki and taramasalata. The eurozone crisis is now generally regarded as a problem with a solution “technically and politically beyond reach”. The evidence certainly supports this dour viewpoint. Fifteen summits, seven changes of government and five master plans later, we are left with precisely zero in terms of substantive achievements. €457bn of European government debt must be refinanced by April, thus few grains remain in the hourglass. In the near term, ‘now’ in other words, European governments’ must acknowledge that contractionary fiscal policy is, yes, contractionary and revise the quack medicine of austerity that is currently prescribed to assuage our economic ills. In the longer term, the failure of the neoliberal underpinnings to the Euro must be acknowledged and institutions redesigned accordingly….if democratic support for a fiscal union is forthcoming.

What started as “the Greek problem” is now a fully fledged “Europe” problem. The credit rating of the entire European Union, not simply those of the pesky PIGS, is under threat of downgrade. Output and employment remain depressed. August witnessed the largest monthly decrease in eurozone industrial production since 2009 and many are predicting a slide back into recession in 2012. Unemployment in the region has soared to a new euro-era high, reaching 10.3% of the labour force in October. Joblessness has remained highest in Spain, where a staggering 22.8% (!!!) of workers are without jobs.

Rebalancing, not retribution, required

The strategies currently pursued by Eurozone institutions either do not go far enough or are opposite to what is required. Further, faster fiscal tightening continues to be dictated. Only yesterday, Spain announced plans to cut €8.9bn from public spending in 2012. Amartya Sen, a Nobel laureate in Economics, described austerity in the current climate as a “snake” within the wider metaphor of the game “Snakes and Ladders”. It is getting us further from where we want to be.

Austerity continues to be prescribed because fiscal profligacy is too highly stressed as an underlying cause of the debt crisis. Inexcusably poor financial discipline, in part a consequence of the moral hazard generated by Euro membership (see previous post), clearly played a role in the Greek debacle, however, fundamental imbalances in competitiveness across the Eurozone cannot be ignored as a salient causal factor.

The health of government finances pre-crisis provided little clue as to which countries would be sucked into economic chaos. As Martin Wolf notes, “fiscal deficits were useless as indicators of looming crises”.  Trade imbalances, on the other hand, correctly identify the countries at the heart of the problem. Estonia, Portugal, Greece, Spain, Ireland and Italy had the largest trade deficits over the period 1999-2007. A trade deficit occurs when the value of what a country imports exceeds that of its exports. In contrast to these tales of woe, Germany has experienced an increase in its trade surplus since 1999. The asymmetries in competitiveness and economic strength between Germany and the ‘peripheral’ states really are stark. Joblessness in Germany has been falling for the last 2 years and the financial market turbulence that is wreaking havoc in many European countries is said to have had “little impact” on the country’s economy. In Europe it really isn’t a case of ‘all in it together’.

It is an accounting identity that a country with a trade deficit must be a net borrower in order to fund that deficit. Within the Eurozone, surpluses in Germany and the Netherlands were previously channeled through the financial system to fund deficits in others, i.e. Greece Ireland, Portugal and Spain. The credit crunch caused these channels to seize up, eliminating this flow of funds, and also initiated a collapse in private borrowing, prompting government deficits to go through the roof.

Acknowledging that deep rooted differences in productivity and competitiveness have played a role in the crisis, leads one to the conclusion that reforms cannot simply be piled on debtor countries. Retributive justice, in the form of harsh spending cuts, is misapplied as reckless profligacy has had but a minor role to play. Rather, shifts in external balances across the eurozone are called for. As one country’s trade deficit is another’s surplus, this calls for adjustment and transfers on the part of surplus countries such as Germany. It is reckless to hold deficit countries to pro-cyclical austerity without countervailing measures to boost import demand elsewhere in Europe. In the absence of demand and credit expansion in healthy eurozone nations, fiscal tightening will continue to have the same impact that it has had up to now: to prolong and intensify the downturn.

Furthermore, not only does ‘more austerity’ inadequately deal with the root causes of the crisis, it is also aggravating our woes and is thus ultimately self-defeating. The Keynesian “Paradox of Thrift” is relevant here. To reduce the size of a budget deficit, a government must increase the size of tax receipts relative to its spending. Governments’ have focused their energies on fashioning large reductions in government spending as opposed to playing around with tax receipts. Public sector layoffs and pay freezes, cuts to departmental budgets and welfare bills are thus the name of the day. However, such coordinated, fierce austerity across the Eurozone is hampering growth and recovery, reducing tax revenues by more than the cuts in spending. Thus, paradoxically, the current austerity measures are ultimately making it harder for governments to repay those dreaded debts .

Eurozone countries are facing an even harder time of it than the UK as, for these countries, there is no exchange rate mechanism through which austerity and low domestic demand can boost exports to their main trading partners. Further, as implied above, credit and demand expansion among creditor nations has not been sufficiently boosted to provide any countervailing force to the cuts made in the peripheral countries.

ECB to the rescue?

In short, the fiscal policy of eurozone countries is a disaster zone: off target and self-defeating. What of monetary policy, that concerned with interest rates and money supply? The ECB has raised its game in the last few weeks but, by only offering credit to commercial banks, has not done enough to pull Europe back from the brink. Basic interest rates have been lowered to 1% and unlimited cash offered to commercial banks for up to three years. These actions will help to alleviate short term liquidity problems in the banking system but will not have any noticeable impact on the real economy or the debt crisis. Banks are adding this additional cheap funding to their capital buffers, compensating for the losses they face on their holdings of government bonds and household mortgages. Therefore, very little of this additional cheap capital is being devoted to easing the funding pressures on households, firms and their governments.

The hope was that, despite only offering credit to commercial banks, these banks would in turn buy the bonds of European governments, thereby easing the sovereign funding crisis. This has failed to occur as commercial banks are unwilling to purchase further government debt. The European Banking Authority recently announced that European banks still need to raise €115billion in additional capital to offset the falling value of government bonds they currently hold. Unsurprisingly, it is the Spanish, Greek and Italian banks with the biggest capital shortfalls. Thus, the banks in the most financially fragile countries are likely to go to their governments for assistance rather than with fresh funds. The ECB’s current actions are thus unlikely to do much to ease the debt crisis: banks are still turning to governments to bail them out, rather than the banks bailing out the governments as was hoped.

Sideshow Summit

The last Europe wide effort to produce a grand plan was, sadly, another grand waste of time. It was attention grabbing for the wrong reasons, bringing the continent no closer to a workable resolution. The fallout between the UK and its European peers may have some unpalatable consequences for us but is really a minor pothole in the road to Eurozone recovery. David Cameron’s actions did nothing positive to protect the City, it will now be harder for EU rules to be negotiated in our favour, and served to marginalise us within the European Union.

However, Mr Cameron’s mistakes are a mere sideshow. Of much greater importance was the failure of European leaders to acknowledge the arguments above that imply the need for reform that is balanced across creditor and debtor nations. Rather tougher controls on budget deficits, written into individual country constitutions, were focused on, with no countervailing measures to boost demand and credit availability at the eurozone core. It was agreed there is to be no fiscal union, only greater fiscal discipline. Therefore, Europe remains decidedly doomed. This summit got leaders no nearer to a credible cure to the continent’s troubles.

A New Year’s Resolution?

A tourniquet must be quickly applied, and life support machine turned on, to prevent the death of the Euro. Leaders must immediately acknowledge that further harsh austerity is wrongly targeted and self-defeating. The focus must be on growth and reducing unemployment. Public sector layoffs must be put on hold and tightening strategies rebalanced to put more weight on tax rises. Effort should be focused on designing a stabilisation strategy that expands import demand and credit supply among those eurozone countries that can afford it, i.e. Germany and the Netherlands.

More fundamentally, the failure of the neoliberal underpinnings to the Euro must be acknowledged. The existence of pervasive market imperfections implies the need to transform the design of eurozone institutions, promote greater fiscal integration and change the role and mandate of the ECB. A single currency eliminates a number of stabilisation mechanisms for individual economies, creating the need for much larger wage and price movements to prevent recessions, especially given that labour and capital are far from perfectly mobile (see my previous post). In this imperfect world, fiscal union is the essential counterpart to a monetary union. Fiscal transfers can then provide a counter-cyclical mechanism to support regional economies in tough times. This is what occurs in the United States, with Virginia playing the role of Greece.

Further, the ECB’s role and mandate must be reviewed. The ECB is not simply independent of European governments, as the Bank of England is to our own, but is ‘detached’. There is full separation of central bank and government finances, with the ECB legally forbidden from buying large amounts of government debt. This again reflects the euro’s neoliberal birthright, subordinating fiscal policy and the role of the state to the market. The neoliberal school of thought sees the sole role of central banks as inflation control. In the future the ECB must be mandated to target wider aggregates than just inflation, unemployment a key indicator. Further, the full detachment of the ECB from the governments it is supposed to serve must end. One potential institutional solution is given by Thomas Palley, who suggests the creation of a European Finance Authority that issues collective Eurozone debt on behalf of member governments which the ECB could then buy.

However, it must be noted that closer European fiscal integration requires the mandate of European citizens. In the short term, the advantages of installing technocrats and making executive decisions outweigh the cost of temporary infringement of democratic rights. However, these rights must not be continually subordinated, especially when it comes to thinking about the future of Europe more generally. It is far from clear that the necessary support for a more integrated Europe is there. Populist parties are increasingly sceptical of the Europe project and extremist politics appears to be making a comeback in a number of nations.

I remain sceptical that there is sufficient support for the extent of fiscal integration required to sustain the Euro. In my opinion, a common European identity is insufficiently forthcoming to motivate popular support for a United States of Europe, especially given the build up of anti-Europe and anti-Germany sentiment currently occurring. The unbalanced prescription of austerity and the stark asymmetries in adjustment pain across the continent is fuelling resentment and riots. Without adjustment by creditor nations who have benefited enormously from Euro membership, unemployment will continue to rise and times toughen in peripheral countries. Without a fiscal union to accompany the monetary union, wage falls and large variation in growth will continue to be the norm. This is a far from ideal backdrop to popular debates on the future of Europe.

In conclusion, we end 2011 with no end in sight to the eurozone debt crisis. Proposed solutions will continue to be off target and inadequate so long as fiscal mismanagement is stressed as the root cause of our woes. Although the consequences of a eurozone break-up will surely be enormously damaging, so too is the continued, futile application of austerity. Especially given that, if leaders continue in 2012 as they have done up to now, a disorderly disintegration looks inevitable. Happy New Year!

It’ll be quiet around here for a bit

I will be away for the next month and so I’m unlikely to post anything new on my blog for a while.

When I get back I’m planning to write a post on China, the US and global imbalances. Keep an eye out if you’re interested!

Email me at if you’d like the economics of a particular issue explained and I will do my best in the future!