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Austerity v Growth: A False Dichotomy

Posted on February 26, 2012 | Leave a comment

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.

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To Be or Not To Be?

Posted on December 31, 2011 | 10 comments

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!

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The PIGS Problem: Surprisingly Difficult to Cure

Posted on August 14, 2011 | 2 comments

Damned with austerity, damned if they don’t. What lies ahead is unclear… except a shortage of bacon. 

Despite the insane number of crazy news stories that 2011 has thrown at us, the column inches devoted to the Eurozone Crisis have proven surprisingly resilient over the course of the year. How has the mess developed and why is it going to be so difficult to resolve? (I should note here that I am heavily indebted to Dr. Christopher Bowdler, a tutor at Oxford University, for his absolutely brilliant lecture notes on this topic which have provided me with most of the theory outlined here).

What’s the story so far?

Let’s start at the beginning. The Euro officially came into existence on 1st January 1999, with Greece joining the single currency in 2001. Concern over the size of certain member countries’ budget deficits started to develop in April 2009, with France, Greece, Ireland and Spain all ordered by the EU to reduce the size of their budget deficits. However, by December 2009 the Greek debt burden had risen to 113% of GDP. Not even a near miss of the Eurozone limit of a debt-to-GDP ratio of 60%. This led the ratings agencies, who give assets a grade depending on how ‘safe’ they are perceived to be, to start downgrading Greek debt.

Things were only to get worse. At the start of 2010, Greek accounting (ahem) “irregularities” were discovered, resulting in the size of their budget deficit being substantially upward revised, from 3.7% of GDP to 12.1%. This was almost four times the maximum allowed by EU rules. The market started to get really worried about the country’s ability to pay its debt. It wasn’t so confident about the other countries mentioned above either. This led to rising interest rates on these countries’ government debt as the perceived likelihood of their default grew (see my first post for more on the mechanism). The Eurozone and IMF intervened offering financial support and loans to Greece and Ireland, and also Portugal by May 2011, conditional on the implementation of austerity measures.

However, for Greece, it’s May 2010 110bn-euro package was still not sufficient to quell investor fears. This may have been due to the difficulty/slow speed at which Greece was implementing it’s announced fiscal tightening. Further speculation surrounding the long term viability of Greek membership of the Euro (or lack of it to be more precise) led to the need for further financial aid. In July 2011, a further 109bn-euro package was unveiled which was designed to (hopefully) resolve the Greek debt debacle and prevent the crisis from intensifying and spreading to other countries. This package included measures to increase the amount of time Greece would have to repay it’s debts, reduce the overall amount that it would have to pay back (a selective default…. the phrase “a rose by any other name would smell as sweet” comes to mind….maybe the language is too beautiful for this context though) and created a role for private sector involvement in the bailout.

Despite initial rejoicing at the package, the storm quickly started to brew again with the EU President Jose Manuel Barroso admitting a few weeks ago that measures had not stopped the crisis from spreading. Italy, in addition to the PIGS, is now also the object of intense scrutiny and concern and the European Central Bank (ECB) has now agreed to buy Spanish and Italian bonds in an effort to reduce the interest rates that the market now demands. Last week, there were also rumours that France was the next to go under, with speculation over the possibility of a downgrade in it’s debt rating. Time to cue “Another One Bites The Dust”?

So to sum up, a sizable portion of the Eurozone countries are in financial difficulty. A lot. Bailout packages have not yet been deemed sufficient to quell investor fears and speculation about the future of the single currency. Interest rates on EU government debt remain high, making the whole situation worse and potentially making an even more severe crisis self-fulfilling. Its not yet clear what the outcome of all of this will be. Everything just seems to be all over the place at the moment.

So there’s the timeline. Now we can ask how this mess developed and why the Euro exists in the first place.

Why would you want to join the Euro anyway?

I mean, poor Estonia. Surely there must have been some pretty big plus points to joining for them to finally adopt the Euro this year. Talk about bad timing.

The main arguments for joining the Euro concern the lowering of trade costs and reducing exchange rate uncertainty. The elimination of these costs could, in theory, allow faster growth and greater prosperity among European nations. The advantages of membership were seen as especially relevant to Greece and other southern European nations. Growth via exporting to high income nations in northern Europe was thought to be more easily achieved within the single currency and there was a belief that the exchange rate stability bought about by conversion to the Euro would help these countries achieve inflation and macroeconomic stability.

Some thoughts on why things got Totally Out Of Control. 

We can break this down into two parts. First, what factors contributed to the huge growth in debt to GDP ratios among certain Eurozone countries. Second, how did membership of the Euro make stabilisation harder?

A. The growth in debt-to-GDP ratios

Government debt in the countries in trouble is high. Very high. However, this was  generally true even before they joined the Euro, partly because strong trade unions and political myopia in these countries contributed to sizable deficit bias. Global imbalances (more on this issue in the future) and the perception of Western macroeconomic stability resulted in very low borrowing costs prior to the financial crisis resulting in it being easy and cheap for governments to raise debt in line with GDP.

However, membership of the Euro has been cited as an underlying cause of high debt levels. Euro membership was thought to have raised southern countries’ growth rates permanently through the advantages above, implying a higher sustainable debt level, and also prevents currency devaluation facilitating cheaper borrowing. The second reason makes investing in these countries ‘safer’ as the value of one’s assets are more protected. Imagine I decided to invest all my money in Greece. Previously, the Greek government could have allowed the drachma to loose value relative to the pound, meaning that what I what I stood to get back from my investment would have been worth less in £ terms. I’d have been worse off and would have want some insurance, in the form of higher interest rates, to protect me from this. With only one currency, the control of which is largely beyond smaller countries, the risk of this currency devaluation is smaller, allowing borrowing rates to fall.

Some have also pointed to the moral hazard arising in currency unions. This is a term you might have heard in connection to the banking crisis. Moral hazard refers to a situation where my incentives to act change after we put our names to some contract. Note that this contract could be implicit– it doesn’t need to be written down, just implied. Membership of a single currency creates an incentive to, or at least removes a disincentive to not, relax about the whole fiscal responsibility thing. Membership creates a presumption (an implicit contract) that a country will be bailed out if they run into trouble with their finances because there is a strong common interest in action which preserves the viability of the Euro. This implicit promise reduced the incentive for Greece to take action to reduce its budget deficit and also lowered the risk to investors, as they knew they would get their money back, making borrowing cheap and easy for countries for whom it really shouldn’t have been.

B. Constraints imposed by the Euro

There are some significant constraints imposed by being a member of a single currency. These constraints have played a role in the current mess as European government’s have been less able to buffer their economies against the financial crisis. So how did Euro membership hinder stabilisation?

(1) Countries have lost the ability to change interest rates to manipulate their economies. They have no individual control over their monetary policy. Thus any stabilisation must be done via changes in tax and government spending BUT at the moment there is no way that investors would accept these countries initiating a widening of their budget deficits. So, there is little the government can do to help ease the pain.

In fact, all the countries in trouble are having to implement harsh austerity measures to get their borrowing costs under control. The Irish Republic passed the toughest budget in the country’s history and the Greek Parliament has also passed severe austerity measures. On Friday, Italy announced further tightening in an attempt to balance the government budget by 2013. Bailout finance has also been made conditional on promises to get debt positions under control. So, what we’re seeing are huge fiscal tightening’s across large swaths of Europe.

(2) With only one currency, nominal exchange rate movements between member countries have not occurred to help rebalance things. Other things equal, one would expect austerity measures and low demand in one country to result in a depreciation of their nominal exchange rate. This acts to makes exports cheaper, boosting their demand and helping to buffer the fall in government spending. Nominal exchange rate depreciation has been an important buffering influence in the UK. Sterling has depreciated by around 20% against the Euro over the last 3 years. The fact that these movements cannot occur quickly means that these countries are hit especially hard, probably harder than the UK, by the onset of austerity measures.

Given the above I’d be pretty nervous as an investor. All the signs suggest that growth among the PIGS is going to be slow…. for some time to come. Therefore, market participants are unlikely to get fully repaid. This has seen the interest rate that these countries can borrow at shoot up making the problem a whole lot worse as this makes the debt financing issue even harder (again, touched upon in post number 1)

What’s next? Oh, if only someone knew!

The outlook is not looking good to say the least. It remains uncertain whether the current bailout packages will be sufficient to impart just a degree of calmness in the markets or will even achieve the desired aims. Greece does appear to be fundamentally insolvent. It is unclear that the state will be able to implement the austerity measures required by the IMF and EU given the widespread social unrest and their sheer scale appears unachievable to me. Further, considering the importance of intracontinental aspects adds some more issues to ponder over. Harsh austerity policy in one country has impacts on others through the trade (export markets dry up) and the financial system (banks and institutions in other European countries will be exposed to their neighbours’ private and government debt and thus defaults in one country directly impose losses on banks in other countries), acting to intensify the slowdown in growth across the region. Thus, it seems to me that the degree of austerity required to quell market fears may actually end up bringing down other countries and thus not get us anywhere closer to a better place.

Basically, I have no idea what the hell is the best way forward. The PIGS are damned with austerity, damned if they don’t. Whatever happens, there will be a transfer of wealth within European countries towards the slower growing, heavily indebted nations either through explicit bailout packages or through the consequences of their default as banks in other countries hold PIGS government debt.

In my opinion, the Euro will not survive in the long term. I have no idea how an exit from the Euro will occur, or what its ultimate impact will be. I just can’t see how the union can stay a union without integration of EU fiscal policy and I don’t think there’s a strong enough European identity for people to be ready to do that. The Economist looked at the states in America which corresponded to the PIGS in Europe. There, huge internal transfers of wealth take place between states and this is possible because of a common fiscal framework and popular support which I take to be grounded in the commonality of values and national identity. Neither of these things are forthcoming in the Eurozone. Also, I don’t think that only ‘a few’ of those in trouble could exit as once outside the union their currencies could devalue, making them more competitive and making it worse for those troubled nations who stuck with the Euro. All or nothing?

There’s the background. No bloody idea what’s going to happen with this one to be honest. Hopefully though this has helped you to understand the background behind the news stories! Let’s see what happens this week……..

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Deficit Bias: Why We Need to Tie Politicians’ Hands….. Loosely

Posted on August 11, 2011 | 3 comments

A couple of people contacted me about the problem of the (lack of) credibility of government promises to cut the debt in the future. I didn’t give this issue enough space. This post should rectify that.

There are good reasons for a government to intervene in the economy during hard times to play a stabilising role. In fact, I don’t know of a theory in which one can cut government spending and raise taxes during a recession and leave output and employment unaffected. Keynes argued that market economies find it difficult to escape deep recessions and that monetary policy could only provide limited push in helping get the economy back on track. For Keynesian economists, a fiscal stimulus in the form of either higher government spending or lower taxes is a good idea during a bad recession. Actually, they’d probably say it was more than just a good idea. In fact, until the whole ‘Greek debacle’ the US and UK governments and even the IMF at times suggested that governments should play a role in recovery.

So lets just accept for the moment that there are good reasons for the government to run a budget deficit during a recession to help smooth out the dip. Then why is it that all we’re hearing at the moment is ‘Cut Cut Cut’? Why the switch from the presumption in favour of fiscal stabilisation to ‘austerity is the ONLY way’? Especially when we hear institutions like the Office for Budget Responsibility (OBR) saying that the austerity measures in the emergency budget last year would increase the risk of a double dip recession. To understand this we need to explore the concept of deficit bias. This discussion will also illuminate the motivation for creating the Office for Budget Responsibility and why both Gordon Brown and the coalition set themselves some rules over fiscal policy.

Deficit bias is basically the idea that it is difficult and painful for the government to reduce debt levels but very easy for them to say that they will in the future. In a recession a government should want to run a budget deficit to help buffer the economy against the storm. Then when times are ‘good’, the government should act to reduce the deficit. The stabilising has been done then. However, in these good times, tax rises and spending cuts are going to remain unpopular. Politicians don’t want to turn round with a smile to their voters and say “Right now everyone, its time for those taxes rises!”. Much easier to just ignore the whole debt problem. This leads to rising debt to GDP ratios. We observe this in reality. For example, among OECD countries levels of debt relative to GDP roughly doubled in the 30 years leading up to the recession for no good reason.

From my first post, you should (hopefully!) know that very high debt levels are to be avoided. There are costs. Investors start getting hot under the collar. This is why there are calls for austerity measures now. If the government could promise to put in place measures to bring debt levels down once the economy is out of the woods then we wouldn’t see the same budget as was presented earlier this year. The government faces a commitment problem. It would be best for everyone if Os-terity Osborne committed to reducing the deficit in the future. But this commitment isn’t deemed credible. So, they say, we must reduce the deficit now. In the middle of the deepest recession since the 1930s. Brilliant. We need someway of tying the government’s hands so they do actually cut the debt in the future, thereby allowing them to help us out now.

Luckily for us there are ways to mitigate this commitment problem, allowing for less cut throat austerity measures right now. I believe that the UK government needs to slow down in its mission to reduce the deficit. I am basically calling for the government to put its hands up and say ‘look guys, I’m going to mainly cut later….only a bit now’. Setting up the OBR and putting in place the new fiscal rules helps the UK government solve its commitment problem, making a promise to get the debt under control when things get less crazy more believable.

The OBR is an independent forecasting body, giving predictions of future growth and employment, assessing the plausibility of the figures which lie behind the government’s plans and evaluating the likelihood of the government meeting its self-imposed targets. Although not under its mandate at the moment, there have been calls for the OBR to also comment on the desirability of plans for deficit reduction and the like. Setting the OBR up in itself sends quite a clear message to investors that the government is serious about fiscal discipline. I mean, its called the Office for Budget Responsibility! The government could use the fact that the OBR forecasts and figures are independently calculated to build a bit of wiggle room into policy. Austerity measures could be staggered and implemented conditional on the speed of recovery and there could be no worry that figures were cooked to let the government off the hook.

Further, the government set itself two fiscal targets when it came into power: (1) to balance the budget 5 years ahead and (2) to have net debt falling by 2015-16. As we saw with the last Labour government, the fact that rules are stated doesn’t mean that they will be followed (that credibility problem again) but the fact that the OBR independently assesses the likelihood of these targets being reached reduces that risk.

Therefore, it seems to me a little odd that we are following the ‘Only-Way-Is-Austerity’ strategy at the same time as setting up an independent body that should allow us to slow the pace of cuts.

Let me ask you now, have I missed something?!

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