Tag Archives: deficit

Still waiting.

Posted on December 18, 2012 | Leave a comment

bored pugProgress is to the UK economy as words have been to my blog. Lacking. News on economic fundamentals, and the associated policy discourse, have consistently underwhelmed. Government concern remains fixed on the same, narrow goal of fiscal consolidation, with inadequate regard of how this consolidation is achieved. 2012 bears evidence to the claim that this concern is misdirected and that the derivative economic strategy is self-defeating. December has born witness to yet another downgrade in UK growth prospects and the rise of measured government debt has only been slowed by the inclusion of projected departmental underspends and the proceeds from the 4G license sales to projections. This post is a summary piece on the the state of the UK recovery and outlines the economics behind why the policies pursued to date have been unhelpful (at best).

The economy, …. 

The underlying picture remains much as it has been for the past two years: one of persistent weakness. Fifty shades of grey minus anything remotely stimulating if you will. The economy performed less strongly in 2012 than anticipated. The OBR cut its growth forecast to predict a 0.1% fall in output this year, followed by growth of 1.2% in 2013. Output is thus at roughly the same level as 2 years ago, 4% below that in 2008. This recession by now far exceeds the “Great Depression” in length. The graph below from the NIESR illustrates the point nicely.

Screen Shot 2012-12-17 at 18.27.43

It is unclear whether below par growth this year derives from “cyclical” (temporary) or “structural” (permanent) weaknesses. Cyclical weakness sits on the “demand side” of the economy– people and businesses just aren’t buying enough stuff–, whilst structural weakness is more pernicious and difficult to tackle, the result of a “supply side” contraction — we can’t make as much stuff. The two are related as cyclical weaknesses can be locked into structural ones via a process called “hysteresis” — see this post for more. There is disagreement as to how much of our current troubles to attribute to one or the other but, regardless, the OBR now forecasts systematically weaker economic growth for the coming years than it previously predicted in March.

Screen Shot 2012-12-18 at 11.00.08

Difficulties (understatement) in the Eurozone have continued to depress net exports and confidence. However, our lacklustre performance is by no means implied by the economic woes that plague Europe and other Western countries. Growth in the US and Germany has consistently dominated that achieved on these shores, and the UK pales in comparison to a host of countries in any ranking of capital investment.

And what of the lauded deficit reduction strategy? Despite (because of?) Plan A(usterity), good news isn’t forthcoming in this domain either. The size of the of the public finance hole is of a similar magnitude to that of 2011. However, even this underwhelming achievement is sullied by the knowledge that without the inclusion of funds from the one-off 4G licensing auction and the predicted “underspends” by certain government departments, the funding shortfall facing the government would have grown this year.

… stupid. 

In his Autumn statement, Osborne upped the dosage of existing prescriptions to cure the UK economy and added a few new measures to the mix. However, don’t expect a return to health soon. Policy remains inadequate and misdirected. There continues to be insufficient concern about the ends that sustainable public finances are supposed to advance. This has contributed to a lack of attention surrounding the composition of the policy mix conjured up on order to coax fiscal sustainability back to UK shores.

Just to remind ourselves, what is a budget deficit? When people talk about the deficit they are referring to the gap between what’s coming into the government coffers through taxes/other revenue sources (call this amount “T”) and what’s being spent (amount “G”).

Budget deficit = G – T

We care about the size of the budget deficit because of the impact that unsustainable public finances have on the economic prosperity of a country and the wellbeing of its citizens. It is not of value in and of itself to pursue low government borrowing (see this post for more on the cost of a deficit). Therefore, the obsession with fiscal consolidation is misguided and has resulted in a misdirected, overly narrow economic strategy. The size of the budget deficit is not the most salient economic ill plaguing the UK at present. If financial markets were overly concerned with the sustainability of the UK fiscal position, we would see interest rates rising with market risk. We have not witnessed this, the opposite in fact, suggesting that indebtedness is not the primary concern in financial markets (see this piece by Adam Posen, former MPC member, for more evidence on why reducing the debt should not be the top priority right now).

A blinding focus simply on the extent of the debt reduction required, without much regard to the how’s and why’s, has promoted a self-defeating economic strategy. The experience of the last 12 months is testament to this. Given that what we actually care about is general prosperity and wellbeing, we should aim for a deficit reduction strategy that protects these ends as far as possible. This demands a detailed analysis of the composition of spending and taxation changes, rather than just a pure focus on levels. This is because the austerity-growth dichotomy often presented in the media and by politicians is a false one. By reallocating government resources to activities with a high “fiscal multiplier” (to be explained!), growth can be supported whilst the budget deficit is reduced.

The Fiscal Multiplier

What does it mean to reallocate spending to activities with a “high 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 for someone that can be 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 for an 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. The introduction above was clearly overly simplified; there is not one fiscal multiplier but a set of them associated with different government programmes. Resources should be shifted to high multiplier activities and the burden of cuts should be disproportionately concentrated on those with low propensities to consume. To illustrate, imagine a balanced budget policy, that simply takes income from one group in society and transfers 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. This helps to highlight that through redesigning the austerity strategy to shift resources to high multiplier groups and activities, growth can be stimulated, and output protected, without a need to increase the debt burden.

The Autumn statement flirted with this principle by earmarking funds for capital spending and investment. These are potentially “high multiplier” activities given the employment and productive projects they facilitate. However, the scale of proposed new capital spending is insufficient. £5bn over the next two years. An amount that, at best, is expected to add 0.1% to GDP. Not exactly pushing the boat out… Secondly, and more importantly, the funding source for the proposed investments has the potential to undermine their (already small) impact. Cuts to welfare and tax credits will be used to fund these measures. However, such cuts will have a significant negative impact on demand in the economy given that they fall on those at the lower end of the income distribution. Such households tend to have a high marginal propensity to consume and little way of smoothing their spending. Therefore, the policy is largely funded by those who’s incomes the government should really be trying to protect if it is to be true to a multiplier guided philosophy. (Note that this is before any equity based arguments are even considered.)

A new voice

“For last year’s words belong to last year’s language

And next year’s words await another voice.

And to make an end is to make a beginning.”

— T. S. Eliot

In the next few weeks, I will write a number of more targeted posts on specific policy proposals and Eurozone developments. However, hopefully this post will have equipped you with some background knowledge on the economy and convinced you that a significant shift in economic strategy and dialogue is required in the UK. The singular focus on austerity has been self-defeating and has contributed to the prolonging the country’s economic woes. We’re long overdue a change in vision and vocabulary. The Autumn statement highlighted some appreciation of the arguments laid out here. In 2013, the government must go further to nurse the economy back to health.

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

Posted on January 8, 2012 | 1 comment

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

rearranging….

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

or….

X – M = (S – I)  + (T – G)

so….

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….

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Desperately Seeking Stimulus

Posted on September 20, 2011 | 3 comments

Plan B is for Bankruptcy? Bullshit. Bold, government backed programmes are needed to kick-start the economy and stem the jobs crisis.

No, we are not out of the woods. The green shoots of recovery still remain smothered by a thick layer of mud. UK unemployment rose to 2.51million people in July. That’s 7.9% of the workforce. A fifth of UK youths are now jobless. These dismal figures are a consequence of hefty falls in public sector employment and pathetic rates of private sector job creation, much lower than that expected by the Treasury and OBR. Furthermore, the UK ranked a pitiful 25th out of 27 countries for growth over the past year, only Romania and Portugal did worse. The Institute for Fiscal Studies shovels more gloom into the mix with the news that median net household income suffered its largest one-year drop since 1981 in the last financial year, battered by the real falls in earnings, benefits and tax credits.

These are not transient troubles. Martin Weale and co authors estimate that the current recession will be the longest since the war, highly likely to lead to a greater cumulative loss of value than the Great Depression. Martin Wolf in the FT argues that it is probable for the depression to last 72 months, making it 50% longer than its longest predecessor in a century. Furthermore, the singular focus on austerity across Europe will act to black out any light at the end of the tunnel. Cameron’s description of the current figures as “disappointing” is, therefore, a gross understatement.

You would think that the continued flow of feeble figures would trigger a revaluation of the current macroeconomic strategy. But no, “Plan B is for BANKRUPTCY” we are told, “The UK will be able to ‘weather the storm’”. Little convincing evidence has been supplied to support these claims. Despite all signals pointing towards a need for change, Osborne insists that no amendments will be made to Britain’s deficit reduction programme. Although Britain does need to make credible its promise to get the public finances in better shape, such policy inflexibility is reckless. We need to slow down austerity implementation to ensure that the scars this recession leaves on the economy are not deeper than need be.

The slowdown began with a collapse in economic demand. However, it is looking more and more likely that this will get locked in by a contraction of supply. A contraction in supply means that we will find it harder to produce ‘stuff’ at the same rate as before. That a fall in demand can feed into a permanent downgrade to our growth prospects is a phenomenon known as hysteresis by economists. If demand for a firm’s output is depressed for a prolonged period, machinery may be scrapped and businesses could decide not to follow through on planned investments. The chaos in the financial sector has resulted in credit being allocated inefficiently at the wrong cost. Others note that a worker’s productivity can be harmed by unemployment. If one is out of a job for a long time, workplace skills start to fade and you become less employable. In addition, the longer someone is out of a job, the more likely it is for them to drop out of the labour market altogether. For example, women may decide to stay at home, early retirement may become an option or that back pain that’s always plagued you may become a reason to seek different types of benefits.

All of this acts to depress the trend rate of growth that the economy can sustainably achieve and will ultimately make it harder to pay those dreaded debts. With slower growth, tax revenues will remain depressed for longer than the Treasury and OBR expected when making their budget projections. Preventing the temporary blemishes associated with recession from becoming permanent scars is of upmost importance.

Unemployment of all ilks is associated with economic and social ills but the current concentration of joblessness among the young and low skilled is something of particular concern. 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. For example, see the evidence in Gregg and Tominey (2005) for the UK and Mroz and Savage (2006) for the US. 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 for them, it’s not their fault that their birth date dictated they join the workforce during the worst post-war recession, as well as being highly damaging to the wider economy.

Furthermore, as the riots bought to attention earlier in the summer, unemployed youths facing a dearth of opportunity are not guaranteed to sit quietly. Unsurprisingly, increases in youth unemployment are associated with a range of social ills. For example, Carmichael and Ward (2001) found youth unemployment is associated with a statistically significant increase in burglary, fraud and forgery, theft and total crime rates. A third of NEETs agree with the statement that their life has ‘no purpose’. The social consequences of a large number of marginalised youths, who are assess their lives as purposeless, are scary to think about.

Some argue that government led job creation is a misnomer. They are wrong. The government has a role in supporting employment through this recession. Bold, innovative programmes are required to help ease the jobs crisis. Given the uncertainty and pessimism that currently clouds private sector vision and judgement, government involvement and financial backing are required to get them started. Technological change and globalisation imply that we also need to shift are thinking on how best to deal with the current labour market woes. Public works programmes represent one strategy to be explored but they are expensive and will create far fewer jobs today than they did in the past. Quoted in The Economist, the major of New York, Michael Bloomberg, notes that new government sponsored construction works will not solve the problem. “The technology is different. If you built the Hoover dam today, you would do it with far fewer people… The average worker standing in line for benefits tends not to be muscular.”

One new idea which I find particularly attractive is the creation of a small business bank. It could either be created through an initial injection of government capital or bonds funded by the Monetary Policy Committee and make use of existing agencies to allocate and dispense the loans. Credit allocation is currently a total mess. Banks aren’t lending to solvent businesses which need cash to invest and grow. If such a bank was set up, it could offer loans to small businesses at low rates, potentially concentrating funds in areas of especially afflicted by unemployment. This strategy has a number of attractions. Easing the funding restrictions on entrepreneurs and small businesses should help to kick-start innovation and growth while supporting employment. The focus on small businesses should prove especially affective at job creation. Research funded by the Kauffman Foundation shows that all net new private-sector jobs in America were created by companies less than five years old. Further, no one can turn round and say, “Oh, think of the benefits culture you’re creating”. This strategy is positive; it’s about supporting new ideas and existing businesses to thrive. In this way, the roots of the problem, as well as its consequences, are targeted.

Over the last few decades, a polarisation of the labour market into ‘lousy’ and ‘lovely’ jobs with little in between has been noted. Many routine manual jobs can now be coded up and performed by computers and machines. Other jobs are now able to be performed by individuals on the other side of the world. These hard facts need to be acknowledged by policymakers and reflected in the design of new labour market policy. Training and education systems need to be overhauled to reflect the new set of skills needed by employers. However, we also need to sit back and think through the consequences that these developments have for our vision of the modern job market. What can be done to best prepare individuals for the new world of work? How can we make the distribution of work more equitable?

These are hard questions but a few things are self evident with little deep thought. Slowing the pace of public sector redundancies will slow the rise in unemployment. Creation of something like a small business bank would not have to add to the public sector debt and could help propel the recovery forward. The government cannot afford to be complacent. A slower recovery adds to the cost of fixing their finances and creates long term hardship for many in society. The UK economy is Desperately Seeking Stimulus. Plan B is for Bankruptcy? Bullshit.

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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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The Cuts and The Riots: Not the Cause, Definitely Not Part of the Solution

Posted on August 10, 2011 | Leave a comment

Its plain lazy to blame the riots on The Cuts but they still present issues for the government’s austerity strategy.

The last few days have seen an unprecedented level of violence, looting and chaos on the streets of many UK cities. Trouble started on Saturday night when a peaceful protest against the police shooting of Mark Duggan turned violent after demonstrators were ignored and left outside the police station on Tottenham High Road. Since then looting, clashes with police and general violence has broken out across London and other UK cities. So far 768 people have been arrested in the capital, with hundreds more arrests being made around the country.

Links have been made between the violence and the austerity measures being implemented to bring down the UK budget deficit. For example, Ken Livingstone, the former London major, described the riots as a “revolt” against the cuts: “If you’re making massive cuts, there’s always the potential for this sort of revolt against that”. Internationally, commentary has also ascribed political motivations to the rioters, suggesting the violence and frustration can be understood as part of wider government resentment and anti-austerity feeling. See Ravi Somaiya in the New York Times as an example.

Blaming the riots on the cuts to public services and anti-austerity feeling is at best lazy. The factors leading to the chaos are many with complex interconnections and seeds sown far back in the past. Even citing the recent closures of local services, it seems unlikely that those kids looting JD Sports are also the one’s you’d find taking actively part in local youth programs. Rather than political riots, these are better described as some fucked up version of Supermarket Sweep.

But this doesn’t mean that the riots have nothing to tell us about modern Britain and the austerity strategy going forward. Although the riots themselves have not been undertaken to prove a particular political point, the behaviour witnessed over the last few days is that of the marginalised and disenfranchised. As criminologist, Professor John Pitts has said in the Guardian, “There is a social question to be asked about young people with nothing to lose.”

I agree that measures must be taken to close the deficit but this point alone does not justify the speed of the current tightenings nor the reliance on spending cuts. As I touch on in my first post, the economics points to the conclusion that the optimal UK strategy would involve more gradualism and a stonger focus on tax rises than the current coalition plans. I believe that current plans could slow the economic recovery, ultimately making it harder to get our finances in order, and create an environment for greater social unrest and unease. The government should revaluate its plans in the light of the riots and the UK’s continued lacklustre economic performance.

We need to slow down. The main argument for a ‘cold turkey’ approach to deficit reduction is to allay bond market concerns over the solvency of the economy, allowing interest rates to fall, stimulating the economy back to growth and prosperity. But interest rates have no where to fall right now and given all the craziness in the world at the moment, Keynesian warnings of the “paradox of thrift” appear justified. Today the Bank of England cut its UK growth forecast for 2011 down to 1.5% and UK output still remains below its level pre-crisis. I think it is unlikely and foolishly optimistic to expect the oft alluded to (less oft seen when its needed) efficient, lean, dynamic private sector to fill the gap left by cuts and thus expect that growth is going to remain slow and unemployment high for some while to come. You aren’t exactly going to create happy, healthy neighbourhoods in a climate of high unemployment, few prospects, limited social mobility with a government who doesn’t seem to care. Slowing the pace of cuts to better support the economy and stimulate job creation seems sensible to put it lightly.

Second, we need a more balanced strategy. Current plans are much more reliant on spending cuts than tax rises. Just considering the short run, economics suggests this isn’t the best as cuts are more likely to generate a large reduction in overall demand as tax rises may be smoothed to some extent (again see the end of my previous post). BUT this isn’t the only thing. The UK is an unequal society with limited social mobility. It is likely that many of those participating in the riots are marginalised from mainstream society and opportunity and are unlikely to have gained much in the boom years. However, low income groups will be hit hard by the welfare reform and cuts to public services which go along with deficit reduction. I’m not going to get into banker bashing (I don’t think that’s really helpful or appropriate) but an economic strategy which shifts pain towards those best able to take it is both fair and makes economic sense. The government can’t go on behaving as if its tagline is “Greed is good if and only if you’re in the top quintile of the income distribution”. Greed is a vice which brings out bad in each one of us and which capitalism doesn’t always channel into good outcomes. Greed played a role in sparking a whole host of deep underlying problems with UK society into the riots and its curtailment should play a key role in reducing the national debt.

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Gallery

UK Deficit 101: Explaining the Malady and Medicine

Posted on August 10, 2011

Oh hearing those fateful words: “Wait, you’re an economist! So what’s the deal on…..”.  I shudder at the memories. This blog is in response to a couple of people who’ve recently asked me to explain the background to some of … Continue reading →

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