Europe is obsessed with the growing stock of public sector debt; fiscal austerity has become the watchword of our time. Little does it seem to matter that fiscal austerity means reducing aggregate demand, thus leading to economic stagnation and recession throughout the EU as all the main forecasts are now suggesting.1 Even the credit rating agencies are worried, as S&P’s downgrading of France and eight other countries shows. Whether it’s Angela Merkel or David Cameron speaking, public debt is denounced as deplorable, and all are told to get used to hard times. As Larry Elliot puts it: “The notion that economic pain is the only route to pleasure was once the preserve of the British public school-educated elite, now it’s European economic policy”.2
In Britain, immediately after the general election, the Tory-led coalition decreed that in light of the large government current deficit, harsh cuts were necessary to win the confidence of the financial markets. But although the current deficit was high, the stock of debt (typically measured by the debt/GDP ratio) was relatively low and of long maturity, the real interest rate on debt was zero (and at times negative) and, crucially, Britain had its own Central Bank and could devalue. As Harriet Harman argued in June 2010, Osborne’s cuts were ideologically motivated. The aim was to shrink the public sector, and the LibDems—fearing a new general election—chose to go along with the policy.
In the Eurozone (EZ), where a balance of payments crisis at the periphery has turned into a sovereign debt crisis, the German public has been sold the idea that if only all EZ countries could be like Germany and adhere to strict fiscal discipline, all would be well. The ultra-orthodox Stability and Growth Pact (SGP) has now been repackaged under the heading of ‘economic governance’ under which Germany and its allies will vet members’ fiscal policies and impose punitive fines on those failing to observe the deflationary budget rules to be adopted. Never mind the fact that indebtedness in countries like Spain and Ireland was mainly private, or that the draconian fiscal measures imposed on Greece have, far from reducing public indebtedness, increased it.
Is debt always a bad thing? In the private sector, obviously not since corporations regularly borrow money for expenditure they don’t want to meet out of retained earnings, while most households aim to hold long-term mortgages. Public debt instruments like gilts in the UK or bunds in Germany are much sought after by the private sector, mainly because such instruments are thought to act as an excellent hedge against risk. Remember, too, that when a pension fund buys a government bond, it is held as an asset which produces a future cash stream which benefits the private sector. So ‘public debt’ is not a burden passed on from one generation to the next. The stock of public debt is only a problem when its servicing (ie, payment of interest) is unaffordable; ie, in times of recession when growth is zero or negative and/or interest rates demanded by the financial market are soaring.
The question is when is debt sustainable? Sustainability means keeping the ratio of debt to GDP stable in the longer term. If GDP at the start of the year is €1,000bn and the government’s total stock of debt is €600bn, then the debt ratio is 60%; the fiscal deficit is the extra borrowing that the government makes in a year – so it adds to the stock of debt.3 But although the stock of debt may be rising, as long as GDP is rising proportionately, the debt/GDP ratio can be kept constant or may even be falling.
Consider the following example. Suppose the real rate of interest on debt is 2% (say 5% nominal but with inflation at 3%, so 5 – 3 = 2). That means government must pay €12bn per annum of interest in real terms. But as long as real GDP, too, is rising—say at 2% per year—there’s no problem since real GDP at the year’s end will be €1020bn. Even if the government were to pay none of the interest, the end-of-year debt/GDP ratio would be 612/1020 or 60%; ie, the debt ratio remains unchanged. By contrast, if real GDP growth is zero, the ratio would be 612/1000 = 61.2; ie, the debt ratio rises only slightly. The rule is that as long as the real economy is growing by at least as much as the real rate of interest on debt, the debt/GDP ratio doesn’t rise. Moreover, this holds true irrespective of whether the debt ratio is 60% or 600%.
But there’s a catch. In a modern economy, the public sector accounts for about half the economy. If a country panics about its debt ratio and cuts back sharply on public sector spending, this reduces aggregate demand and may lead to stagnation or even recession. When a country stops growing, financial markets decide that its debt ratio may rise and so become more cautious about lending and demand a higher bond yield (ie, interest rate). The gloomy prophecy of growing public indebtedness becomes self-fulfilling.
This is exactly the sort of ‘debt trap’ which faces much of the EU and other rich countries. The way out cannot be greater austerity. What works for a single household or firm doesn’t work for the economy as a whole. A household can tighten its belt by spending less, saving more, and thus ‘balancing the books’, but an economy cannot. If everybody saves more, national income falls. Of course, Germany and some Nordic countries can balance the government books because an export surplus offsets domestic private saving. But the Club-Med countries cannot match them. When no EZ country can devalue, to ask each EZ country to balance the books by running an export surplus is empirically and logically impossible. Even if all could devalue, what would follow is 1930s-style competitive devaluation.
The way out of the ‘debt trap’ is the same as the way out of recession: if the private sector won’t invest, the public sector must become investor of the last resort. It doesn’t matter whether new investment is financed by more government borrowing, quantitative easing or redistribution (some combination of the three would be optimal). What matters is growth.
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[1] See Joe Weisenthal http://articles.businessinsider.com/2011-11-10/markets/30380618_1_fiscal-consolidation-economic-growth-slow-growth
2 See Larry Elliott, http://www.guardian.co.uk/business/economics-blog/2012/jan/08/eurozone-crisis-angela-merkel-whip-hand?
3 See Paul Segal http://www.guardian.co.uk/commentisfree/2010/sep/03/government-debt-growth-unemployment
#1 by MrHappyMan on January 15, 2012 - 2:01 am
Thank you Sir, you have done a great public service today.
You have explained to me Economics 101 in layman’s terms. You have explained to me why austerity is inherently deflationary and the importance of growth in supporting an economy. Thank you very much.
#2 by Marcel on January 15, 2012 - 5:10 pm
Perpetual economic growth is impossible. Now there’s something you never read in all of the obsolete ‘economic theory’ books. Perpetual economic growth requires perpetual population growth (ie more people = bigger market) and thus perpetually increasing debt just to maintain the same living standard.
But there’s a catch, the space and the resources on the planet are limited, thus limiting the viability of the perpetual population growth model. It is said, that without modern mass agriculture techology, we’d only be able to feed 4.5-5.5 billion people, there’s your problem right there. And how about the current ‘western’ level of prosperity, can it be applied across the globe? Not if you factor in the quantity of resources available. And no, the rest of the world will not stand idly by letting us loot them (as we did throughout colonization) to maintain our prosperity at their expense.
The decline of the west is inevitable, and the most important thing about it is, it cannot be stopped. Period.
And of course, if you factor our government overspending, there hasn’t been any growth at all the last 5 years or so.
Is it possible that our economic model of ‘perpetual population growth’ has run its course? I believe it has. And its not just the debt, its the leverage too. And the blind desire by politicians to prop up the rich bankers at the poor peoples expense, to hand guarantees to thieving investors to be paid for by Joe Average. The western world is acting as a parasite upon this planet, consuming far more than is sustainable in the long run, its time that was ended.
#3 by Igor on January 16, 2012 - 11:38 am
I would agree with the author on this: there are sharp differences between Northern and Southern Europe, and so the answers of spending cuts in the North produce terrible results in the South. The solution should be government investment.
Now, the tricky part is “what is investment”. Because, coming from Portugal, I know what Portuguese politicians (and probably not only Portuguese ones) think is investment. They think that it is building roads and bridges and airports. Like in the 30′s. But it is not. A road doesn’t reproduce wealth, specially not when you already have plenty of them. It doesn’t even reduce unemployment, because Portuguese workers don’t build roads, immigrants do.
So, investment would have to be the government creating companies to produce goods (real wealth). And the implications (social, political, economical, legal even) of that?
#4 by partha shakkottai on January 21, 2012 - 5:14 pm
Deficits are good, surplus is bad and govt debt does not matter! For sovereign money governments which create money, the debt problem is a red herring. For example, if a person owes a mortgage of $350,000 on an annual income of $70,000 should he worry about his debt to income ratio = 5 yr ?The US debt to GDP is near 1 yr (100%). Japan’s debt to GDP is 2.3 years. Japan has paid off its real estate loss in 10 years keeping GDP constant with no austerity and USA should be copying Japan to escape a depression.
Income taxes play a minor role in macroeconomics. It has a role in income inequality and inflation control.
Govt “debt” is the same as private wealth. FACT! Two key equations in economics which apply to any system of govt:
a) Federal Deficits – Net Imports = Net Private Savings. For numerical proof see
figure 4 of http://pragcap.com/resources/understanding-modern-monetary-system
b) Gross Domestic Product = Federal Spending + Private Investment + Private Consumption + Net exports.
USA has no problem creating more dollars and solving the problem except for the dysfunctional congress and their economic ignorance and incessant “debt hysteria” by main stream economists, The GDP is equal to approximately 5 times govt spending. Actual data is in
http://pshakkottai.wordpress.com/2011/10/16/us-gdp-vs-govt-spending-2/”
I would like to know your views on the debt to GDP limit.
#5 by Bernard Clayson on January 22, 2012 - 8:42 pm
Why is government debt related to GDP?
GDP is not government income any more than an employers turnover is related to an employee’s debt.
It encourages spending beyond your income and passes the debt to the future.
The future has arrived with the baby-boomers, and I can’t blame the youngsters if they resent paying the bill.
Re: $350,000 mortgage on an income of $70,000.
It depends on whether his annual expenditure is $75,000.
Re: Japan, it also has a debt to GDP of 220%.
If debt does not matter, why is the global financial system grinding to a halt?
Simple, the investors are unsure of getting their money back i.e. haircuts and Greece.
Ditto with banks, they have lent money without calculating the risks, now they are doing what they should have been doing instead of flogging the risk to someone else.
#6 by partha shakkottai on January 23, 2012 - 1:32 am
GDP is the gross domestic product. Empirical data shows it is close to 5 G, the Govt spending. Govt creates money and makes the economy possible (barter is much less efficient). GDP = C + I + G + (X – M) , the sum of Consumption, Investment, G and net export. $350000 and $75000 are simply typical numbers for mortgages. The annual expense will be about 20% of this , similarly to GDP/5. A typical mortgage is paid off in 25 years. Why is the global financial system grinding to a halt? I would guess neo liberal ideology, not understanding monetary sovereignty, not talking about sectoral balances and thinking that govt debt is like personal debt. In the Eurozone debts do matter because of non-sovereignty. The problem is that all countries can’t have surpluses in (X-M) and austerity is forced on Southern Europe which can’t borrow Euros year after year. In any case 2.2yrs (220%) in Japan’s case is safe.
http://www.paecon.net/PAEReview/issue58/Koo58.pdf
#7 by Bernard Clayson on January 23, 2012 - 9:22 pm
Again, GDP is a countries turnover (which has been manipulated numerous times to cover governments debts) and it does not relate to government spending.
Correct accounting and budgeting procedures would list expenditure and income, that ratio is conspicuously absent.
Governments do not make money, they print it, the consequence of doing so deflates the value of the currency. An example is the US$, it is now worth about 4 cents compared to the value when the Federal Reserve was created.
Industry makes money, hence the much under-rated terminology – Base Industries.
I think it was Einstein who said “The only one who thinks infinite growth on a finite planet is possible is a madman or an economist”.
We have a finite planet and finite resources, we also exponential growth in population (350% in my lifetime) and exponential growth in consumption.
Keynes obviously did not understand the exponential function, neither do his disciples, the Club of Rome spelt it out in ‘Limits to growth’ in 1972, and its more recent update.
When any entity exceeds its ability to maintain a perceived lifestyle, it ‘pulls its belt in’, hence the ‘business cycle’, so which came first, the contraction caused by living beyond the ability to maintain that lifestyle, or the austerity measures?
Which is it, a cause or consequence?
Which raises another point, where is the economist who is prepared to go to a tent city and convince the occupants that debt is good?
Their debt, along with developers and free spending governments (buying votes) contributed to the growth of GDP which had to collapse, and it did.
#8 by Robert Atkins on January 25, 2012 - 1:43 pm
The truth is there are too many people making a living out of non productive work.
Nobody had the ability to save time and money in the past. Spend spend spend attitude takes priority.
If you took all the political clap trap and socialist good will thinkers out the equation.
You are left with a few people and member states manufacturing goods to make new money.
I think people of have forgot that the EU project was initially for Germany and France to trade coal and steel.
That made money.
Too many do gooders trying to re invent the wheel and line their own pockets in the process.
Lets face facts some member states are rich, the others that are not are desperately trying to fleece the EU to keep them afloat.
Why dont some of these EU liberal socialist thinkers put there hands in there pockets and bail out the countries like Greece.
Everybody is that well educated from and money making Uni in the Europe. They have forgot what makes money in the economy.
More austerity is needed. Everywhere right throughout society. Rather than using the credit card.
Why do member states have to pay anything into the EU at all ?
No one can give a very simple answer to that question.
Can someone show me a balance sheet for the EU signed off from a non European independent authority ?
Lets see some receipts as to who gets what from the EU budget. Lets see the expense sheets for all member states and departments.
How much money is wasted percentage wise ?
But as the flappy clappy people say, Love thy neighbour, some countries are quite happy to bankrupt others for keeping them afloat. As there own stupid politicians could not save one Euro between them.
If i were Mrs Merkel in Germany i would want to know what the hell the rest of the EU had been upto with its finances.
Lets have a Russian of Chinese head of the EU. Why not , the Queen of England is German.
Lets have an open door in the EU to the rest of the world please for anyone and everyone to trade without restrictions.
What have you got to lose, besides your job.
There is too many people out there telling you how you should be spending your own money. As they are they are quite happy to spend it for you given half a chance.
#9 by Josef Straka on January 27, 2012 - 7:08 am
Russian propagandist Khazin was right. If there was not Berlin wall demolition, this meltdown could hapen in 90′s.
The New Bible say a lot how it worx. The old testament of the New bible is called The Blood bankers. And the New testament is called Confesion of an economic hitman.
There is a tricky http://www.webofdebt.com
I just do not understand why folx R wasting time to write crap. To whom ye sold UR soul?
“The Central Intelligence Agency owns everyone of any significance in the major media.”
–William Colby, former CIA Director, quoted by Dave Mcgowan, Derailing Democracy
“You could get a journalist cheaper than a good call girl, for a couple hundred dollars a month.”
–CIA operative, discussing the availability and prices of journalists willing to peddle CIA propaganda and cover stories. Katherine the Great, by Deborah Davis
“There is quite an incredible spread of relationships. You don’t need to manipulate Time magazine, for example, because there are [Central Intelligence] Agency people at the management level.”
–William B. Bader, former CIA intelligence officer, briefing members of the Senate Intelligence Committee, The CIA and the Media, by Carl Bernstein
“The Agency’s relationship with [The New York] Times was by far its most valuable among newspapers, according to CIA officials. [It was] general Times policy … to provide assistance to the CIA whenever possible.”
–The CIA and the Media, by Carl Bernstein
“Senator William Proxmire has pegged the number of employees of the federal intelligence community at 148,000 … though Proxmire’s number is itself a conservative one. The “intelligence community” is officially defined as including only those organizations that are members of the U.S. Intelligence Board (USIB); a dozen other agencies, charged with both foreign and domestic intelligence chores, are not encompassed by the term…. The number of intelligence workers employed by the federal government is not 148,000, but some undetermined multiple of that number.”
–Jim Hougan, Spooks
“For some time I have been disturbed by the way the CIA has been diverted from its original assignment. It has become an operational and at times a policy-making arm of the government…. I never had any thought that when I set up the CIA that it would be injected into peacetime cloak and dagger operations.”
–former President Harry Truman, 22 December 1963, one month after the JFK assassination, op-ed section of the Washington Post, early edition
http://newworldorderreport.com/News/tabid/266/ID/980/33-Conspiracy-Theories-That-Turned-Out-To-Be-True-What-Every-Person-Should-Know-Updated-Revised-and-Extended.aspx
#10 by Josef Straka on January 27, 2012 - 7:13 am
Solidarity with Hungary – against EU dictatorship! The Orban government is punished for going against the international financial capital
Hungary shows that the old left-right distinction, which had to 1989/90, broadly speaking, their validity has outlived its usefulness. The government Orban, although nominally on the right has, de facto, the most decisive measures carried out against the financial capital of Europe – that could have been earlier described as left. Also for our libertarian friends Orban offers good lesson: It is started in the nineties, as neoliberal privatizers. Since he is in power, however, he used the state to interfere in the economy, in the best sense. The practice is still just the best teacher.
The Orban government has initiated three things that they have made a hate object of international finance capital:
a) a tax reform has decided that the foreign capital, especially finance capital, to fund more requests than domestic, manufacturing.
b) that by law the foreign banks that have in recent years, foreign currency loans given to Hungarian citizens, forced to renounce part of their debts, resulting only from the rise in the respective foreign currency (mainly Swiss francs) against the forint . This is really the best Keynesianism, for the benefit of the citizens!
c) the so-called independence of Central bank replaced by a real independence. This is good because the previous “independence” was only a mask for the uninhibited access to the Hungarian Central Bank, the ECB, which is the alienation of the Hungarian National Bank of Hungary’s national interest. Under the new law, the National Bank is still independent of government transfers, but their peak is defended on Hungary and its interest. A matter of course! The FAZ is outraged, however, that the swearing-in that conflict was not disputed that the Hungarian National Bank “is also a member of the General Council of the ECB” is. The EU and banking interests are for the Eurocrats to the national interest, and anyone who resists, how Orban is declared a rogue.
Current pressure on EU-Hungary, is that the country needs financial support from the EU after the international financial capital has withdrawn capital. . The EU, however, denied new loans. The argument that Hungary’s economy shaky, is threadbare: Hungary’s debt has risen in the last six months to just 82 percent of economic output, which is only slightly above the German level (c. 75%) and far below the Italian (125%) or even Greek (150%). The difference: Grichenland Italy and do everything that the international financial capital will, and by now have the appropriate Government. Orban but wants to remain independent.
All other arguments against the Orban government – human rights abuses, press censorship, threats to independent judiciary – on the other hand are not important. Not that the action at all is not true! But there are internal affairs of Hungary, who have foreign countries and the EU Commissioners to tackle anything. Who is stupid to understand is that although the Left, which incites diligently against Hungary, in cooperation with Springer Press, Brussels Politburo and London City.
http://juergenelsaesser.wordpress.com/2012/01/18/solidaritat-mit-ungarn-gegen-die-eu-diktatur/
Translated by google.
#11 by partha shakkottai on January 28, 2012 - 2:29 am
Reply to #7 by Bernard Clayson on January 23, 2012 – 9:22 pm :“Governments do not make money, they print it, the consequence of doing so deflates the value of the currency. An example is the US$, it is now worth about 4 cents compared to the value when the Federal Reserve was created.” You are explaining inflation. But govts create money. Money is merely a token to keep the game of economy running. Real wealth is production of desirable goods.
a) Federal Deficits – Net Imports = Net Private Savings is strictly true. Govt “debt” is the sum of all deficits and appears on one side of the equation whereas the private sector “debt” means negative savings. Govt deficit is the source of money. Maybe a new word should be coined for govt “debt”, say,” tbed” to avoid confusion.
#12 by Timo Kikonen on January 29, 2012 - 10:03 pm
Charges by a former board member of the Hellenic Statistical Authority (ELSTAT) that the government deliberately inflated the size of the 2009 economic deficit has prompted an investigation into possible wrongdoing and a criminal complaint that its former vice president, Nikos Logothetis, hacked into the e-mail account of the authority’s President, Andreas Georgiou.
Logothetis denied the charges and his lawyer said he was set up because he was critical of the board’s procedures.
Zoi Georganta, who, along with the rest of the board apart from Georgiou, was forced to resign by Finance Minister Evangelos Venizelos, told local media that ELSTAT, after being pressured by the European Union’s statistical agency Eurostat, inflated the 2009 revised deficit from about 12-13% to 15.4% to insure that Greece would have to adopt strict austerity measures to get a $152 billion rescue loan package from the EU, International Monetary Fund and European Central Bank.
http://bbs.chinadaily.com.cn/thread-715338-1-1.html
A few months ago we reported that unlike in any other Banana Republic, where the natural bias is to fudge one’s numbers higher to make the economy look better and get the stock market to rise, in Greece even the traditional banana metrics are upside down. To wit: “Greek newspaper Eleftherotypia reports that according to a just terminated member of the Greek Statistical Authority, Greece artificially misrepresented its 2009 15.4% deficit number to Eurostat in order to obtain aid from the EU and IMF.” Sure enough, two months later even this absolutely bizarre story has been confirmed. The FT reports that “The head of Elstat, Greece’s new independent statistics agency, faces an official criminal investigation for allegedly inflating the scale of the country’s fiscal crisis and acting against the Greek national interest.” Not surprisingly, the man who allegedly cooked the books is none other than a 20 year former IMF employee: precisely the kind of guy who knows just what buttons to push to get the US-funded organization to dole out capital. “Andreas Georgiou, who worked at the International Monetary Fund for 20 years, was appointed in 2010 by agreement with the fund and the European Commission to clean up Greek statistics after years of official fudging by the finance ministry.” And just because someone needs to be made a scapegoat, if convicted Georgiou may face the same sentence as Madoff: “Mr Georgiou is due to appear before Greece’s prosecutor for financial crime on December 12 to answer the charges. If convicted of “betraying the country’s interests”, he could face life imprisonment.” Well, that’s fine: the man should rot in hell for not learning that “minus” is not really “plus” – surely no greater ex-capital punishment crime exists. Yet we wonder – will the same life sentence follow all those others who are found to have betrayed their countries interest and inflated numbers higher thus not getting US taxpayer-funded bailouts? Because when it comes to Europe, it is now every many for himself (as the soon to be faded rumor du jour of a €600 billion IMF-funded bailout of Italy confirms)… all the way to Joe Sixpack’s wallet.
http://www.zerohedge.com/news/former-imf-employee-and-greek-statistics-head-faces-life-prison-if-found-guilty-making-greece-l