Posts Tagged budgetary policy

Europe’s debt trap

Posted by George Irvin in EU on January 14, 2012

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

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The Eurozone is already a transfer union

Posted by George Irvin in EU on June 1, 2011

Five years ago I wrote a book supporting the euro, but saying inter alia that Eurozone governance was fatally flawed and that a European Treasury was needed.[1] Although not taken very seriously at the time, this view has today gained wide currency. Like it or not, a US-style Treasury is needed to guarantee states’ financial system and to effect fiscal transfers within the Eurozone. Yes, the Eurozone is a ‘transfer union’ and the sooner the rich countries face up to this reality the better. The alternative could be collapse of the euro, followed by financial chaos.

Intra Euro debt: Claims between national central banks (£bn)


 

 

 

 

 

 

 

source: M Wolf, ‘Intolerable choices for the Eurozone’ FT, 31 May 2011.

In a series of excellent pieces in the Financial Times, Martin Wolf has spelled out a compelling case for fundamental reform.[2] The eurozone, Wolf reminds us, started life as a reincarnation of the gold standard. Eurozone member states were meant to finance a trade deficit by borrowing abroad; ie, by emitting their own central bank bonds. If markets were unwilling to buy these, a member-state would have no option but to find the money internally by means of a squeezing labour costs, or what is euphemistically termed ‘internal devaluation’.

There are two problems here. One is that squeezing wages may have an unacceptably high political cost. While it is true that cutting aggregate demand sufficiently will balance the books at some (very much) lower level of national income, the patient may stop breathing as a result. (For example, Ireland has now experienced four years of recession and the young are emigrating in droves.)

The second problem is the banking system. Since private credit died up after 2008, the ECB (and the Bundesbank) have acted de facto as the Eurozone’s lender of the last resort, both in buying the sovereign debt of the periphery’s Central Banks and helping Europe’s large private banks to do so. Indeed, the accompanying figure illustrates the unnerving symmetry between Germany’s position as chief central bank creditor and the growing indebtedness of the Eurozone periphery—unnerving because the Germans are indirectly financing the periphery through the banking system rather than through explicit fiscal transfers. Although this has helped peripheral states to weather the storm, what happens if peripheral countries default?

Many commentators (including myself) believe that some form of default is now inevitable[3]—but default could have dire consequences too. The insolvency of periphery governments would almost certainly threaten the solvency of debtor country central banks, leading to large losses for creditor country central banks (eg, Germany), which national taxpayers would need to shoulder. Doubtless this is a major reason for Signor Smaghi’s implacable opposition to default. And in the absence of support from the ECB and other creditor central banks, the threat of default by Greece or Ireland would hasten contagion and paralysis. Banks would not want to rink continued lending to any potential defaulter, credit would seize up and, ultimately, the existing financial transfer mechanism would collapse.

The options for the eurozone are narrowing. Either default will result in weaker countries leaving the eurozone—a lengthening list as contagion and financial collapse spreads—or the eurozone must undergo radical reform. This means tearing up the current system under which Greece and its banking system depend on selling sovereign bonds to the market and establishing in its place a Eurozone Treasury which would, like its US counterpart, guarantee the integrity of the Eurozone’s financial system as a whole. Needless to say, other key reforms would be necessary (true e-bonds, smaller trade imbalances) which I shall not dwell on here.

All this boils down to a single basic point: Europe already has a central bank ‘transfer union’, but it is under growing threat. Either Europeans bite the bullet and accept the need for true fiscal union and economic governance, or they can stand aside and watch the Eurozone disintegrate. Just as in the case of climate change, it’s too late to think that we can merely wish for the best and ‘muddle through’.

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1 See George Irvin, Regaining Europe; an economic agenda for the 21st century, London: Federal Trust, 2007.

2 See http://www.ft.com/cms/s/0/1a61825a-8bb7-11e0-a725-00144feab49a.html#axzz1O2IdJ0I6; also see http://on.ft.com/lCP0jT

3 See http://ftalphaville.ft.com/blog/2011/05/10/564346/roubinis-guide-to-a-greek-debt-restructuring/.

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The big bailout scam

Posted by George Irvin in EU on April 11, 2011

Suppose that my rich neighbour down the road mortgaged his mansion up to the hilt to bet on the horses, ran up millions in debt and asked me, an ordinary punter, to pay off his debts plus interest. Suppose that foolishly I accepted, and while I struggled to pay it off while barely able to feed my family and pay off the mortgage, my super-rich neighbour acquired an even bigger mansion. To make matters worse, he used all sorts of clever dodges in the Caymans to pay negligible taxes, while if I failed to pay mine I knew I’d be sent to prison.

It may sound like total madness, but that’s pretty well what’s happening to a growing number of Europeans (including Brits) today.

How did we get here? In Britain, the 2008 credit crunch produced a massive recession which played havoc with government finances. In Ireland the government took over the entire debt of its banking system, while in Greece, the rich paid minimal taxes and successive governments, unwilling to challenge them, indulged in creative accounting.  That’s somewhat simplified, but it’s the essence of the story.

Everywhere in Europe, voters are being told that decent pensions and universal welfare provision are no longer affordable and that we must all tighten our belts. Governments can no longer borrow because the credit rating agencies might downgrade their bonds. First it was Greece and Ireland, today it is Portugal, and tomorrow perhaps Spain, then Italy, and then … who knows?

But ordinary punters are starting to wake up. Instead of enduring years of economic depression, the Greeks and the Irish will probably have to default, as will the Portuguese if their economy reacts the same way to belt-tightening.[1]   And what if Spain has to be bailed out, still less defaults? That would spell a major hit for banks in Germany, France, the UK (and elsewhere), all of which could easily add up to another major financial crisis.

Are we really so vulnerable? The answer is indeed yes—-because so little has been done to address the underlying causes of the 2008 crisis.

While the recent Basle Three agreement requires banks to carry a slightly higher cash cushion, nothing has been done to re-establish the division between investment banking and commercial high-street banking, a division which disappeared with the repeal in the US of Glass–Steagall in 1999. Except for a temporary ban on naked short sales in Germany, the derivatives trade remains mainly unregulated.[2]  Credit default swaps (a form of insurance on risky financial products) are still sold over-the-counter rather than through an official market, the US President having failed to follow up his 2009 promise to re-regulate these.[3]

Meanwhile, the trillions poured into the big banks since 2008, instead of going to cash-starved small business or being used to build infrastructure and to create jobs, have largely helped fuel a new stock market bubble.[4] The extraordinary rise in the value of companies such as Facebook and Zynga provides a worrying parallel with the dotcom bubble of 2000.

Tax dodging is now a major growth industry—witness the latest GE scandal. As for making the bankers pay by introducing some form of Tobin tax, there’s been much talk but little action.

Perhaps most galling of all is the injustice of using Keynesian economics to justify the need for state intervention in banking bailouts while claiming today that the profligate state caused the problem, as politicians now argue in London, Brussels and Frankfurt.[5] How long will sensible people go on accepting this nonsense before venting their anger on our ruling classes?[6]

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(An earlier version of this piece first appeared at http://www.social-europe.eu/2011/04/the-big-bailout-scam)

1 http://www.bbc.co.uk/news/business-12864413

2 http://online.wsj.com/article/SB10001424052748703957904575252611852571860.html

3 http://www.cnbc.com/id/30731157/Regulating_Wild_West_CDS_Market

4 http://www.marketoracle.co.uk/Article19523.html

5 See Ha-Joon Chang, ‘The revival—and the retreat—of the state?’ Red Pepper, Apr/May 2011.

6 http://www.france24.com/en/20110312-300000-protest-job-insecurity-portugal

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UK Targeting Stagflation

Posted by George Irvin in EU on March 2, 2011

However circumspect Mervyn King may have been about raising interest rates in the Bank of England’s (BoE) quarterly inflation report issued in February, it is clear that the City wants him to do so. Indeed, judging from the fact that 12-month interest rate futures are now 1.4%, it is generally thought that there will be three to four quarter-point hikes over the next twelve months, while over the coming two years the rise may be twice that figure. One must ask, first of all, is such a rise justified by inflation; and secondly, if not, what damage will raising UK interest rates do?

The proximate cause of the problem is that the Retail Price Index (RPI) has jumped to just over 5% in the UK, mainly reflecting rising world food and energy prices, but also the effect of a sterling devaluation of over 20% in 2008 working its way through the economy as well as January’s VAT rise. Even the Consumer Price Index (CPI), which strips out housing costs, is rising at a rate of 4%, twice the BoE’s 2% target.

Of course, stripping out food and energy, core inflation is well below the BoE’s target, but inflation hawks would argue that several other factors must be taken into consideration. First, inflation is rising not just in the UK but in the US and the core Eurozone countries such as Germany and France, in part reflecting strong inflationary pressures in countries such as China and Brazil. Secondly, UK firms may be raising prices to recoup the profits lost during the credit squeeze, or even in anticipation of lower future profits. Finally, the fact that the recession has pulled down UK trend growth means that the weight of the structural deficit is all the greater;  ie, a return to (lower) trend growth would leave a larger proportional gap between public spending and receipts than would have been the case before the recession. On this view, the larger the structural deficit, the higher are domestic inflationary expectations.

The counter-argument goes roughly as follows. First of all, the main domestic culprits—devaluation and the VAT rise—are once-and-for-all events, so their inflationary impact can be expected to decline over time. Secondly, with regard to the key imported components, mainly food and energy, it is not so much a case of gradual price inflation; rather, these prices have exhibited strong fluctuations. Energy prices peaked in 2008, then fell and have now risen again; there is every reason to believe that they will fall again. And even if imported inflation continues to rise, raising domestic interest rates will not seriously arrest this rise. Thirdly, there is no sign of wage inflation in the UK economy—indeed, with unemployment at 2.5 million and rising, real wages are falling. Moreover, with the bulk of government spending cuts still in the pipeline, unemployment will rise (and real wages fall) further. This being the case, ‘inflationary expectations’ are groundless. As one academic colleague put it, ‘there has been no Phillips curve [expectations augmented or otherwise] in the UK for a generation’.[1]

Little wonder then that Mervyn King is being circumspect about raising interest rates when the prospects for UK growth are so poor and their impact on inflation is likely to be negligible. Nevertheless, it is equally clear that George Osborne wants higher rates and that the MPC, which has been dovish on the matter, is now split and edging towards hawkishness.[2] Such hawkishness will come at a cost. In the words of one commentator:

‘charts in the Inflation Report suggest the Bank now believes the UK economy must grow by about 0.25 percentage points less than it thought in November to avoid sparking inflation. That is a loss to economic output which accumulates by roughly an additional £4bn every year, making fiscal consolidation even more difficult.’[3]

Indeed, such a loss would come on top of the cuts. A recent report by the IMF suggests that, even if interest rates remain near zero, public sector cuts equivalent to 1.5% of GDP per annum over the next four years will subtract an equivalent amount from growth, or about £20bn every year.[4]

According to the IFS ‘green budget’, between 2010 and 2015, the UK is forecast to have the third largest reduction (behind Ireland and Iceland) in the share of government borrowing in national income among 29 high-income countries.[5] As Martin Wolf has noted, using the OBR’s latest figures, the implicit (compound) rate of growth of GDP between 2007 and 2015 is just 1.2% per annum.[6] And if interest rates rise in response to a perceived inflationary threat, the growth rate will be even less.

In a word, Britain under the Tory-led government faces years of not merely stagnation, but quite possibly of something worse: stagflation. Perhaps Monsieur Trichet at the ECB should be pondering the lesson for the Eurozone.

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*diagram source: N Cohen, ‘King denies interest rate rise certainty’ FT, 16 Feb. 2011
1 In private correspondence with Martin Hoskins.
2 David Blanchflower is more optimistic and believes the MPC will remain dovish; see http://www.newstatesman.com/blogs/david-blanchflower/2011/02/mervyn-king-growth-inflation
3 See C Giles, ‘Slower growth seen as inflation buster’, FT, 16 Feb 2011; http://www.ft.com/cms/s/0/3279a6ee-3a0c-11e0-a441-00144feabdc0.html#axzz1EDbJnmWK
4 See Duncan Weldon ‘The danger of spending cuts: some advice from the IMF’; http://duncanseconomicblog.wordpress.com/2011/02/15/the-dangers-of-spending-cuts-some-advice-from-the-imf/
5 See http://www.ifs.org.uk/publications/5460.
6 See M Wolf, ‘Britain’s experiment in austerity’ FT, 8 Feb 2011; http://www.ft.com/cms/s/0/5e5a6d1e-33c9-11e0b1ed-00144feabdc0.html#axzz1EDbJnmWK

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VAT and voodoo economics

Posted by George Irvin in EU on January 5, 2011

Whatever else can be said about the British Chancellor, George Osborne, he certainly does not lack chutzpah. His latest canonical pronouncement is that VAT (value added tax) is a progressive tax. For sheer guile, this statement must rank alongside Arthur Laffer’s famously misleading advice to Ronald Reagan that cutting income tax for the rich would actually increase tax revenue, a statement (rightly) dismissed by the then US Vice-President, George H W Bush, as ‘vodoo economics’.

How does Osborne justify his position? The simplest argument–as advanced on 4 January by the BBC’s flagship Newsnight programme–is that VAT is progressive because the poor pay less in absolute terms than the rich; ie, if  (say) you earn only £10 a day, the £2 you pay in VAT is far less than the £20 in VAT paid by somebody on £100 a day. Since £20 is greater than £2, the conclusion is that the rich ‘shoulder the heaviest burden’. Note that this holds true even if the rich man saves half his £100-a-day income, paying total VAT of only £10. The accompanying diagram illustrates admirably how to mislead the public with numbers.

That television presents data in such a manner says a good deal about the near contempt with which our elite view the average member of the viewing public, but never mind. More to the point, the above argument is just plain wrong. A progressive tax is one which takes a larger proportion of one’s income as income rises. This is true by definition. The principle that tax should be linked to the ‘ability to pay’ comes from Adam Smith’s Canons of Taxation in The Wealth of Nations (1776).[1] We accept as fair an income tax system based on rising marginal rates of taxation, just as we reject (say) a flat poll tax. Equally, we make the distinction between a direct tax (such as income tax) which is progressive, and an indirect tax (such as VAT) which is regressive, precisely because it is thought unfair to tax the rich and poor at the same flat rate.

When I was an undergraduate, Alfred Marshall’s Principles was required reading: Marshall, perhaps Britain’s best known neo-classical economist, famously set out the principle of ‘diminishing marginal utility of money income’—in everyday English, that an extra daily £2 is worth much more to a poor man than to a rich one.

Consider the example. If the rich and poor consume all their income, each pays 20% of income in VAT. But if the rich man saves half his income and pays only £10 in VAT, he pays out only 10% of his income. So where the rich save more than the poor, the proportion of income paid out in VAT is actually lower for the rich; ie, the tax is highly regressive.

So far so good, but apologists for Osborne don’t stop there. Rather, they roll out three further (and logically distinct) arguments. The first argument can be dealt with fairly rapidly. Because some basic necessities (food, children’s clothing) are VAT exempt in the UK, it can be argued that VAT is ‘mildly progressive’, a view apparently shared by Vince Cable.[2] But for this to be true, the share of non-VAT rated items as a proportion of the bottom decile’s income would need to be greater than the savings propensity of the top decile.

In the UK, the poorest 10% of the population spend about 15% of their income on food.[3] Look again at the above example. For simplicity’s sake, let us assume I receive £10 per day but that instead of paying £2 per day in VAT, I pay £1.70 (because only £8.50 of my daily income is spent on VAT rated items); the effective rate of VAT I pay is 17% of income. Now look at savings behaviour. Roughly speaking, in normal times the average British household saves about 7% of its total income; moreover, the higher your ‘financial capability’ (the richer you are), the more likely it is that you will save more.[4] So take our rich man who receives £100 per day; he can safely be assumed to set aside twice this proportion (or £15), spending the remaining £85 on which he will pay 17% effective VAT—no progressive element discernible there.

The second argument is that the above calculations depend on looking at the economy in ‘snapshot’ mode rather than considering the lifetime behaviour of economic agents. When people are young—so goes the argument—they earn little and pay little VAT, but as they get older and earn more, their VAT increases (and of course when they retire, consumption falls as does the VAT burden). But the counter-argument is simply that the lifetime consumption profile doesn’t matter. What we want to know is the likely impact of the VAT rise today and in the months to come. For example: a tax/benefit system which comprised a tax system with a personal allowance of (say) £10,000, a 40% flat income tax rate above this, a proportional VAT on all goods and no benefit system at all (including pensions) might be highly progressive in a lifetime incomes context, but it would also leave a lot of low-income people dependent on charities, or dead in the streets.[5]

The third argument is perhaps the most important, since it comes from the much-respected Institute of Fiscal Studies (IFS). IFS argues that instead of looking at the distributional impact of VAT as a proportion of income, we should take income net of direct tax and savings and look at VAT as a proportion of consumption. Of course, if there was zero household savings and direct tax across the income distribution, using such a measure would make no difference. But since the rich consume less than they earn (and the poor use their credit cards to consume more), the consumption pyramid is far flatter than the income pyramid. Combining this with the fact that the poor spend more of their income of zero-rated essentials such as food produces a mildly progressive VAT impact.

However, such an argument is simply disingenuous. As a matter of accepted convention, calling a tax ‘progressive’ depends not on looking at consumption propensities but rather (as Adam Smith argued) on comparing people’s ability to pay. The IFS has simply dragged out yet again an old argument about ‘not taxing savings’ since future investment depends on the ‘supply of loanable funds’, an argument disposed of long ago by Keynes but still echoed by the UK Treasury.

Let me leave the reader to ponder the apparent paradox that according to Tim Montgomerie, a leading right-wing blogger, four of London’s leading conservative think-tanks have now attacked the rise in VAT as a bad idea.[6] We should perhaps recall that although George H W Bush was a fiscal conservative who attacked ascendant neo-liberalism as ‘vodoo economics’, much of that same voodo is still picked over today.

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[1] See Book V, Chap 2, part 2.
[2] See http://www.libdemvoice.org/vince-cable-why-the-vat-rise-had-to-happen-20039.html
[3] See http://www.foodsecurity.ac.uk/issue/uk.html
[4] See http://www.cfebuk.org.uk/pdfs/CRS02_Financial_capability_and_saving_summary.pdf
[5] This argument comes from Howard Reed who is gratefully acknowledged.
[6] See http://conservativehome.blogs.com/thinktankcentral/iea/

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Could the euro disappear?

Posted by George Irvin in EU on December 1, 2010

Let me make it clear that I strongly support the euro; I’m a Brit who believes in European integration and who has little time for Euro-sceptics. But I can also see the writing on the wall. The euro—and with it the whole EU integration project—is in grave danger. It is entirely possible that in five years’ time, travelling from Paris to Berlin and thence to Madrid or Rome will entail queuing to change money and struggling through customs posts once again.

Why should the euro be in danger? After all, the Eurozone taken together is in quite good shape, considering the fact that we’ve been though the worst recession since the 1930s. The 16 euro-states’ budget deficit in 2010 as a percentage of GDP is 6.9% (versus 10.2% for the USA); the ratio of public debt to GDP is 84%, far lower than the US figure of 94%.[1] So what’s the problem?

The problem is the peculiar architecture of economic governance. Since tax receipts fall and spending rises in a recession, government deficits necessarily swell and must be financed by borrowing. Because the Eurozone has no federal treasury and cannot emit federal bonds, smaller member states whose domestic bond markets are too narrow must go to the international market to sell their own Eurobonds.

In normal times, member-states’ government bonds are considered a safe bet by the market. But as past financial crises show clearly, bond markets tend to be driven by the herd instinct; ie, once the rumour circulates that one country’s bonds are at risk, everyone joins in. This is commonly known as ‘contagion’, and there’s lots of it about today. Witness the fact that not just Greece, Ireland, Portugal and Spain are under threat, but in the past week Belgium and Italy have been added to the list.

The joint European/IMF bailout plan agreed earlier this year provided some €750bn (€860bn if Greece is included) in potential relief to afflicted countries—with plenty of nasty strings attached, one must add. The plan covers the period 2010-14, but the combined borrowing requirement over 2011-14 of Italy, Spain, Portugal, Greece and Ireland totals nearly €650bn and is growing. Add to this Belgium’s public debt of about €350bn, and the total is €1tr, far larger than the bailout package. The size of the package is unlikely to increase because of political resistance and possible required changes to the Lisbon treaty; per contra, what is likely to increase is the troubled states’ borrowing requirements. The financial markets have already done their sums, the main reason they are betting against the longer-term success of the rescue.

What are the options? First, Chancellor Merkel and President Sarkozy recently agreed on a sovereign debt default mechanism for troubled Eurozone countries thus forcing bondholders to share the bailout pain. Doubtless such a scheme will appeal to taxpayers and sacked public-sector workers alike, but as Paul De Grauwe has noted forcefully, legitimating sovereign debt restructuring makes speculative runs more likely, not less so; ie, the new mechanism increases potential turbulence.[2]

Of course, it is not just the troubled states that are being rescued; it is the major banks holding troubled Eurobonds that are in danger. Everybody knows—except apparently the German electorate—that when Germany ‘bails out’ Greece, the main beneficiaries are German banks (just as the main beneficiary of the recent UK ‘bailout’ for Ireland will be RBS). As ever, these are deemed to be ‘too big to fail’. To ensure their solvency, the European Central Bank (ECB) has been lending them money at a typical rate of 1 percent, money which is then on-lent to Greece or whomever in the form of bond purchases yielding 5 percent or more.

The problem here (quite apart from the big commercial banks making huge profits) is that the resources of the ECB are finite. It simply cannot conjure up another trillion euros if required. Of course it could do so by engaging in Quantitative Easing (QE)—a form of monetisation—but politicians think this will lead to inflation.

And here lies another trap. Although core inflation in the Eurozone remains very low, once energy and food are added back into the measure the rate goes up. In the next few years, food and energy inflation (both largely imported) are likely to accelerate. And if the ECB prints money, politicians—most of whom still believe in the simple ‘quantity theory of money’—will take the blame.

Finally, there is the fundamentalist solution preached by the deficit hawks: make all the ClubMed countries (including those not bordering the Mediterranean) cut their spending and balance their budgets! But there are two problems here. First, budget balancing might be feasible for one country when the world economy is buoyant, but in a world where the OECD economies are stagnating, asking many countries to balance their budget is not feasible. As a recent IMF study shows, ‘expansionary fiscal contraction’ is not the answer.[3]

So what is the answer? The answer is twofold: first, the ECB, not member states, should be able to issue Eurobonds, an idea which has recently gained limited traction. Secondly and more important, in the long term there must be a Eurozone Federal Treasury, akin to the US Federal Treasury. As the President of the ECB, Jean-Claude Trichet, said in the summer “Nous sommes une fédération monetaire. Nous avons maintenant besoin l’équivalent d’une fédération budgetaire” (Le Monde, June 1st).[4] He repeated this warning to a European Parliamentary Committee on 30 November.

To date, Europe’s political class has been unwilling to listen. They argue, inter alia, that Germany’ constitutional court would never cede fiscal sovereignty. Indeed, the tradeoff between monetary and fiscal sovereignty was at the heart of the Maastricht Compromise of 1992. It is most certainly not in Germany’s interest to allow the euro to flounder. Let’s hope Europhiles wake up before it’s too late.

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[1] See FT Alphaville 23 Nov 2010; http://optionalpha.com/european-national-debt-2010-as-a-percentage-of-gdp-9001.html
[2] See P De Grauwe ‘A mechanism of self-destruction in the Eurozone’ 9 November 21010; http://www.ceps.eu/book/mechanism-self-destruction-eurozone
[3] See http://www.social-europe.eu/2010/11/expansionary-fiscal-contraction-and-the-emperor%E2%80%99s-clothes/
[4] See G. Montani, ‘European Economic Governance and fiscal sovereignty’; http://www.thenewfederalist.eu/European-Economic-Government-and-Fiscal-Sovereignty

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The mistake of the century

Posted by George Irvin in EU on October 26, 2010

In Brendan Barber’s words, Britain has been experiencing a ‘phoney war’—living in anticipation of what the cuts might mean, without experiencing their reality.[1] Although high-profile academic economists, from Robert Skidelsky to Paul Krugman and Joe Stiglitz, have warned about the consequences of Osborne’s reckless gamble, it is only now that the results of the spending review have become official that one can begin to appreciate the irreversible nature of the deed.[2] It was David Blanchflower who put it most succinctly in The Guardian on 18 October: ‘The austerity package is likely to turn out to be the greatest macro-economic mistake in a century.’[3]

George Osborne has pursued his goal of emasculating the welfare state with unswerving determination and ruthlessness. What is more, according to a recent YouGov poll, nearly half the electorate believe that the last Labour government was responsible for Britain’s current economic plights—less than one-fifth blame the Coalition.[4]  Cameron et al have endlessly chanted the mantra of Labour’s irresponsible spending as the cause of the crisis, which flies in the face of everything we know about the origins of the banking fiasco, the OECD-wide recession following the credit crunch and the collapse of Britain’s fiscal balance which until 2008 had been reasonable.

The Coalition’s message may be totally at odds with most economists’ take on the need to react to an economic slump by stimulating aggregate demand, but Osborne has capitalised on the widespread belief that when times are bad, everybody—starting with Government—must tighten their belt. The Tories have put right-wing LibDems like Nick Clegg and Danny Alexander in key positions, marginalised Vince Cable and kept out the rest. It has been an object lesson in the realpolitik of the Thatcherite legacy.

There is a real sense in which Labour share the blame for all this. For a decade Brown boasted of his ‘fiscal prudence’, attempting to offset what New Labour perceived as the damaging legacy of its tax-and-spend image. The Brown-Darling response to the credit crunch was as Friedmanite as it was Keynesian, while the economic downturn which followed produced a puny stimulus package.[5]  Early in 2010, Alistair Darling caved into the IFS-led chorus of deficit cutters and proposed cuts ‘deeper than Thatcher’.[6]

Nor does the change in leadership appear to have radicalised Labour. Ed Milliband, sensitive to the accusation that he was elected by the ‘union bosses’, was visibly absent from the TUC rally against the cuts on 19 October. Alan Johnson, the new shadow chancellor, has little bark and no credible bite, while within the shadow cabinet the row continues over the proportion of spending cuts and tax rises in Labour’s own deficit reduction plan.[7]

In truth, the economic crisis presented both Labour and the Tories with an opportunity for radical change—an opportunity which Labour squandered and which the Tories were quick to capitalise on.

If Labour really had been a party of the left, it would have taken the bailed-out banking sector into genuine public ownership, re-introduced mutualisation, thoroughly reformed the tax system using the proceeds for public-led investment in sustainable growth and jobs, and reversed the creeping privatisation of public services. In Brussels, Britain would have called for an EU-wide stimulus package and backed improved economic governance and better financial regulation.

The single-mindedness with which the Tories have capitalised on the crisis to drive through draconian measures stands in stark contrast to Labour’s inability to seize the moment. In a decade’s time, history may judge Osborne’s cuts with the same disdain as it does the poll tax and similar Thatcherite policies. But by then it will be too late—Slasher Osborne will have killed the welfare state in Britain.

It goes without saying that there’s a wider lesson for the rest of Europe to draw about what’s happening in Britain.

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[1] See http://www.guardian.co.uk/politics/2010/sep/10/tuc-brendan-barber-spending-cuts

[2] See http://www.guardian.co.uk/commentisfree/cifamerica/2010/oct/19/no-confidence-fairy-for-austerity-britain; also see http://www.skidelskyr.com/site/article/the-wars-of-austerity/

[3] See http://www.guardian.co.uk/commentisfree/2010/oct/18/george-osborne-spending-review

[4] See http://www.guardian.co.uk/commentisfree/2010/oct/19/osborne-public-wrath-labour-blame-game

[5] See http://www.social-europe.eu/2010/08/running-a-permanent-fiscal-deficit/

[6] See Larry Elliot, ‘Alistair Darling: we will cut deeper than Margaret Thatcher’, Guardian, 2010; http://www.guardian.co.uk/politics/2010/mar/25/alistair-darling-cut-deeper-margaret-thatcher

[7] See http://www.guardian.co.uk/politics/2010/sep/26/darling-balls-labour-deficit-clash

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Cuts won’t work: the UK example

Posted by George Irvin in EU on October 17, 2010

As the Comprehensive Spending Review is unveiled in Britain, some of you will recall the recent Compass pamphlet, The £100bn gamble, of which I was a co-author.[1]  I’ve just read an exceptionally good short piece by Malcolm Sawyer, Professor of Economics at Leeds, which made me realise that the pamphlet did not pay sufficient attention to Osborne’s highly unrealistic assumptions about just how much the private sector is assumed to expand as the public sector shrinks.[2]  As the current plight of Greece and Ireland shows quite clearly, cutting public sector spending in the name of ‘sound finance’ could make things worse, not better.

To show how shaky the current budgetary assumptions are, Sawyer rightly starts with the basic national accounting identity for the ‘savings balance’:

Investment = domestic private savings plus domestic public savings minus the current account.

Why is the current account (CA) netted from the above? Because if a country is running an external current deficit (which is true for Britain just like the USA), it must be financed by a capital inflow from abroad; in economists’ jargon, such a capital inflow is known as ‘foreign savings’. So if you wish, you can replace the phrase ‘minus the current account’ in the above definition with the phrase ‘plus foreign savings’.

Table 1 below—which I’ve taken from Sawyer—shows the evolution of macroeconomic aggregates used by the Treasury to underpin Osborne’s position.[3] In particular, look at the bottom row which shows the percentage changes implied.

Britain’s problem at the moment can be characterised thus. While domestic private savings is (once again) positive, domestic public savings is negative (the budget is in deficit) while foreign savings (the current account deficit) is high. So if both the government and current accounts are to move to zero, export growth must recover strongly and private investment must shoot up by 2015 must match the pool of domestic private savings.

Table 1:  Key Macroeconomic aggregates 2009-2015 (figures in £bn at constant prices)

Year Household

Consumption

 General Govt Consumption Investment Exports Imports GDP

(mkt prices)

 Houshold savings CA= trade balance
2009 825.5 288.8 182.4 323.3 353.4 1264.6 62.1 -30.1
2010 827.5 293.9 196.6 337.2 373.2 1279.3 61.3 -46.0
2011 837.8 290.5 208.9 355.8 380.8 1309.2 61.1 -35.0
2012 852.1 284.8 225.3 378.1 391.1 1346.3 58.3 -13.0
2013 869.9 278.2 244.7 401.3 405.4 1385.7 55.5 -4.0
2014 888.9 269.8 264.1 424.8 421.4 1423.3 52.7 +3.4
2015 908.7 264.1 282.1 448.9 438.9 1462.0 51.9 +10.0
Change 2015/2010 81.2 -29.8 85.5 111.7 65.7 182.7 -9.46 40.1
%change 9.8 -10.1 43.5 33.1 17.6 14.3 -15.4

Source: Table 1.11 and Table 1.6 (and Table 1.3 for household savings rate) of Office for Budget Responsibility (2010), and calculations (for household savings) based on those Tables.

First, consider the current account. By 2015, it is forecast that the overseas trade deficit will have shrunk to near zero (ie, foreign savings will be negligible). For the period from the beginning of 2011 to the end of 2015, exports are assumed to growth 33% and imports by only 18%. The forecast for the current account in 2015 is the most favourable since 1983. This is totally at odds with the current trend. In the past decade, imports have grown faster than exports. Moreover, despite a nominal devaluation of 23% since 2008, export growth in 2010 was still negligible.

Next consider domestic savings. With the budget assumed to be in balance by 2015, government savings is zero. Household savings decline somewhat as a percentage of GDP. Although corporate savings do not appear explicitly, these can be calculated and their GDP share is seen to fall by about 10%. Such a result is important since corporate savings are such a large proportion of total domestic savings. But corporations have been busy ‘deleveraging’; ie, rebuilding savings. In reality, it is difficult to see why corporate savings would fall for the period in question.

Crucially, it will be seen that investment is assumed to rise by 44% between 2011 and 2015. UK gross Investment (including public investment) at present in slightly less that 14% of GDP: the Treasury assumed that it will reach over 19% of GDP by 2015. This is higher than at any time in the past decade, and is to be achieved despite cuts in public sector investment. The resulting annual GDP growth rate forecast for the period 2011-2015 is 2.7%, higher than the underlying trend growth rate in the past decade.

In summary, if private investment does not growth as rapidly as forecast, if export growth does not quickly outpace that of imports and if domestic savings do not fall enough, it will not be possible to balance the budget. This is not a matter of conjecture but of national accounting definitions. Moreover, as Sawyer’s piece rightly argues, since the probability of each of the above outcomes is not high, the probability of their joint occurrence is remote. George Osborne’s gamble looks problematic indeed!

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[1] See http://www.compassonline.org.uk/news/item.asp?n=11115

[2] See M. Sawyer ‘Why the structural budget deficit will not be eliminated by 2015’;  http://129.11.89.221/MKB/MalcolmSawyer/budget2010.pdf

[3] See HM Treasury (2010a), Budget 2010, London: The Stationary Office, HC61; also Office for Budget Responsibility (2010), Budget 2010:The economy & public finances– supplementary material

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Why Club-Med cuts won’t work

Posted by George Irvin in EU on October 4, 2010

It is conventionally assumed that the Eurozone crisis arose because Club-Med governments have been too profligate. If only they had been as cautious as northern European countries, the argument runs, they would have retained their export competitiveness. A recent carefully researched paper, popularly known as the RMF Report and compiled by academics at the University of London, SOAS, shows this view to be entirely without foundation. [1]

Inter alia, the Report investigates the relationship between Club-Med current account (external) deficits, government deficits and the countries’ total stock of debt. Club-Med governments have not been wildly profligate: Greece, Spain and Portugal all have government deficits lower than the UK, and with the exception of Greece, their net public debt-GDP ratios are running at 60% or less.

The key point, however, is that much of Club-Med debt is held by the private sector: nearly 90% of all debt in Spain, 85% in Portugal and over 50% in Greece. Moreover, less than half of all Spanish debt has been contracted abroad (in contrast to Portugal and Spain where the overseas proportion is much higher). Secondly, a far higher proportion of private debt is relatively short-term, meaning it will need to be refinanced sooner than much of the public debt.

In Spain, private profligacy has mainly to do with a sharp rise in private investment resulting from the housing boom. In Portugal and Greece, by contrast, private investment growth was much less important; in essence, private savings have contracted to finance rising consumer demand. Nor is there anything surprising in these patterns—until 2008, the UK experienced both a private housing boom and a private savings collapse to sustain consumer demand.

All-round austerity starting with government deficit reduction has become the official answer to the problems of the Eurozone. But as the case of Ireland demonstrates, severe cuts reduce aggregate demand and induce further economic contraction, thus lowering government revenue faster than expenditure.

The main argument used by Eurozone deficit hawks—since devaluation is no longer possible—is that public cuts will restore the competitiveness of Club-Med countries. Once again, the problem is that where everyone practices fiscal retrenchment, aggregate demand throughout the Eurozone contracts. Because so much of the Eurozone’s trade takes place within it (ie, is ‘intra-trade’), what may benefit one country taken singly cannot benefit all simultaneously. Competitive wage-cutting has much the same effect as beggar-thy-neighbour devaluation did in the 1930s. And with the poor performance of the US economy increasing competitive pressures in the rest of the world, Club-Med countries cannot easily increase net exports outside the Eurozone.

In effect, we face three possible Eurozone scenarios.[2] The first is a decade of very low growth and high unemployment all ‘round. The danger is that in a decade’s time, Europeans will be so thoroughly disillusioned with the European project that it will fall apart politically.

The second scenario is default—whether partial or full. A partial default or debt restructuring exercise will, minimally, involve losses for creditor banks in Germany and France and necessitate further bailouts. Maximally, debtor-led full default would lead some Club-Med countries to leave the Eurozone, entailing the possible demise of the single currency. Alternatively, growing German resistance to ‘bailouts’ and a serious falling out with Paris over its export-led growth model might lead Germany to quit the euro and revert to its beloved DM.

The third scenario is fundamental reform of the Eurozone: the establishment of a genuine European Treasury with a substantial budget and fiscal powers and reform of the ECB, starting with the emission of federal Eurobonds. It is becoming increasingly clear that if the euro is to be saved, this is the path Europeans will need to adopt. By contrast, universal fiscal retrenchment enforced by levying fines on ‘profligate countries’ fails to address the real issues. But will European political leaders listen?

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[1] See Lapavitsas, C et al (2010) ‘The Eurozone between austerity and default’, RMF, University of London, SOAS <http://www.researchonmoneyandfinance.org/media/reports/RMF-Eurozone-Austerity-and-Default.pdf>

[2] See http://www.skidelskyr.com/site/article/europes-debt-crisis-and-implications-for-policy/

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The Eurozone and the USA

Posted by George Irvin in EU on July 15, 2010

I’ve had a number of posts on my blog about my piece on Merkelomics. I shall ignore the one which says ‘all debt is bad’: has the person in question has ever had a mortgage?

Let me take the more serious point made by one commentator (Commentator ‘A’) who clearly wants to Eurozone to succeed—a sentiment I share fully. ‘A’ says: ‘I believe the fault in your analysis is that you don’t see the Eurozone as a national economy in the making. If you were, you would’ve realised that it doesn’t matter whether Eurozone exports originate in Germany or some other Eurozone country.’

My reply? I do indeed wish that the Eurozone were a national economy in the making and that I could praise the Germans for their export-led growth model. That German industry is admirably efficient I have no doubt (far more so than the UK). But perhaps I can best explain the case for Eurozone reform in the following manner. Below is a short ‘thought experiment’.

Let us assume—you can tell I’m an economist—that the contemporary USA were like the Eurozone, that there was little labour mobility, no Federal Treasury, that Congress was weak and that power lay almost entirely with the individual states (as indeed it did in the late 18th century). Let us further assume that because there was no Treasury but only a Central Bank, there was no federal borrowing and that individual states had to finance themselves through taxation and state bond issues.

In such a world, the ‘rating agencies’ would look at the trade statistics of the various US states. Suppose that most US state-level trade was with other states (which it is) and that Michigan and Ohio (which produced mainly manufactures) had enormous trade surpluses while the relatively poor states of Louisiana and Mississippi (which produced mainly fish) ran persistent trade deficits. (Remember, this story is allegorical.)

Ohio and Louisiana might initially both have AAA+ ratings, but because Louisiana was dirt poor and suddenly was struck by a hurricane causing coastal devastation, its economy became a basket case and its tax receipts collapsed. In consequence, the rating agencies downgraded Louisiana’s dollar bonds, making it nearly impossible for the state to borrow. Nor could Louisiana export its way out of trouble because, as part of the dollar zone, it could not devalue. Drastic cuts (internal depreciation) would make it even poorer and more likely to default.

So Louisiana—-together with Alabama and Mississippi— needed help from richer states like Ohio and Michigan. But Ohio, Michigan and various other ‘northern states’ were not without internal problems, and their citizens were reluctant to help the ‘lazy and feckless southerners’. Nor would they let the Central Bank buy the bonds issued by these poorer states … until a major crisis occurred.

I leave the reader to finish the story. Needless to say, the crucial point is that the USA is not in the above situation because it has the economic institutions necessary for operating a federal economy.

At least the USA had Alexander Hamilton and James Madison to shape its structure—today, Europe has Angela Merkel and Nicolas Sarkozy. I’m not optimistic.

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