Posts Tagged econmics

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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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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Deficit hysteria will kill Europe

Posted by George Irvin in EU on May 29, 2010

It’s not just Britain’s £6bn in cuts—deficit hysteria is sweeping the rest of the EU. First it was Ireland where draconian spending cuts have led to an estimated 9% annual fall in GDP this year and resulted in widening the budget deficit. Then Greece, where an EU-IMF imposed deficit reduction plan of 10 percentage points over two years has led to a forecast fall in GDP of 20%.

Today it’s Spain and Italy which have recently announced €15bn and €25bn respectively in austerity measures. Portugal has accelerated its budget reduction programme to get from 9% in 2009 to below 3% by 2013, or by about 2.5% a year.[1] In France, where the budget deficit is 8%—well below Britain’s—President Sarkozy is under pressure to follow Ms Merkel’s budget balancing act. Lest anybody forget, in 2009 Ms Merkel committed Germany to a permanently balanced annual budget after 2016, the so-called ‘debt-brake’ law, which means extra budgetary cuts amounting to €10bn per annum.[2]

A lost decade?

As though all this fiscal tightening were not bad enough, the OECD has recommended tightening monetary tightening as a precaution against inflation.[3] Both the Bank of England (BoE)  and the ECB are thought to be considering raising interest rates at the end of 2010, despite the fact that the ECB forecasts that the Eurozone will contract by 4.6% this year and that in June inflation fell 0.1% compared to a year ago, the lowest inflation rate since 1953.

What does all this mean for growth? Take the Eurozone-16 countries alone; their average current deficit in 2010 is about 7% of GDP, and it will probably be 8% next year. The current aim is to bring this figure within the 3% limit by 2013; ie, to make budgetary savings of 5% over two years. If we assume a (small) government spending multiplier of  1.5 and that its impact is distributed evenly over the three years following 2013, this would mean a 2.5% annual loss in growth until 2016. But average Eurozone growth since 2001 has only been just above 1% per annum, so we can expect deficit cutting to lower future growth to near zero (or less).

In short, Europe’s pro-cyclical budget cutting will, at worst, prolong the slump turning it into a 1930s style depression. At best, it will produce Japanese-style stagnation, a ‘lost decade’.  Whichever of these outcomes occurs, the economic and social costs will be high. Growth elsewhere in the world will be affected—this is what the quick European tour by Messrs Geithner and Summers is about. Prolonged unemployment means that a whole generation will remain jobless, and even when recovery takes place, they will enter the labour market without the skills they would otherwise have acquired and thus with little bargaining power. Many industries will decline, and some will disappear altogether, as will the wider communities which they helped support. Income and wealth inequalities will grow.

Perhaps most disturbing is that Europe’s ‘social model’ will be so deeply damaged by lack of public finance that it will in effect cease to exist, or else become a patchwork of  support programmes for the ‘deserving poor’ (those in work) as in the Anglo-Saxon countries. The deficit cutters are burrying Social Europe.

Why?

Why has it come to this? The answer lies partly in the power of the financial sector, and partly in the near universal acceptance of neo-liberal ideology. Like Britain and America, Europe has poured in excess of a trillion euros into bailing out its banking sector. Doubtless this was correct at the time. But as the recent sovereign debt crisis has shown very clearly, the very same financial markets that governments bailed out have raised sovereign borrowing costs to exorbitant levels for Greece and others while making fistfuls of money short-selling their Eurobonds.

Although there has been fresh impetus for greater regulation of financial markets—led to their credit by France and Germany—there has been no corresponding change in ideology.  The orthodox ideology is not so much monetarist or even Austrian—-it is quite simply the ‘common sense’ notion of bankers and shopkeepers alike that an economy’s budget is no different from the family budget. They assert that a sound budget, whether private or national, must balance.

As I have argued elsewhere, both Friedman and Keynes would have agreed that the financial crisis required the banks to be bailed out—which Europeans have done generously.[4] Where Keynes disagreed with the prevailing orthodoxy during the Great Depression was on the question of balancing the budget. Keynes argued famously that when the private sector was rebuilding its saving, government must spend more; otherwise, aggregate demand would fall leading to falling output, employment and tax revenue.

Some of Ms Merkel’s slightly more sophisticated followers (eg, George Osborne in the UK) would argue that more state spending leads (through inflation or increased borrowing) to higher interest rates which ‘crowd out’ private sector investment. Unfortunately, for this argument to be true, one would need to show that ‘full’ crowding out takes place, something which according to this theory can only happen at the natural rate of unemployment. Since the ‘natural’ unemployment is unknowable, the argument fails.

As for Keynesian economics, despite the near Depression of 2007-09 many of Ms Merkel’s colleagues appear to remain blissfully ignorant of the subject. As Keynes explained in his ‘paradox of thrift’, although saving may be a good thing for individuals and businesses, the more a country tries to save, the more income falls and the less it can actually save. A good example of economic illiteracy is the oxymoronic title of a recent piece published by two journalists in the influential magazine, Der Speigel, ‘European  austerity is the first step to recovery’.[5] As the Berliner Zeitung put it, the end result of this sort of nonsense is that: ‘Europe will save its way into the next recession’.[6] A deeply pessimistic conclusion, but inescapable I’m afraid.

[1] See http://www.ibtimes.com/articles/22922/20100509/portugal-promises-eu-to-cut-budget-deficit-more-in-2010.htm

[2] See http://www.spiegel.de/international/germany/0,1518,696760,00.html

[3] See http://www.guardian.co.uk/business/2010/may/26/oecd-backs-coalition-spending-cuts

[4] See http://blogs.euobserver.com/irvin/2010/04/13/why-sound-money-is-unsound/

[5] See http://www.spiegel.de/international/europe/0,1518,697098,00.html

[6] See http://www.spiegel.de/international/europe/0,1518,697098,00.html

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A banker’s tax for the EU!

Posted by George Irvin in EU on April 7, 2010

Most readers will have heard of the ‘Robin Hood tax’—now under study at the Commission—a well-chosen term for what economists refer to in their jargon as a Currency Transactions Tax or ‘Tobin tax’ (see my earlier piece on this blog). The basic idea is that the word financial market is now so large that taxing it at some miniscule rate (0.05%, or 50 euro cents in every €1,000 traded) would rake in billions.

How much would it raise?
Just to give you some idea, the Bank of International Settlements (BIS) estimates that in 2007 the world’s yearly currency transactions totalled US$800tr (that’s fifteen time world GDP, or nearly a quadrillion dollars) of which 80% is purely speculative. A 0.05% tax on this annual turnover would yield 400 billion dollars (about €250bn) each year, enough to fight poverty, deal with global warming and have shedloads of money left over for repairing our government budgets. Because almost all such trades are computerised, software already exists for collecting such a tax wherever it takes place.

And even if financial markets were able to avoid tax on half that sum, we’d still be getting US$200bn per annum. It’s a no-brainer, really.

The pros and cons

Or is it? A lot of bankers and financial journalists oppose it. In essence, the ‘devil’s advocate’ argument against such a tax consists of four questions: (1) will the proceeds reach the right people? (2) is 0.05% high enough to stop speculative activity? (3) will the bankers find a way of ‘passing it on’? and (4) can it work unless the US supports it?

‘Will it reach the right people?’ is always a concern, but to reject a Robin Hood tax on those grounds is a bit like rejecting aid to the victims of the Haitian earthquake on the grounds that some small percentage of them are thieves.

Is 0.05 high enough? That’s a good question: James Tobin originally proposed 1% in the 1970s, then decided two decades later than 0.1 would be enough to ‘place grit in the wheels of the speculators’. If not, there are at least two remedies. First, the tax could be varied according to the type of trade involved, with higher rates on, say, short-term derivatives than long term futures contracts. Secondly, to avoid foul play, such a tax could be complemented by a new bankruptcy regime requiring unsecured creditors and other counterparties to be forcibly and swiftly converted into shareholders, until the failed institutions are adequately recapitalised.

Will bankers ‘pass it on’? The answer is that where the tax is low and the market highly competitive, it probably won’t be worth their while? After all, Britain levies a stamp duty of 0.5% on everyday share trades, and nobody argues that that banks and brokers ‘pass it on’ to the average citizen. Banks and brokers ‘take a fee’ on such trades, just as they do on currency trades, but the fee is paid by the counterparty.

What if the US doesn’t play ball?

Finally, can it work if the US is opposed? But who in the US is opposed? Tim Geithner, Obama’s Treasury Secretary, seems opposed, but he’s an ex-banker who has worked closely with Bush’s Treasury Secretary, Hank Paulson. Larry Summers, Obama’s chief economic advisor, was an early advocate of a Tobin tax. Obama himself is keeping quiet for the moment because he’s anxious not to make any more Congressional enemies.

If Germany, France and Britain—all of whom support some form of Robin Hood tax—were to proceed unilaterally, it is hard to see how the US could oppose it. Moreover, with the US budget deficit approaching 10% of GDP and much of the US press calling for budget balance, a Robin Hood tax is Obama’s lifeline.

Who’s betting billions against the euro at the moment? The big financial speculators, that’s who! A Robin Hood tax is both quite feasible, and it imaginatively reflects the public’s desire to make the speculators pay for the havoc they have caused.

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Greece: socialism for the rich and capitalism for the poor?

Posted by George Irvin in EU on March 2, 2010

Olli Rehn, the EU’s Economic Affairs Commissioner, has urged the Greek government to tighten its belt and make further cuts—-translation: slash wages! This is perhaps to be expected coming from a member of Finland’s Centre party, but it is deeply divisive for Europe. Unsurprisingly, a centre-right Commission holds centre-right economic views—views which are unchanged despite the lessons of the current financial and economic crisis.

Overspent or underfinanced?

Yes, Greece has a serious current government deficit about which it cooked the books (12.5% of GDP in contrast to 10% of GDP in the US). But the public stock of debt as a percentage of GDP is around 40% of GDP, well below the Eurozone norm. The problem in Greece has been wrongly portrayed as one of overspending. And although some Greek public sector expenditure is nepotistic and unnecessary, most of it goes to low-paid teachers, nurses and other public servants. The real problem lies elsewhere; namely, in a poor tax collection system allowing the rich to move money to tax shelters. Poor tax collection is greatly compounded by the collapse in government revenue resulting from recession, and these matters will not be put right overnight. Mr Papandreou must be given time if he is to bring about fundamental structural reform. He does not need the sort of labour unrest which will follow a massive wage squeeze.

Devaluation not the answer

Several British economists writing in the Financial Times have suggested that Greece might briefly leave the eurozone in order to devalue. But devaluation is not the answer. The view that devaluation has been good for Britain (for which there is still scant evidence) cannot be applied to the eurozone as a whole. Had the eurozone not existed, the markets would certainly have attacked the drachma, punt, peseta and so on, possibly unleashing a round of competitive European devaluations of the sort experienced in the 1930s.  Moreover, in the unlikely event of Greece temporarily leaving the eurozone, its euro-denominated debt would rise in value relative to the new currency, thus exacerbating the country’s problems.

The key question to be asked is how rich eurozone members can help the poorer ones guard against currency speculators. There are two types of actions to be taken: short-term and long term.

The short-term solution

The short term solution is for the European Central Bank (ECB) to extend beyond next January its refinance operation in which government debt rated at less than A- is accepted as collateral. The ECB engages in weekly “refinancing operations” to add liquidity to the European banking system. Banks that need cash can trade in bonds in return for fresh euros, the ECB then charges them interest in return for what is effectively a secured loan. Prior to the crisis, the ECB would accept any bond rated A- or above by any of the three major ratings agencies. During the crisis, to get more liquidity into the damaged banking system, the ECB dropped the required rating to BBB- or above. On January the 1st 2011, the ECB will return to the old A- standard. It is the fear that Greek Eurobonds cannot be traded for cash—not the fear of the Government ‘going broke’—that is at the heart of the refinancing problem. Postponing a return to the old A- standard beyond next year would solve the crisis. It would not cost the German taxpayer a single euro, and it would not cost ordinary Greeks their jobs.

The longer-term solution

The longer term solution involves changing the economic architecture of the eurozone in two critical respects. The eurozone needs a proper Federal Budget enabling the centre to help the regions.  A number of economists have called for this before; eg, Andre Sapir called for a Federal ‘rainy day fund’ back in 2003, and several prominent MEPs have recently argued that a genuine Federal Budget is needed. Such a budget—perhaps 5% of Eurozone GDP initially— could easily be funded by a small Tobin tax on euro foreign exchange transactions.

What is also needed—and here I recall the argument advanced by Keynes at Bretton Woods in 1944— is a mechanism whereby countries such as Germany spend their surpluses in deficit countries in a matter which increases the productivity, and hence the repayment capacity, of the latter.

The powerful nations of the eurozone have generously bailed out their banks using ordinary people’s money. It is time for them to support the ordinary people who are most at risk from swingeing cuts in government expenditure being called for by these same financiers.

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