Saturday, November 22, 2014

Austerity According to St. Augustine

SANTIAGO – The guardians of austerity in Europe are striking back. Their emerging narrative goes like this:

When some economists spoke of panic and confidence crises, they meant their own. Bailout funds and Eurobonds were an invitation to moral hazard. Throwing money at the problem turned out to be unnecessary. Europe’s problem was an old-fashioned one: too much spending. Now that technocrats have replaced populists in the eurozone’s Mediterranean members, sustained fiscal austerity will get us out of trouble.

Sounds good, right? If only it were true.

To see how misguided this narrative is, imagine Europe today without the big gun of cheap three-year loans from the European Central Bank to the continent’s commercial banks. You do not have to be a dyed-in-the wool Keynesian to conjecture that southern European country risk would remain sky-high, and that talk of default would still be heard everywhere.

Such massive central-bank intervention was necessary because a confidence crisis gripped much of the eurozone, with government bonds and banks on the losing end of a slow-motion speculative attack.

The relevant logic is at the core of modern macroeconomics – precisely the kind of thinking that European leaders have ignored at their peril. A country with a large public debt (say, more than 50% of GDP) is safe if everyone thinks the debt will be serviced; the interest rate charged on the debt remains low, and the country can indeed pay it, following a path of virtuous self-fulfilling expectations.

But everything changes if markets come to doubt that the debt will be repaid; then the interest rate demanded by investors can rise so high that the country cannot pay. Default follows, owing to a vicious self-fulfilling panic.

If a country’s bond market is about to move from virtuous to vicious dynamics, there is only one solution. Fans of firearms refer to it as the big bazooka; followers of Colin Powell advocate deploying overwhelming force; pyrophobes call it a firewall; sailors like to tie themselves to the mast. But, ultimately, it comes down to the same thing: having enough money at hand that no one can doubt, not even for a second, that the debt will be repaid.

If European leaders had deployed a rescue fund endowed with overwhelming financial force in early 2010, Europe and the world would have been spared two years of agony. In the end, it was the ECB that stepped into the breach, drowning eurozone banks with liquidity to make sure that they purchased every government bond that moved – and then some.

So the speculative attacks were stopped, at least temporarily (though interest-rate spreads in Spain and elsewhere have begun to creep up again). That was the first task. But there remains a second one, and here the guardians of austerity are getting it wrong again.

With a small public debt, a country cannot be the victim of a debt run. This is where Greece, Portugal, Italy, and Belgium differ from Canada, Norway, Singapore, and Chile. In the past, some European countries spent too much and taxed too little, and are paying for it today. To prevent a repeat of the last two years, they must reduce their public debt dramatically.

The question is how. In Greece, debt forgiveness was the only answer. Some has been accomplished; more will be necessary down the road.

For the rest of Europe, massive upfront austerity of the kind advocated by German Chancellor Angela Merkel – and supported by the prevailing German orthodoxy – will not do the trick.

Spain is a case in point. Spending has been cut and taxes raised. A new conservative government has reaffirmed Spain’s commitment to austerity. Yet deficit targets continue to be missed. The fiscal gap was a whopping 8.5% of GDP in 2011, and, after much haggling with Brussels, the target has been reset at 5.3% of GDP for this year. With output flat or falling, the debt-to-GDP ratio will keep rising.

The key to the solution lies in St. Augustine’s plea: “Grant me chastity and continence, but not yet.” A fiscal compact like the one approved recently is useful to anchor expectations of future adjustment, but only if the new system is flexible enough to be politically credible.

Up-front gradualism must be the name of the game. And adjustment must be wedded to a growth strategy. Revenue will grow consistently only if the tax base – that is, the economy – grows. And that growth requires higher public investment in infrastructure and human capital.

The guardians of orthodoxy are not about to put forward such a growth strategy. Will anyone else?

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    1. Portrait of Cynthia Mei Balloch

      CommentedCynthia Mei Balloch

      The commitment to upfront austerity comes from both European leaders and from citizens. As in America, in a time of economic crisis, where households are cutting back, to voters it seems irresponsible that government spending should rise. The nuanced distinction between short term stimulus and long term trajectory - or, gradualism - seems to have been lost.

      Who could do more to inform leaders and citizens of the need for credible plans for long term growth and sustainability?

    2. CommentedZsolt Hermann

      Unfortunately the article is a good example how we lost sight of normal reality.
      As our profit oriented, expansive, constant growth economy is totally reliant on finances, since people are urged, tricked into buying goods they do not really need, for money they do not have, way beyond their necessities and resources, slowly the banking system and the provided credit has become the most important pillar of this type of lifestyle, and then with the development of investment banking, speculations, stock markets money, finance itself have become the object of desire, the most important measurement of our "health".
      Not surprisingly today whenever there is a crisis the instinctive reaction is to support, and bail out the banks, fill them with money, as if it would guarantee the well being of the whole society.
      What we see now in Europe or we saw in the US in 2008, is that in order to resuscitate, strengthen the banks, financial markets, everything and everybody else is sacrificed.
      The public, the well being of the people does not count any more, and each time someone resents they are threatened to death by catastrophic scenarios in case the banking system collapsed.
      Moreover it is becoming clearer and clearer that the main problem is that we have lost the engine, since the present false economic structure and lifestyle is unsustainable so it does not matter how much we inflate the financial institutions with virtual money, the only thing that could truly support the system, continuing growth, is not possible any more. Thus we treat bubbles with bubbles, pay with credit for credit and then pray for recovery but we have no idea where that would come from.
      The public which could maintain the consumer system is weakened and abandoned, and the flood water washing away the different layers of society is rising steadily.
      Unless we identify the true cause of the problem, the system failure we evolved into, and address the real cause by returning to a necessity and resource based economy, all the bubbles start bursting until all the superficial, cosmetic solutions will run dry and we are left with nothing to build on.