Wednesday, November 26, 2014

Clarity about Austerity

MILAN – I have just had the privilege of speaking at the main annual conference of Germany’s Economic Council, the economic and business arm of the Christian Democratic Union, the current governing party. Chancellor Angela Merkel and Finance Minister Wolfgang Schäuble were among the other speakers. It was an interesting event – and, more important, an encouraging one.

It seemed clear that Germany (or at least this rather large gathering of government, business, and labor leaders) remains committed to the euro and to deeper European integration, and recognizes that success will require Europe-wide burden-sharing to overcome the ongoing eurozone crisis. The reforms in Italy and Spain are rightly reviewed as crucial, and there appears to be a deep understanding (based on Germany’s own experience in the decade and a half following reunification) that restoring competitiveness, employment, and growth takes time.

Greece has no good options, but a serious contagion risk remains to be contained in order to prevent derailment of the fiscal and growth-oriented reforms in Italy and Spain. In the face of high systemic risk, private capital is leaving banks and the sovereign-debt markets, causing governments’ borrowing costs to rise and bank capitalization to fall. This in turn threatens the functioning of the financial system and the effectiveness of the reform programs.

Thus, the central European Union institutions, along with the International Monetary Fund, have an important role to play in stabilization and the transition to sustainable growth. Their efforts are needed to bridge the gap created by the exodus of private capital, thereby enabling the reform programs to be completed and begin to take effect. The IMF’s role reflects the huge stake that the rest of the world – advanced and developing countries alike – has in Europe’s recovery: it is a high-return investment.

All of this seemed to me to be well understood among German politicians and business leaders. Moreover, this kind of support is and should be conditional on the extent of the reforms carried out in Italy and Spain, the eurozone’s third- and fourth-largest economies, respectively. Labor-market liberalization in pursuit of competitiveness and growth is crucial – and remains to be implemented.

Buying time for reform to work requires socialization of short-term risk. There is no other way to keep bond yields under control and banks functioning, and there is no ironclad guarantee that the reform programs needed to do the job will be approved.

Eurobonds, viable in the longer term, are thus premature, because they imply a relaxation of conditionality, thereby weakening incentives to implement reforms. But if it all works, sharing risk now will not be expensive in the end. It might even yield a positive return.

What, then, of the much-discussed conflict between austerity and growth? I believe that it is based on a fairly serious misunderstanding. For Germans, austerity, in the form of sustained wage and income restraint, was an important part of the growth-oriented reforms that their country completed in 2006. Much time and effort was devoted to ensuring that the considerable burden of restoring flexibility, productivity, and competitiveness was shared equitably across the population.

But, on the receiving end of the message in southern Europe (and across the Atlantic), “austerity” is interpreted largely in fiscal terms – as an excessively rapid and potentially growth-destroying drive to cut deficits faster than the economy can structurally adjust and fill the gap in aggregate demand. In other words, harsh austerity is being viewed largely through a Keynesian lens.

Finding the right balance between excessively rapid and dangerously slow deficit reduction is important, and not all that easy. But that is just one component of rebalancing. Growth is essential to bringing down public debt/GDP ratios, and thus is a key part of fiscal stabilization. And it is true that the benefits of deficit reduction, if achieved too fast, will be more than offset by the negative effect on growth.

At the same time, to restart an economy’s growth and employment engines, other measures are needed, and vary somewhat across countries, owing to different initial conditions. But they generally include removing rigidities and other barriers to competition in labor, product, and service markets; investment in skills, human capital, and the technology base of the economy; and rebuilding safety nets in ways that promote and support, rather than impede, structural adjustment.

These reforms require the sacrifice of certain kinds of protections, as well as of income and consumption growth. The benefits come in the form of sustainable patterns of growth and employment in the future. Discipline and austerity thus entail inter-temporal and intergenerational choices about the price to be paid now – and how fairly that burden is to be borne – for greater economic opportunity and social stability in the future.

After all, restoring stability and growth is only partly about reviving short-term aggregate demand. It is also about structural reform and rebalancing, which comes at a cost. Achieving a sustainable pattern of growth requires choices that affect not just the level of aggregate demand, but also its composition – for example, investment versus consumption.

Whether one calls this austerity or something else is a matter of semantics. But the confusion that has resulted is anything but harmless. On the contrary, it has become a major impediment to a common understanding of current challenges, and thus to achieving a broad consensus on the right path forward – one with well-defined and differentiated responsibilities – in confronting them.

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    1. Commentedpeter fairley

      Reply to Gary Marshall. The flaw is: the govt needs to get revenue somewhere to make payments on the pure govt debt system you propose. You have not stated what 'for profit' enterprises the govt would use the borrowed money for."Worthy public expenditures" do not imply revenue production unless they are something like toll roads, which most people consider 'a tax'. Where is my $50,000?

        CommentedGary Marshall

        Hello Peter,

        And where does the government currently get the revenue from to make payments on the government debt that exists now?

        They would get it from the same collective, though participation in that collective will vary.

        Now, the government need not actually collect the money to repay the debts. In my example, you will note that if the government were to tax the community to erase the acquired debts, the government would take the money from the community and hand it right back to the community. So in the aggregate taxing to pay off the debts in no way alters the wealth of the community. Erasing debts just erases assets.

        So, in effect, the government need never make the theoretical transfer. The money is there, however the costs in making the transfer are far greater than just letting the national assets and their equivalent liabilities rise indefinitely.

        Its sort of like a bank. Its assets in loans rise along with its liabilities in depositor's money indefinitely. The individual depositor shall see his money returned to him if desired, but the assets and liabilities will accrue forever with the bank living on the margins between interest paid and interest earned.

        To pay off every depositor would mean collapsing the bank. Why go through such trouble. One would just estimate the value of the bank and have it reflected in the share price.

        Money will be borrowed with a cost. So each public expenditure will have to be justified financially wherein benefits exceed costs. Otherwise, the expenditure is never made.

        For example, access to clean water could be accounted a worthy project with good returns. Dirty or disease laden water can cause a community grievous harm. The local hospital may be overrun with patients suffering all sorts of water borne maladies. The medical costs, lost work days, etc could be erased with a modest investment in purifying the water.

        Simple cost and benefit analysis. If the cost to the community of water borne diseases are $5 million, and construction costs of a water filtration plant $1 million with $1 million in annual expenditures, is this not a valued return to the community?

        Is it inflationary? No because the community now has $3 million per year to go and spend on other items, perhaps better healthcare, better education, a larger home.

        An idle person will cost the community or nation in welfare costs. An annuity of $10,000 would require an initial investment of $200,000 with an interest rate of 5%. If a person collects $10,000 per year, the community or nation would be better off lending funds of say $50,000 for training or education up to amend the burden.

        I hope that answers your questions.


    2. Commentedmmm bbb

      Yes, there is a misunderstanding in Europe regarding the definition of austerity and it is almost funny that nobody treated until now. (or at least I did not notice - sorry for my ignorance)

      On the other hand, growth may appear even if the austerity measures are going on, or better to say the austerity is consolidated.

      Indeed it is a fine mechanism to adjust the speed of implementing the austerity measures and the ones related with growth.

      Who should act for finding the right compromises?
      A researcher, an artist, an economist, a mathematician, a philosopher, a sociologist, a politician?

      Why is needed such a long period of time to harmonise the differences among the partners in EU?

      Greece could had a better chance, and implicit EMU, if the actions of partners were more quickly established...

    3. CommentedAl Hick

      Like other proponents of the German model of structural reform, Mr. Spence fails to recognize that Germany's success in in building a
      "competitive" economy during the 2000s was based on having counter parties who would provide the needed demand for the excess supply caused by wage suppression in Germany. If southern Europe, the U.S. and other "irresponsible" countries had not experienced credit fueled bubbles over the past decade, Germany would still be in a deep and long 10 year recession. It is essential that changes in the Euro periphery are matched by expansionary fiscal policy in Germany or expansionary monetary policy from the ECB. To suggest that southern Europe follow the German model, without addressing were the demand is going to come from is simply to wish unnecessary misery on the populations of Southern Europe.

    4. Commentedsrinivasan gopalan

      Mr Spence plea for return to simplicity by shouldering burden now so that posterity does not blame you for recklessness reeks of asking too much from a generation that is inured to comforts and free lunch. Welfare programmes as practised in some European countries without ensuring concomitant responsibility on the present of beneficiaries is unfortunately the patent reason for the current mess in some of the Southern European countries. When ailments afflict the system bitter medicine is but inevitable but people in real life do not countenance this diagnosis and the attendant treatment. The best course open to the countries mired in crises of all sorts is to make a few adjustments in life so that this phase will be a passing one before days of comfort and delight break out. What the crisis-laden countries of Europe need is a moral leadership and not economic policies that divide the people between austerity and persistence with the same level of living they had been accustomed to. Probably faith in themselves and in the ability of things to shape out to their benefit by degrees need to be nurtured so that undue expectations of a disaster can be averted.
      G.Srinivasan. New Delhi

    5. CommentedGary Marshall

      Hello Mr. Spence,

      In conventional economics you are right -- Greece has no good options. But in progressive economics, they have a very good option: the abolition of Taxation.

      Below is the very simple proof for this measure.

      If you or anyone can find the flaw, I shall be more than happy to give the reward of $50,000. None have yet been successful.

      Its not the end of the world, but a new beginning.



      The costs of borrowing for a nation to fund public expenditures, if it borrows solely from its resident citizens and in the nation's currency, is nil.

      Why? Because if, in adding a financial debt to a community, one adds an equivalent financial asset, the aggregate finances of the community will not in any way be altered. This is simple reasoning confirmed by
      simple arithmetic.

      The community is the source of the government's funds. The government taxes the community to pay for public services provided by the government.

      Cost of public services is $10 million.

      Scenario 1: The government taxes $10 million.

      Community finances: minus $10 million from community bank accounts for government expenditures.
      No community government debt, no community
      government IOU.

      Scenario 2: The government borrows $10 million from solely community lenders at a certain interest rate.

      Community finances: minus $10 million from community bank accounts for government expenditures.
      Community government debt: $10 million;
      Community government bond: $10 million.

      At x years in the future: the asset held by the community (lenders) will be $10 million + y interest. The deferred liability claimed against the community (taxpayers) will be $10 million + y interest.

      The value of all community government debts when combined with all community government IOUs or bonds is zero for the community. It is the same $0 combined worth whether the community pays its taxes immediately or never pays them at all.

      So if a community borrows from its own citizens to fund worthy public expenditures rather than taxes those citizens, it will not alter the aggregate finances of the community or the wealth of the community any
      more than taxation would have. Adding a financial debt and an equivalent financial asset to a community will cause the elimination of both when summed.

      Whatever financial benefit taxation possesses is nullified by the fact that borrowing instead of taxation places no greater financial burden on the community.

      However, the costs of Taxation are immense. By ridding the nation of Taxation and instituting borrowing to fund public expenditures, the nation will shed all those costs of Taxation for the negligible fee of borrowing in the financial markets and the administration of public

      Gary Marshall

        CommentedGary Marshall

        Hello Daniel,

        What I advocate is the abolition of all Taxation. If the state retain any of it, then it is still able to control its finances and the people whom it is appointed to serve. Without Taxation, the state is forever dependent upon its citizens for its existence.

        Singapore does have a range of taxes and fees, though quite moderate compared with NA. It is also a very small country.

        Regards, GM

        CommentedDaniel Gomes

        Gary, your proposal was implemented in Singapore a few decades ago.

        The taxation base is extremely low and almost all of the credit is forcefully obtained from the tax payers via a forced savings scheme called Central Providence Fund.

        Interestingly, on paper, Singapore has one of the highest sovereign debts in the world but seems not to worry a single bit about it.

        CommentedGary Marshall

        Hello Mr. Ravazzolo,

        A pension is indeed a financial asset, a financial asset for a member of a nation, and in the aggregate for the nation itself.

        A water holding and treatment facility is indeed an asset for a community and its members. Water borne ailments can have a devastating impact on a community's productivity and health care costs. For a small investment, all that will disappear.

        Similarly with education, police and fire, and garbage collection. These are all useful services that create wealth in a community. Without police and fire, whole communities can disappear in a conflagration or riot. Insurance costs would be prohibitive without such a wise investment.

        Welfare recipients could be given loans to enhance education and training in order to make those unproductive souls productive. When employed they can pay back the loan. The annuity now comes with a great cost to the community and no solution.

        With the unemployed, a loan could be given if there are no other means available to maintain them, repayable when conditions improve.

        Government expenditure with a capital charge will change drastically. The erstwhile taxpayers now become the nation's bankers will ensure that the government now justifies every expenditure. There will be no corporate welfare. There will be no subsidies to favoured producers. Mineral rights will be handed back to those that own the land. There will be no customs and excise, or tax collection. There will be no deterrent effect from an abolished taxation. Pensions will no longer be needed as the population will now have government bonds. Publicly funded healthcare could be limited to difficult cases or for those without means because everyone should possess bonds with which to pay for them.

        What a better world it will be!

        Gary Marshall

        CommentedMiriano Ravazzolo

        Mr. Marshall

        Your idea is quite interesting, but I am afraid it would only work if all public expenditures could be configured as assets. In the modern world unfortunately (or fortunately) there are way too many expenses that can be categorized as "services", which get consumed at the moment of fruition and therefore do not add to the financial assets. Think healthcare, or pensions, which while contributing to the general economy do not create any bookable asset...

    6. CommentedPaul A. Myers

      A lot of metrics are thrown around in the European debate, but it seems to me the core metric is economic productivity over time. Germany successfully accomplished a decade-long productivity improvement program that put it into its enviable position today.

      Other countries have to implement productivity-converging policies or otherwise fail in some fashion.

      So I would think that changes in future productivity should be the criterion by which policy proposals are evaluated.

    7. CommentedThomas Lesinski evidenced by the increase in poverty rate in Germany from 11% in 2001 to 15% today, despite the increase in employment.

    8. CommentedThomas Lesinski

      Is there a single point of hard evidence towards the idea that labor-market flexibility is favorable to growth ? Or is it just a talking point taken for granted by the high priests ?

    9. CommentedRussell Pittman

      A related point is that made by an earlier Nobel laureate, James Meade, in the "burden of the debt" debate: A policy with a given level of fiscal stimulus has a much different long-term impact depending on what the stimulus money is used for. In that light, spending borrowed money on improving infrastructure or strengthening tax enforcement has a lot to recommend it as compared with, say, funding military adventures or propping up unsupportable pension schemes.

    10. CommentedMatthew Cowan

      I'm glad to see that someone has broken the austerity vs. growth argument down into its component parts. This is where we can make a real difference in improving economic outcomes.

      The larger debate of stimulus vs. fiscal austerity too often overshadows the component parts and execution of a particular stimulus or austerity plan. Done correctly, either can be an flying success or a dismal failure.

      The debate needs to move beyond stimulus vs austerity to how to stimulate and/or cut back spending effectively and how to effectively time austerity and/or stimulus measures to optimize the outcome.

    11. CommentedRobert Winter

      The writer states "But, on the receiving end of the message in southern Europe (and across the Atlantic), “austerity” is interpreted largely in fiscal terms – as an excessively rapid and potentially growth-destroying drive to cut deficits faster than the economy can structurally adjust and fill the gap in aggregate demand." It would have been of interest had he address whether in his view the terms that have been imposed to date on Greece and other countries reflected the balanced burden sharing he suggests or excessively rapid and growth destroying policies. As best I can tell, the better argument is that at least to date it has been the latter.