Sunday, November 23, 2014

End Austerity Now

EDINBURGH – In recent weeks, talk about a budding recovery in the eurozone has gained traction, with key indices pointing to expansion in the core countries – data that many are citing as evidence that austerity is finally working. Money-market funds from the United States are returning, albeit cautiously, to resume funding of European bank debt. Even Goldman Sachs is now bullishly piling into European equities. But is a recovery really underway?

Cynics recall that a European recovery was supposed to take hold as early as the fourth quarter of 2010, and that every International Monetary Fund projection since then has predicted recovery “by the end of the year.” Instead, GDP has collapsed, with the Spanish and Italian economies expected to contract by close to 2% this year. Portugal’s economy is set to shrink by more than 2%, and Greece’s output will fall by more than 4%.

Moreover, unemployment in the eurozone has skyrocketed to an average rate of roughly 12%, with more than 50% youth unemployment in the periphery countries implying a long-term loss of talent and erosion of the tax base. And, despite the spike in unemployment, productivity growth in the eurozone is decidedly negative.

More significant, over the last year, the public debt/GDP ratio rose by seven percentage points in Italy, 11 in Ireland, and 15 in Portugal and Spain. If the sine qua non of recovery via austerity is the stabilization and reduction of debt, the cynics’ case appears to have been made.

Against this background, the return of US investors to provide short-term dollar funding for European bank debt smacks of a desperate hunt for yield that relies on European Central Bank President Mario Draghi’s promise to do “whatever it takes” to save the euro. As for Goldman’s equity play, as bond-market guru Bill Blain put it, “the words ‘buy cheap, sell a bit dearer on the up, and then dump and run’ spring to mind.”

In fact, any talk of recovery is premature until the losses incurred by austerity are recouped. As it stands, every country that has implemented an austerity program without imposing losses on private creditors has more debt now than when it started. For example, according to official estimates, Spain’s public debt, which amounted to only about 36% of GDP when the crisis began, has almost tripled – and the actual figure may be much higher. More telling, the countries that cut expenditure the most experienced the largest bond-yield spikes and the most significant debt growth.

The explanation for this is simple. When a country gives up its monetary sovereignty, its banks are effectively borrowing in a foreign currency, making them exceptionally vulnerable to liquidity shocks, like that which sparked turmoil in Europe’s banking system in 2010-2011. The government, unable to print money to bail out the banks or increase export competitiveness through currency devaluation, is left with only two options: default or deflation (austerity).

Austerity’s underlying logic is that budget cuts, by reducing the debt burden and restoring confidence, ultimately enhance stability and support growth. But, when countries pursue austerity simultaneously with their main trading partners, overall demand plummets, causing all of their economies to contract and, in turn, increasing their debt/GDP ratios.

But the problem with austerity in the eurozone is more fundamental: policymakers are attempting to address a sovereign-debt crisis, though the real problem is a banking crisis. With Europe’s banking system triple the size and twice as leveraged as its US counterpart, and the ECB lacking genuine lender-of-last-resort authority, the sudden halt in capital flows to peripheral countries in 2009 created a liquidity-starved system that was too big to bail out.

As holders of euro-denominated assets recognized this situation, they turned to the ECB for insurance (which the ECB could not deliver under its previous president, Jean-Claude Trichet, whose leadership was defined by his commitment to maintaining price stability). Investors’ subsequent efforts to price in the risk of a eurozone breakup – not the volume of sovereign debt – caused bond yields to spike.

But the financial-market turmoil fueled a panic among eurozone leaders, leading them to misdiagnose the malady and prescribe the wrong medicine, which has served only to generate new symptoms. While Draghi’s promise, embodied by the ECB’s “outright monetary transactions” program – as well as its long-term refinancing operation and emergency liquidity assistance program – has bought time and lowered yields, the eurozone’s banking crisis persists.

Eurozone leaders must recognize that spending cuts will do nothing to stabilize the balance sheets of core-country banks that are over-exposed to peripheral countries’ sovereign debt. Until Europe rejects austerity in favor of a growth-oriented approach, all signs of recovery will prove illusory.

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    1. CommentedMichael Hennigan - Finfacts

      Still, one can wonder how Mark Blyth, as a finance minister of one the main core countries, would have reacted to the challenges?

      In Ireland from the late 1990s, income and capital taxes were cut and the low corporate tax was extended to domestic business. The proportion of income earners exempt from income tax increased from 34% in 2004 to 45% in 2010.

      There was no real world growth absent the property bubble from 2001 and when the bust came, public revenues were suddenly in a sink hole with the loss of property-related revenues. Meanwhile, spending on social protection which stood at €7.84bn in 2001 had grown to €20bn while inflation increased by around 30% during the same period. In 2001 the Irish public service pay and pensions bill (ex local authorities) was €10.2bn; it was €16.2bn in 2006 (the peak year of the bubble); €17.6bn in 2007; €18.7 in 2008 and €17bn in 2012.

      In a short time, Ireland went from being perceived as having a 'miracle economy' to one where many expected gifts like the cargo-cultists of the South Pacific.

      However, while there was no Santa Claus and the sustainability of debt remains a big question, beyond the 24% unemployed (broad rate), the international bailout has ensured that life for many has remained relatively unscathed. Taxes remain below levels in many European countries; doctors remain among Europe's best paid and the well-connected lawyers are coining it through boom and bust. The tourism and travel deficit (excess of outward travel) in 2012 was almost unchanged compared with 2007.

      As for Greece, it had fiddled its national accounts data and it's not clear if Mark Blyth as a finance minister, would have been happy to transfer cash without strings.

      Without external pressure, the scrounging elites would surely have used such cash prudently!

      For example, George Papandreou, then Greek prime minister, told Der Spiegel in early 2010: "In a study done last year, the OECD described government-run Greek hospitals as deeply corrupt. It concluded that we could save 30% of the costs, which is enormous. The hospitals generated a deficit of €7bn last year. Imagine what an unbelievably large amount of money we could save by simply introducing computers into hospitals. Until now, there has been far too little control over the purchasing of medications and equipment. In Germany, a stent for heart operations costs about €500. In Greece it costs €2,000 to €2,500. The fault lies with corruption."

      Mark Blyth uses terms such as 'skyrocketed' and 'collapsed,' but Italy hardly grew at all in the years that preceded the crisis and it's unemployment is back to the mid 1990s level. Just before its property boom, Spain had a jobless level of 21% in 1997.

      As for youth unemployment being over 50%, it's bad but not as bad as that figure suggests - according to Eurostat, when for example youth in Greece who are in third level education are excluded from the denominator, the rate of 55.3% in 2012 becomes an unemployment ratio of 16.1%; Spain's falls from 53.2% to 20.6%.

    2. CommentedMoctar Aboubacar

      From Brown lectures to FT articles, no one has quite influenced how I see the financial crisis quite like prof. Blythe. I hope this is more than a one-time column on this site.

    3. CommentedJay Mac

      While experts are quick to place the blame of the lack of recovery in Europe solely at the feet of austerity, why do they consistently fail to address the fact that years of unrealistic and unsustainable fiscal policies have simply come home to roost and are bearing the fruit of their acceptance? Until impediments to production are removed, no amount of stimulus spending or convenient blaming of outcomes on austerity will provide a permanent solution to the economic malaise.

    4. CommentedJosé Luiz Sarmento Ferreira

      When austerity programs were first implemented, their alleged purpose was to decrease debt, not to increase it. But debt has increased in every instance, without exception.

      So austerity has failed and must be replaced by more effective policies, right?

      Wrong. We are told it must go on and on until some miracle happens to make it work.

      And so I wonder: What if debt reduction was never intended? What if deficit reduction was never intended? What if the whole exercise has always had one, and only one purpose - creating rents for the financial oligarchies?

      Doesn't this explanation fit the observed, and by now undeniable, facts much better than the "profligacy and laziness" myth that Northern European right-wing politicians have been selling to their constituencies with the help of the unscrupulous tabloid media?

    5. CommentedMarc Sargen

      If the Euro Members find that a common currency is to burdensome to use then they should give it up. That is simple. Since they don't do it, then the benefits that they had been, are, or believe they will receive outweighs the problems they believe they are currently having.
      The issue is they want the benefits of both & are complaining because they can't have it.
      Prior to 2000 plenty of the weaker countries in Europe were having issues with rampant inflation & the need to borrow in Dollars or Marks because they were few would lend in a weak & devaluing currency. Many though the Euro would wave a magic wand to solve these issue but they did not go away & are now much worse because they have been ignored for a decade +.

        CommentedJosé Luiz Sarmento Ferreira

        None of the Euro Members - and this goes for Germany as well as for Greece - are political monoliths. There are forces in all of them that would benefit and forces that would lose by leaving the Euro. It is quite possible that a common currency is too burdensome for "Spain" to use; if so, "Spain" should indeed give it up.

        But who exactly is "Spain"? The Spanish people or the Spanish bankers? It doesn't matter how burdensome the common currency is for the people as long as the bankers are in charge.

        And as long as the bankers are in charge, all will go well. If not for "Germany", "Austria", "Finland" and so on, at least for their financial oligarchies.

    6. CommentedTomas Kurian

      Very true, excellent analyses.

      And add to the wrong solutions one, that all across Europe is aiming at postponing the retirement age as a result of deficit in pension systems.

      Why this is exactly the opposite from what we should be doing, you can read at:, chapter
      4.3.1 Postponing the pension age – the biggest economical nonsense ever

      The world experienced huge increases of productivity in the last 20-30 years, but somehow failed to pass these gains to the people in the form of more free time.
      As technological progress advances, higher and higher taxes are needed to maintain the aggregate demand keeping up with AS. Without higher taxation, bigger share of profits go towards capital, which is not able to spend it. So employees supplement their missing income with loans - but this is not a sustainable solution and leads to current problems of too high leverage.

      Read about this, the possible solution and more at: