Wednesday, September 7, 2011

Why do We Want Austerity Exactly?

Here is Wolfgang Schauble, German Finance Minister, in an op-ed in the Financial Times on September 5 (my highlights) titled "Why Austerity is Only Cure for Eurozone".

"Whatever role the markets may have played in catalysing the sovereign debt crisis in the eurozone, it is an undisputable fact that excessive state spending has led to unsustainable levels of debt and deficits that now threaten our economic welfare. Piling on more debt now will stunt rather than stimulate growth in the long run. Governments in and beyond the eurozone need not just to commit to fiscal consolidation and improved competitiveness – they need to start delivering on these now. The recipe is as simple as it is hard to implement in practice: western democracies and other countries faced with high levels of debt and deficits need to cut expenditures, increase revenues and remove the structural hindrances in their economies, however politically painful. Some progress has already been achieved in this respect, but more needs to be done. Only this course of action can lead to sustainable growth as opposed to short-term volatile bursts or long-term economic decline. There is some concern that fiscal consolidation, a smaller public sector and more flexible labour markets could undermine demand in these countries in the short term. I am not convinced that this is a foregone conclusion, but even if it were, there is a trade-off between short-term pain and long-term gain. An increase in consumer and investor confidence and a shortening of unemployment lines will in the medium term cancel out any short-term dip in consumption. These efforts will inevitably bear fruit, but it will not come overnight. This time, we will have to take the longer view. For too long we have forsaken long-term gains for short-term gratification with the result we all know."

There it is, perfectly clear, not the slightest bit tricky or evasive, and not the slightest hint of uncertainty: the voice of neoclassical economic orthodoxy. And this guy matters. He's the power alongside Angela Merkel in Germany. He speaks for her in discussions with the ECB (European Central Bank) and its current leader, fellow conservative Jean-Claude Trichet. Many millions of Europeans will feel the affects of Schauble's austerity. Many millions.

And he's wrong. Just like Boehner and Republicans are wrong in the US. Austerity is not the cure; it is an extension of the problem.

This is why our choice of economists to admire matters a great deal. Conservative US economists would applaud Schauble's words. Keynesian and MMTers are horrified. How can pulling demand out of an economy help to cure it? If this formula is accurate:

                                        GDP = C + I + G + (X - M)

Then how can reducing G increase GDP? The conservative answer: reducing Government spending increases confidence, unleashing spending by both consumers hand business. Or as Schauble argues:

"An increase in consumer and investor confidence and a shortening of unemployment lines will in the medium term cancel out any short-term dip in consumption."

This is what Hoover tried, with no luck. This is also what FDR was finally convinced by conservatives to do in 1937, which put the US back into recession. Why are we trying this again? Have we learned nothing? Apparently not, for when we tossed Keynes out the window in the 1970s', to be replaced by Milton Friedman, Eugene Fama and George Lucas, we gave up any substantive access to fiscal policy.

To present a more detailed refutation of Schaubel, I turn to Martin Wolf, one of the economic wisemen of journalism, writing for many years for the Financial Times. I would describe him as a Keynesian, with close ties to MMT (Modern Monetary Theory). In his FT column today, he takes a look at Sectoral Balances in both the US and the UK:

Here is Wolf's analysis:

"The massive fiscal deficits of today, particularly in countries where huge financial crises occurred, are not the result of deliberate Keynesian stimulus: even in the US, the ill-targeted and inadequate stimulus amounted to less than 6 per cent of gross domestic product or, at most, a fifth of the actual deficits over three years. The latter were largely the result of the crisis: governments let fiscal deficits rise, as the private sector savagely retrenched.To have prevented this would have caused a catastrophe. As Richard Koo of Nomura Research has argued, fiscal deficits help the private sector deleverage."

In other words, the massive deficits, starting in 2008 in both the US and the UK happened as a result of retrenchment by the private sector, both Households and Business. Beginning in 2008 (a bit earlier in the UK) both Business and Household spending lines move up on the graph, which means moving from being a source of spending (values below the 0 line/x axis) to being a use of spending (values above the x axis). In the case of Business in the UK, in 2008 this demand category was already in a Use position; it just moved up as a greater User of funds/demand. In other words, both businesses and consumers aggressively retrenched, causing the deficit blowout. If the Private Sector wants to retrench, the Public Sector MUST be in deficit, as long as the external balance is negative (above the line for both the US and UK - more imports than exports, USING funds, not acting as a Source of funds).

Schauble is wrong in his very first declaration, that it is "indisputable" that excessive public spending has caused the problem. And because he has the problem wrongly identified, it's no surprise he gets the solution wrong - i.e., his call for austerity. You cannot force consumers to spend, or businesses to invest when they want to retrench. The Government Sector must listen to the Private Sector and support its desire to repair their balance sheets with deficit spending.

Or as Martin Wolf says in the title of his piece - "We Must Listen to What the Bond Market Tells Us." Yields are moving quickly towards Japanese levels (in the US and the UK, each of which has their own currency, where European countries do not). The markets are telling us that the problem is an economic slump, not inflation and certainly not default.

Schauble has it wrong for the Eurozone. Boehner, Republicans and the majority of US economists also have it wrong.

As Wolf says, we should listen to the markets, and urge our Government to borrow at low rates and invest in the country's future. In a future post, will tackle the question of building up debt levels and what this means for the future.

No comments:

Post a Comment