Showing posts with label Fiscal deficits. Show all posts
Showing posts with label Fiscal deficits. Show all posts

Thursday, June 7, 2012

Grexit nears as austerity bites

NYT has an excellent account of how austerity is forcing Greece ever closer to a sovereign default. Forget repaying its external creditors, the Greek government may not even be able to pay its employees and pensioners. 

Fears of a Grexit has left bond yields soaring, effectively forcing the country out of the capital markets. 

Austerity is taking its toll by way of lower aggregate demand and attendant fall in tax revenues. The Times writes that the government has not made much headway with reforming the taxation system and increasing tax collections,
Salaries and pensions in the private and the public sectors have been cut by up to 50 percent, leaving Greece 495 million euros short of its revenue targets in the four months ended in April, according to the Greek Finance Ministry. With less cash, consumers have curbed spending, leading thousands of taxpaying businesses to fail. 

Income expected from a higher, 23 percent value-added tax required by the bailout agreement has fallen short by around 800 million euros in the first four months of 2012. That is partly because cash-short businesses that were once law-abiding have started hiding money to stay afloat, tax officials said. Greece’s General Accounting Office said recently that the state collected 25 percent less revenue in May than it did a year earlier. And the state has had to slash its goal of raising 50 billion euros from privatizations to just 3 billion euros as foreign investors lose interest.
With debt-to-GDP ratio rising steadily to 165% and fiscal deficit projected at nearly 7% for 2012 Greece is clearly facing a solvency crisis. After declining by 6.9% in 2011, the Greek economy is expected to continue the same trend, albeit contracting annually by 4-5% for 2012 and 2013. In the circumstances, Greece immediately needs both massive fiscal transfers as budgetary support and low cost loans from the ECB, and that too for a sustained period of time. And even with this, the issue of regaining competitiveness will remain unresolved.    

Monday, May 14, 2012

Eurozone - fiscal irresponsibility was not the problem

The Eurozone crisis is far from a simple story of fiscally irresponsible governments running up huge debts that they are now struggling to repay.

As the graphic below shows, public debt as a percentage of GDP has remained remarkably stable for most countries since the mid-nineties. In fact, it even declined for countries like Italy, Spain, and Ireland - all currently accused of being among those most fiscally irresponsible. Even Greece did not suffer anything like the spectacular explosion in public debt that has currently become conventional wsidom. Now, once the crisis exploded and economies tanked, the sovereign debt ratios have risen steeply and have become dangerously high for many of them.

In fact, apart from Ireland, none of these economies accumulated debt much higher than the prevailing average debt levels for developed economies.

Even government expenditure as a percentage of GDP has remained more or less stable. The graphic below does not have the signatures of the classic fiscal irresponsibility induced financial crisis and economic recession. It exploded in Ireland. But in Greece, Spain, and UK, while it did increase, but not at a rate that merited a financial crisis and recession of this magnitude.

So are households responsible? While household consumption did rise in Ireland and Greece, it was remarkably stable elsewhere. These are not the usual indicators of a crisis of this magnitude.

Clearly closer scrutiny is required. More than government and household balance sheets, those of non-financial corporations and financial institutions in the peripheral economies today look unsustainable.

The massive inflow of cheap capital in the aftermath of the currency union led to unsustainable resource misallocation and bubbles. Construction activity and real estate markets in many countries boomed. Ireland, Iceland, and Spain, were the three worst affected by this misallocation problem. In fact in Spain, financial institutions have accumulated 323 billion euros ($418 billion) in real estate assets, of which 175 billion euros was labeled “problematic” by the Bank of Spain last year. Notice that construction activity declined throughout this period in Germany.  

Corporates across manyof these peripheral economies binged on these inflows. As the graphic below shows, corporate borrowings boomed, especially in countries like Spain. Again Germany stands out in its restraint. As the Times recently wrote, the Spanish debt crisis is built on corporate borrowing, and its nonfinancial private sector debt at 134% of GDP is higher than any major economy in the world with the exception of Ireland.

There are two immediate crises that need to be addressed. The most important is the banking crisis, which directly impinges on institutions in the center and the periphery. The core economy banks remain heavily heavily exposed to the peripheral economy banks. As the saying goes, it becomes your problem if someone has borrowed a million dollars as against a few hundred dollars. If recent events are any indication, Spain looks set to go down the Ireland route and nationalize its banking system so as to avert a full-fledged banking crisis.

A series of reform measures have been announced by Spain, where three-fifths of Spanish banks’ €310bn property lending exposure is “problematic”. Increased provisioning for bad loans, including the possibility of a "bad bank" (like was done in Ireland in 2009) to house these "problematic" loans, so as to restore market confidence and ease the credit markets, are among the reforms. Then there are the larger Eurozone reforms required - ECB to become a lender of last resort, the creation of a European Deposit Insurance and Resolution Fund. One immediate policy change could be to permit the euro zone’s new bailout fund, the European Financial Stability Facility, to lend directly to struggling banks rather than solely to national governments.

Then there is the challenge to prop up economic activity. The private sector is hobbled with the double whammy of badly bruised balance sheets and badly frozen credit markets. Households too are in no position to step in with the big-bang required to boost aggregate demand. In the circumstances, there is no alternative to some form of government spending and significant external support. In a recent FT op-ed Nouriel Roubini suggested "monetary easing by the ECB, a weaker euro, fiscal stimulus in the core, less front-loaded austerity in the periphery, more international firewalls and debt mutualisation".

But unfortunately, austerity remains the preferred medicine. A starving man is now being deprived off his only remaining source of food. And all this, even at the cost of pushing him to death, is to drive home the message of prudence and eliminate any moral hazard of him becoming lazier still. 

Saturday, April 28, 2012

The Swedish lessons for Europe

Fiscal austerity is the current buzzword in macroeconomic policymaking. Across Europe, despite very strong domestic political opposition, governments have embraced wildly ambitious fiscal adjustment targets in an attempt to rein in soaring public debts, restore market confidence, and thereby engineer economic recovery. 

However, evidence from nearly three years of such experimentation across Britain and the Eurozone economies has been dismal. Bond markets have remained unimpressed and sovereign bond yields continue to rise. Not only have the expected recovery not materialized, but these economies have slipped further down the abyss. And this has been the fate of economies within and outside the Eurozone. The latest casualty is Britain, which has officially slipped into a double-dip recession, its second recession in three years. It joins Belgium, the Czech Republic, Greece, Italy, the Netherlands and Spain who are already in recession.

As with Greece, Ireland, and Portugal earlier, Spain too is now experiencing the wages of the same austerity medicine. Amidst a contracting economy, its sovereign debt rating has been downgraded and cost of borrowing has been rising. One-in-four Spaniards are unemployed and half all Spanish youth are out of work, both the highest among advanced economies. Even with all the belt-tightening, Spain is expected to easily miss its target of lowering budget deficit from 8.5% of GDP to 5.3% in 2012 and do no better than 6.2% .   

As could have been anticipated, the blind embrace of austerity has had the effect of accepting the worst of all worlds. As economic growth has contracted, public debt-to-GDP ratios have gone up even higher and tax revenues have dipped sharply. In the absence of either the private sector or external sector stepping in top stanch the space vacated by public expenditures, it was natural that the economy would contract.

All this has raised unemployment rates and inflicted untold suffering on citizens across Europe. Economic hardship have triggered off pent-up social tensions. Political rebellions and protests have become commonplace in these countries. Many governments have lost power in the face of street protests and failures to push through the tough fiscal adjustment measures required to secure external funds. At last count governments in Greece, Ireland, Italy, Portugal, Spain, Netherlands, and now Romania have lost power due to the pains caused by spending cuts.     

In this context, it has become important that these economies abandon their dogmatic ideological embrace of austerity and fall back on policies that can get their economies growing. Robert Samuelson has a nice article which highlights the less-discussed economic turnaround of Sweden since its banking crisis induced economic recession in early nineties. In recent years, Sweden has emerged, along with Germany, as among the best performing developed economies.

Instead of being wedded to ideology-driven policies, Sweden embraced prudent policies that combined both the conservative and liberal social and economic agendas. For a start, it did not bail out its banks but forced them to take massive losses and virtually nationalized its banking sector. The real estate bubble that was inflated by the financial deregulation of the 1980s deflated in 1991-92. As pressure mounted on the krona, overnight interest rates spiked to 500%, and the Swedish economy contracted steeply and unemployment quadrupled in three years to 12%. After a series of bank failures, the government moved in swiftly with a series of measures,

In September 1992... the government announced that the Swedish state would guarantee all bank deposits and creditors of the nation’s 114 banks. Sweden formed a new agency to supervise institutions that needed recapitalization, and another that sold off the assets, mainly real estate, that the banks held as collateral. Sweden told its banks to write down their losses promptly before coming to the state for recapitalization. Facing its own problem later in the decade, Japan made the mistake of dragging this process out, delaying a solution for years...

By the end of the crisis, the Swedish government had seized a vast portion of the banking sector, and the agency had mostly fulfilled its hard-nosed mandate to drain share capital before injecting cash. When markets stabilized, the Swedish state then reaped the benefits by taking the banks public again.
This was followed with several far-reaching structural reforms that turned the largely statist economy into one of the world's most dynamic economies, without compromising on its social-democratic principles. The reforms drew from both the conservative and liberal playbooks,  

Sweden’s income tax base was broadened and tax rates were sharply reduced (marginal tax rates fell from 46% in 1996 to 33% in 2010). Spending was cut on old-age pensions, child allowances, unemployment benefits and housing subsidies. Union power over wages was reduced. Many markets (banking, air travel, telecommunications, electricity production) were deregulated. Low inflation and balanced budgets became broadly embraced popular goals...

Although Sweden trimmed social benefits, it hardly abandoned the welfare state. Overall government spending is still about 50 percent of the GDP, much higher than in the United States... To reduce income tax rates, the government raised other taxes. Gasoline and cigarette taxes were increased; so were taxes on dividends and capital gains, hitting the rich. Altogether, deficit reduction totaled a huge 12 percent of GDP from 1991 to 1998. Slightly more than a third of that came from higher taxes...
The aims were clear: to reward work by cutting income tax rates; to push people back into the labor market by reducing some government benefits; and to promote productivity by increasing competition. Productivity and “real” (after-inflation) wage gains improved markedly. Still, Sweden has less economic inequality than most advanced countries.

Sweden also benefited from favorable external economic conditions. Its recession coincided with a sustained period of economic strength across much of the world. Sweden could therefore export its way out of recession. A 25% devaluation of the krona boosted exports. Unfortunately, none of the peripheral European economices today can afford this luxury. None of the Eurozone economies have the freedom to undertake this policy route. See also this excellent presentation by Swedish Finance Minister Anders Borg.

The choices facing Eurozone governments are stark. Currently the austerity policies are merely pushing their economies down the hill, with no hope of finding an anchor that can drive economic recovery in the foreseeable future. It is necessary for all the Eurozone economies to start regaining their economic competitiveness for any sustained recovery to take hold. This can happen only with either a Eurozone exit and/or fiscal transfers from the Eurozone's center. There has to be some period of fiscal accommodation in the periphery and consumption increase in the center.

This is an opportunity to push through the tough labour market liberalization and industry dergulation policies that have for long contributed to sclerosis in Europe. More than that it is an opportunity for the Europen monetary union to become a loose political union, a necessary requirement for the continent to stave off similar situations in future, leave alone escape the current mess.   

Monday, April 23, 2012

Fiscal policy Rules - Chilean experience

Arguably the biggest short-term challenge facing the Government of India is to get its fiscal balance in order. With elections due in two years, the propsects of any significant roll-back on subsidies, the major contributor to the fiscal imbalance, appears bleak. However, at a policy level what are the options available for the government to address this challenge?

The ultimate objective of any fiscal policy framework is to maintain long-term budget balance. In the long-run this can be achieved only by running up surpluses during the good times so as to build up the buffer to draw upon when the economy hits rough weather. But real world implementation of such counter-cyclical fiscal policy is difficult in democracies. As the good times arrive and tax revenues soar, pressure inevitably builds to spread it around. Not many countries have successfully managed this challenged.

The most famous experiment with fiscal policy rules is the European Union's Stability and Growth Pact, which defined a budget deficit target of 3% of GDP, beyond which defaulters could attract steep fines. It was thought that the clear target and the severity of the fines would deter countries from defaulting. But as we have seen over the past decade, this target was rarely met, even by its more fiscally prudent members.

Closer home, India's own experiment with fiscal policy rules has been disappointing. The Fiscal Responsibility and Budget Management (FRBM) Act was enacted in 2003 with the objective of eliminating revenue deficit and bringing down fiscal deficit to 3% of GDP by March 2008. However, the sub-prime crisis and the global economic slowdown resulted in the suspension of its implementation in 2009. In the context of India's dismal fiscal balance, there have been calls from within the government for reviving the FRBM.

However, Chile, as in many other cases of macroeconomic policy making, stands out as an excellent example of successful fiscal management. Since 2000, Chile has managed a truly counter-cyclical fiscal policy through a set of very clearly defined fiscal policy rules. At the heart of its fiscal policy framework is a clear budget target. The budget target was originally set as a surplus amounting to 1% of GDP, but was lowered to 0.5% in 2007 and to 0% in 2009. The government is permitted to run a deficit larger than the target only if the output falls short of its long-run trend (say, in a recession) or if the price of copper (it accounts for 16% of government's income) falls below its medium-term (10 year) equilibrium. Jeffrey Frankel writes,
The key institutional innovation is that there are two panels of experts whose job it is  each mid-year to make the judgments, respectively, what is the output gap and what is the medium term equilibrium price of copper. The experts on the copper panel are drawn from mining companies, the financial sector, research centers, and universities. The government then follows a set of procedures that translates these numbers, combined with any given set of tax and spending parameters, into the estimated structural budget balance. If the resulting estimated structural budget balance differs from the target, then the government adjusts spending plans until the desired balance is achieved.
He writes about how the government of Michelle Bachelet (2006-2010) instututionalized the structural budget rule (it was initially followed voluntarily by the government of Ricardo Lagos) into a Fiscal Responsibility Bill 2006 and resisted the temptation to indulge in public spending when copper prices boomed. 
The real test of the policy came during the latter years of the copper boom of 2003-2008 when, as usual, the political pressure was to declare the increase in the price of copper permanent thereby justifying spending on a par with export earnings. The expert panel ruled that most of the price increase was temporary so that most of the earnings had to be saved. This turned out to be right, as the 2008 spike indeed partly reversed the next year. As a result, the fiscal surplus reached almost 9% when copper  prices were high. The country paid down its debt to a mere 4 % of GDP and it saved about 12 % of GDP in the sovereign wealth fund. This allowed a substantial fiscal easing in the recession of 2008-09, when the stimulus was most sorely needed.
As indicated, the critical innovation in Chile was the clear identification of budget-relevant macroeconomic variables (output gap and copper prices), entrustment of its estimation to independent panels, and the fortification of this framework as a statutory mandate. This approach to fiscal policy making has the twin-benefits of letting a technocratic agency determine the outer boundaries of the fiscal balance at any time, while leaving elected governments with the freedom to allocate spending among competing claims. However, as is the case with all such neat solutions, the challenge lies with its political acceptability.

One encouraging sign as we set out in this pursuit of fiscal policy rules comes from the evolution of central banks and their monetary policy making role. We often take for granted the independence and objectivity of monetary policy decisions. This glosses over the fact that independent, target-focussed and rules-driven monetary policy decisions by central banks is, even in developed economies, a recent phenomenon. In countries like India, central banks have gained tremendous authority and credibility in their interest rate decisions over the past decade or so. Governments have exercised great caution and restraint in promoting central bank autonomy. There is some reason to hope that fiscal policy rules too could similarly evolve and gain strength over a period of time.

Tuesday, April 17, 2012

Eurozone's rebalancing challenge

Regaining external competitiveness dented by a decade of massive external capital inflows, asset price bubbles, and investment booms, is arguably the biggest challenge facing many of the beleaguered Eurozone economies. Martin Wolf, quoting two Goldman Sachs research papers, “Achieving fiscal and external balance”, points to the magnitude of this re-balancing challenge facing the peripheral economies.
To achieve a sustainable external position, Portugal needs a real depreciation of its exchange rate of 35 per cent, Greece one of 30 per cent, Spain one of 20 per cent and Italy one of 10-15 per cent, while Ireland is now competitive. Such adjustments imply offsetting appreciation in core countries. Moreover, with average inflation of 2 per cent in the eurozone and, say, zero inflation in currently uncompetitive countries, adjustment would take Portugal and Greece 15 years, Spain 10 years and Italy 5-10 years. Moreover, that would also imply 4 per cent annual inflation in the rest of the eurozone.
But the danger is that even if the required inflation environments can be sustained for long periods, the austerity policies being followed by these economies could choke off any growth and push them down a contractionary spiral. Spain's targeted fiscal correction by 5.5% of GDP over two years, with 3.2% adjustment proposed for 2012, from its fiscal deficit of 8.5% of GDP for 2011, is one of the biggest fiscal adjustments ever attempted by a large industrial country. Such severe austerity threatens economies with large unmeployment rates, debt-ridden banks, and fiscally constrained governments. Predictably, as with the case of Spain, the markets have reacted with alarm driving up Spanish bond yields and CDS spreads.

Monday, March 12, 2012

India's fiscal crisis in graphics

It is clear that whatever the RBI does with monetary accommodation, the path towards creating conditions for sustainable economic growth lies in reining in the growing fiscal deficit.

A recent report by the Goldman Sachs estimated the combined fiscal deficit of states and center for 2011-12 to touch 9% of the GDP, easily the highest among all the major emerging economies. It attributes this high deficit to the twin problem of falling tax base and ballooning subsidy burden. The Rs 40000 Cr gap in the ambitious disinvestment target is another major contributor.

The biggest long-term concern is the low tax-to-GDP ratio. India's tax-to-GDP ratio is again among the lowest among the major emerging economies.

Worse still, after steadily rising since beginning of the last decade, it has been falling since the recession struck. And it shows no signs of having bottomed out and is expected to fall further this year.

Subsidies are the elephant in the room. The food, fertilizer and fuel subsidy bills have been rising alarmingly in recent years. Unfortunately, with the 2014 elections looming large, the prospects of structural reforms to roll-back subsidies appears bleak.

Wednesday, February 22, 2012

Eurozone crisis in graphics

A series of excellent graphics from Paul Krugman that points to the underlying causes behind Europe's current crisis.

Contrary to conventional wisdom, surging public debt and fiscal irresponsibility was not the cause for the current problems, even among the peripheral economies. Greece was the only exception. The graphic shows how public debt to GDP ratios continued to decline across the PIIGS throughout last decade till the crisis struck.

However, in the aftermath of the Eurozone integration, there was a sharp surge in capital inflows from the core to the peripheral economies. Both demand and supply side forces drove these flows. On the demand side, the single currency and the resultant sharing of sovereign risk lowered the cost of capital for all these economies, thereby making debt available at cheap rates for the domestic industry.

On the supply side, this capital flow bubble was induced by the sudden decline in the sovereign risk of the peripheral economies (given their integration into a single currency union), the bright economic prospects and the potential for higher returns. Investors assumed that the biggest supporters of European integration, Germany and France, would never let a weaker eurozone country default on its obligations, for fear of derailing the political union of Europe. This belief enabled precisely such countries and their private financial institutions to borrow heavily at cheap rates. Predictably, these flows led the emergence of large current account imbalances.

The sudden influx of easy money led to a sharp increase in price levels and wages across the PIIGS economies. The economic competitiveness of these economies took a hit, especially in relation to the core area economies.

Despite the austerity programs under implementation in these economies, the debt-to-GDP ratios are not expected to come down anytime soon. The shrinking economies have contributed to the declines in interest rates.

Update 1 (28/2/2012)

Paul Krugman on what caused the Eurozone crisis,

At root, their problems are primarily caused by balance-of-payments rather than sovereign debt issues; they had huge capital inflows between 1999 and 2007, which led to inflation, and now they need somehow to regain competitiveness. But overlaid on this is a sovereign-debt crisis, which has forced them to seek aid — and the lenders are demanding harsh austerity in return, which is further depressing economies already suffering from severe overvaluation.

See also this set of graphics from Krugman. This shows the impact of austerity on Greece.

Monday, January 30, 2012

The fiscal and monetary "wiggle-space" - where does India stand?

Free Exchange points to the contrasting macroeconomic positions of developed and emerging economies. While the former has limited fiscal and monetary space to stimulate their economies any more, the later have adequate cushion on both fronts, if the need arises.

The average budget deficit of emerging economies last year was only 2% of GDP, against 8% in the G7 economies. And their public debt ratios were on average only 36% of GDP, compared with 119% of GDP in the rich world.

The Economist article uses a mix of fiscal and monetary policy paramters to arrive at the respective nations flexibility to manoeuvre with expansionary policies. It points to five parameters that determine the monetary policy space - inflation, credit growth, real interest rate, exchange rate movements, and current account balance. It added up the scores on these five parameters to produce an overall measure of monetary manoeuvrability. On the fiscal policy side, it constructs a fiscal-flexibility index, combining government debt and the structural (ie, cyclically adjusted) budget deficit as a percentage of GDP.

It ranked 27 emerging economies according to their monetary manoeuvrability and fiscal flexibility using a "wiggle-room index" constructed using the aforementioned parameters. This index is a reflection of the ability of countries to withstand a global downturn by stimulating their economies. The verdict,

The index suggests that China, Indonesia and Saudi Arabia have the greatest room to support growth. At the other extreme, Egypt, India and Poland have the least room for a stimulus, thanks to excessive government borrowing, large current-account deficits, and uncomfortably high inflation. Brazil is also in the red zone.

At first glance, on most parameters, India stands out as being among the most constrained of emerging economies. On the fiscal side, its combined government fiscal deficit of around 9% of the GDP, means that there is limited space available for any stimulus spending.

However on the monetary side, given the recent declining trend in inflation, the 13 consecutive repo rate increases by the RBI in response to rising inflation gives the central bank adequate monetary space to stimulate the economy. Further, since credit growth has been below par and exchange rate appears to have weathered its brief period of volatility, the monetary side space may not be as constrained as it appears now.

Further, while its total public debt, at about 68% of GDP, may look high by the standards of emerging economies, closer analysis reveals that it may not be as dismal as is being projected. Here are three reasons

1. The overwhelming share of this public debt is owed to domestic creditors. In fact, the total external debt (public and private) is estimated to decline to 17.4 of GDP for 2011, with government share being a mere 4.4% of GDP. As of end-September 2011, of the total external debt of $326.6 bn, with government and non-government shares in the total external debt being 24.3% and 75.7% respectively. Short-term debt accounted for 21.9% of the country's total external debt, while 78.1% was long-term. Adjusted for this, the real effective debt burden, in relation to a sovereign debt default risk, shrinks considerably. The only area of slight concern should be the 27.4% CAGR in external commercial borrowings between end-March 2006 and end-March 2011.

2. At 122% of GDP, its overall debt is the second lowest among all the major economies. Only Russia has a lower overall debt-to-GDP ratio.

3. Though its government may be profligate, the other major engines of economic growth - households, non-financial corporates, and financial institutions - have the healthiest balance sheets among all major economies, including China.

This means that all the non-government drivers of economic growth stand on very strong platforms and have enough "wiggle-room" to manoeuvre. All that is now required is for the government to get governance and policies right. Will that happen?

Wednesday, December 7, 2011

The austerity-leads-to-growth evidence is missing

The three most cited examples of fiscal austerity in the face of economic contraction as the preferred strategy to restore economic normalcy are Ireland, Latvia, and United Kingdom.

A year on after it received a 67.5 billion euro bailout, Ireland represents a very mixed macroeconomic picture though the social impact of austerity has been much more damaging. In 2010, Ireland passed the most austere budget in the country’s history, and public sector pay cuts were a centerpiece of the government’s reform effort. Though green shoots of economic growth are back, exports have been rising, and deficit is shrinking (it fell from 32% in 2010 to estimated 10% for 2011), public debt burden far from plateauing and declining has been rising, albeit slower than earlier, and bond yields have been climbing. Most damagingly, unemployment rates are climbing and nearly 40,000 Irish have fled the country this year alone in search of a brighter future elsewhere.

More worryingly, as this Times report indicates, the platform for sustaining short- to medium-term growth looks shaky.

"Salaries of nurses, professors and other public sector workers have been cut around 20 percent. A range of taxes, including on housing and water, have increased. Investment in public works is virtually moribund... government is announcing an additional 3.8 billion euros in tax increases and spending cuts for 2012 that will affect health care, social protections and child benefits. Retail sales fell 3.8 percent in October from a year earlier as spending was down even on things like school textbooks, shoes and other basic goods... welfare payments have steadily been reduced even as the unemployment rate has ticked up to 14.5 percent, and is forecast to remain high at least through next year."

In this context, as Paul Krugman has repeatedly pointed out, the experience of Iceland, which went against conventional austerity, is instructive. Faced with a unsustainable external debt, run up by its reckless banks, Iceland let its bankers go bust and even expanded its social safety net. It also imposed capital control. Instead of internal devaluation through wage freezes, Ireland devalued the kroner. While, like others, it did suffer sharp output contraction, it has managed to keep unemployment rates from getting out of control.

In fact, this direct comparison of the Latvia and Ireland, is very stark. Even on output contraction, the austerity experiment appears a relative failure.

Admittedly, Iceland had its currency and could manage an external devaluation, and regain competitiveness and put the economy on recovery path. The Eurozone economies do not have that and other sovereign instruments to tide over such crises. But United Kingdom has the option of currency devaluation and other regular instruments, and still choses austerity.

More than a year on into its austerity program involving cutting 600,00 public sector jobs, the British economy appears no close to recovery. Early last week, the British chancellor of Exchequer has admitted that growth would be slower than forecast and "debt will not fall as fast as we’d hoped". This meant additional austerity measures, including pay freezes for two more years beyond 2015. The initial plan to eliminate budget deficts has been pushed back by two more years to 2017 and Britain would now require to borrow an additional £111 billion, or $172 billion, through 2015.

A report by the Office for Budget Responsibility has forecast that the British economy will grow 0.9% his year, less than the 1.7% predicted earlier, 0.7% next year, and 2.1% in 2013. It also predicted that debt as a share of GDP would peak at 78% in the fiscal year ending in 2015, higher than the 71% initially predicted. The output gap is expected to persist well past 2017, and the November 2011 estimate shows it worsening since the March 2011 estimate.

The austerity and the squeeze on public spending is expected to take a heavy toll on the GDP growth, as seen by this graphic. The contributions of government compensation, procurement, and investment to the economic growth is set to decline strongly in the years ahead.

Given the inevitability of output contraction and the difficulty of accommodation due to fiscal space, the only immediate political economy issue of concern is how to mitigate adverse consequences of the the slowdown on the nation's population. Atleast on this count, all the aforementioned experiences show that austerity fails.

For more on the social impact of savage austerity, see this report on Lithuania. It achieved a fiscal adjustment of 9% of GDP by cutting public spending by 30% (incluing slashing public sector wages 20-30% and reducing pensions by as much as 11%), raising corporate taxes to 20% from 15%, value added tax from 18% to 21%, and also taxes on a wide variety of goods. In Britain, the wages of austerity are taking an increasing toll and the winter of discontent appears to be making a comeback with nationwide strikes and protests.

Update 1 (2/2/2012)

The FT writes that "after the initial stimulative boost, fiscal policy began to steadily contribute less and less to growth until finally becoming a drag for most of last year and part of the prior year. That’s why the federal contribution to growth is roughly a wash during the recovery."

The CBPP graphic hilights the true magnitude of the austerity. In fact, the cuts backs in state and local government spending make it the worst period since 1944. As CBPP writes, "state and local governments have cut deeply their spending on schools and other public services for three straight years. In fact, economic output from state and local governments fell by 2.3 percent in 2011 — marking the steepest drop since the wartime economy of 1944. By reducing economic activity, these cuts have slowed the economic recovery."

David Leonhardt maps the evolution of the US economic growth over the past four years with respect to the trends in private and public sector consumption growth rates.

Saturday, July 16, 2011

The call for austerity - cure worsens the disease?

Carmen Reinhart and Ken Rogoff, the foremost historians of macroeconomic crises, have an excellent article in Bloomberg, where they express concern at the high debt overhang among developed economies.

Their magisterial examination of the history of financial crises and the relationship between growth and public liabilities found that when the debt-to-GDP ratio exceeds 90% in case of developed economies, it starts having adverse impact on long-term growth and macroeconomic stability. And this level has either been already breached or is fast approaching in most developed economies.

They cast doubt on the arguement of advocates of fiscal expansion, who claim that the ultra-low interest rates justify another round of stimulus despite the high public debt ratios. They argue that market interest rates can change dramatically in a few months with disastrous cascading consequences, whereas debt reduction takes years. Further, as the Japan example shows, high debt overhang, even without high interest rates, can hinder growth.

Though this analysis cannot be faulted, the implied solution - reining in debt with austerity and tax increases - is fraught with even bigger dangers. As I blogged earlier this week, expansionary fiscal consolidation holds limited promise. It contracts private domestic demand and the GDP. This should not come as a surprise since private consumption and business investment, which form the predominant source of growth in the absence of government spending, remains abysmally weak and shows no signs of revival. The only other remaining source of growth, external trade, too holds little promise and in any case cannot provide the thrust for recovering from such a bad crisis in case of large economies. See this and this.

Without private sector consumption and investment recovering, any contraction in government spending will only push the economy further down the recessionary path. The knock-on effect on the revenues side of the fiscal balance will be disastrous.

As has been well documented with the impact of the Great Recession on the US government deficit, the biggest concern during a recession is the reduction in government revenues and the resultant widening of fiscal deficits and debt-to-GDP ratios. In other words, the prescription turns out worsening the disease!

Paul Krugman has this concise response to the two most frequent arguments that deficits will drive up interest rates - government borrowing crowding out private borrowers and driving up rates, and fears of government's solvency frightening off investors and increasing the cost of borrowing.

Update 1 (17/7/2011)

The two big concerns for conservatives who advocate fiscal contraction are fears of high borrowing costs (bond-vigilantes) and high-inflation. These two concerns go against all standard macroeconomic models of economies stuck in slowdowns with interest rates at the zero-bound. Moreoever, they have been proved as wildly misplaced both from experience till date and from all available long-term forecasts.

In fact, quite to the contrary, all evidence points to a period of persistent low interest rates and low inflation (so much so that some economists, including the IMF, have called for raising the inflation target). This points to deflation, accompanied by Japan-style deep recession, as the greater danger now.

As to why the fiscal contraction story continues to grip the imagination of opinion makers, Paul Krugman points to Robert Kutter. They argue that this line of reasoning supports the interests of creditors, with significant exposure in bonds, loans, and cash. Mike Konczal calls it as "wealth and income defense". These rentiers have an interest in keeping inflation down and they positively benefit from a deflationary environment. Unfortunately, these run exactly opposite to the interests of workers and others.

Update 2 (3/9/2011)

Excellent op-ed in the Times which points out how Argentina, faced with similar high unemployment rate and a sovereign default, rebounded not with austerity but with massive fiscal expansion. For a start, the government intervened to keep the value of its currency low. It then increased taxes to finance a New Deal-like public works binge, increasing government spending to 25% GDP from 14% in 2003. It also strengthened its social safety net - the Universal Child Allowance, started in 2009 with support from both the ruling party and the opposition, gives 1.9 million low-income families a monthly stipend of about $42 per child, which helps increase consumption.

The Washington Post writes that a downturn in Europe deepened by choking off government revenues and increasing the demand for public services, could put struggling countries such as Spain and Italy at risk of missing the very deficit-reduction targets that budget cuts and other austerity measures were meant to achieve.

Wednesday, May 25, 2011

More on macroeconomic policy arguments during the Great Recession

The Great Recession has become a fertile ground for considerable analysis of the prevailing conventional wisdom macroeconomic policies. The relative merits of contractionary and expansionary monetary and fiscal policies are at the heart of all ideological battles.

Conservatives fret at the inflationary effects of expansionary conventional (zero-bound interest rates) and unconventional (quantitative easing) monetary policies and call for tightening monetary policy or atleast oppose any further monetary expansion. They also point to the unsustainable public debt and fiscal deficit and argue any fiscal expansion. Some even argue that all this is crowding out private spending, despite the overwhelming evidence of massive idling resources and capacity in the US economy. Their general belief is that hard money and sound government finances are necessary for a robust recovery to take hold.

Paul Krugman has been the strongest proponent of the view that when faced with a liquidity trap, increases in the monetary base (which includes bank reserves as well as currency) doesn’t cause inflation, or even a rise in broader definitions of the money supply. Faced with a recession and the zero-bound, businesses postpone investments and consumers their spending, thereby forcing banks to hold on to their reserves. This propensity to hold on to reserves is amplified by the fact that under such conditions, cash and T-Bills become near perfect substitutes, and the Fed cannot therefore expand M2.

Krugman points to the evidence from old and recent history to highlight this. At the onset of the Great Depression, though the Fed expanded the monetary base considerably (admittedly this may have been smaller than was required), it did not result in the expected increase in money supply and inflation remained muted.

Much the same happened in Japan. Despite a dramatic expansion in the monetary base by the Bank of Japan, prices kept falling.

Since the beginning of the Great Recession, the US Federal Reserve has been quick in dramatically expanding its balance sheet and increasing the monetary base. The result - M2 money supply and consumer prices have hardly budged.

However, even among those who favor monetary expansion, there is one group who argue that the Federal Reserve could have done more to avert a deep recession in 2008 and 2009 if it had indulged in much more aggressive monetary expansion. Scott Sumner, David Beckworth and others argue that the central bank using monetary policy tools can do more, even when faced with a zero-bound in interest rates, to stimulate aggregate demand and expand the economy.

They advocate setting an explicit nominal GDP target (or nominal GDP growth path) to shape future market expectations about current and future nominal spending and thereby boost economic growth or prevent aggregate demand crashes. This, they argue, can be done by purchasing assets other than Treasury Bills, like longer-term securities, to lower long-term rates and thereby incentivize investment and consumption spending so as to reach the nominal GDP target. David Beckworth writes,

"Set an explicit nominal GDP level target so that expectations are appropriately shaped. If such a rule were adopted expectations of current and future nominal spending would be anchored around the level target... Even if a spending crash did occur the catch-up growth needed to return nominal spending to its level target would most likely imply an expected path of short-term real interest rates consistent with restoring full employment...

if the monetary base and t-bills became perfect substitutes because the 0% bound is reached the Fed should buy longer-term treasuries or foreign exchange... The 0% bond for us really is not a big deal, but simply an artifact of monetary policy using a short-term interest rate as the targeted instrument."

As David Beckworth acknowledges, this understanding is not that different operationally than a New Keynesian invoking a higher inflation target to lower the expected path of real interest rates or the portfolio channel to drive down the term premium on long-term bonds.

Paul Krugman points to evidence from Japan to question the quasi monetarist position on the utility of monetary policy during such liquidity trap crises. In this context, he also draws attention to the views of the late Milton Friedman who had advocated that the central banks push more reserves into the banking system through monetary expansion. In fact, Friedman had famously blamed the Fed's unwillingness to indulge in sufficient monetary expansion as the major contributor towards the Great Depression.

However, unlike the Fed in the 1930s, the Bank of Japan indluged in massive monetary expansion. However, this did not result in the expected rapid growth in the money supply or monetary base.

Paul Krugman concludes that "in the face of a really big shock, which pushes the economy into a liquidity trap, the central bank can’t prevent a depression". In the circumstances, the only option left is fiscal policy. Here Krugman points to the critical role that the government borrowing and spending played in making up for the steep decline in private consumption.

Update 1 (28/10/2011)

FT Aplhaville points to a Goldman report which advocates nominal GDP targeting for the US.

"For the US, we advocated a shift to nominal GDP targeting, backed up with asset purchases, as the best of these options if further easing is needed. We think nominal GDP targeting probably provides the best way of communicating a credible intention to deliver a more aggressive easing without taking risks on long-term inflation. First, the framework is simple and transparent and avoids the complications of choosing a particular price index. Second, it deals directly with the problem of large excess capacity in the economy and focuses on a variable that is more directly linked to the ability to cope with debt contracts that were mostly made on the assumption that nominal income would be much higher than it currently is. Extending the price level trend for the US or UK would not deliver as strong a case for easing (and in the UK may argue for tighter policy). Third, it does not focus directly on generating inflation, which may make it more palatable to the public, or on the exchange rate, which could raise international tension. Fourth, it defines a clear exit strategy for policy and so minimises the risk of runaway inflation. Other policy options meet some of these criteria, but we think overall score less well."

Sunday, May 15, 2011

Global unemployment challenge

The biggest immediate problem facing the developed economies is arguably the persistence of high unemployment rates. As the graphic below reveals, among the major economies, apart from Germany, unemployment rate remains well above the level before the onset of the Great Recession in September 2008.

Its innovative short-work scheme that encouraged companies to keep workers on reduced hours rather than let them go and the strength of its exports sector played a major role in limiting the impact of the Great Recession on the German labor market. Labour market reforms initiated in the last decade too helped Germany retain its competitiveness during the Great Recession.

In the circumstances, contractionary fiscal and monetary policies, driven by fears of burgeoning deficits and inflationary pressures, are only likely to further shrink these economies. This danger is all the more so since aggregate demand is very weak and the private sector is in no position to lead the recovery.

Anemic economy will only exacerbate the debt crisis and increase the debt-to-GDP ratios. As to inflation, given the considerable idling resources in all these economies, it looks like a phantom menace. The immediate challenge should be to get these economies back on some stable recovery path, so that jobs are restored and created, by continuing the expansionary policies for some more time. Or else, we could be staring at a lost decade for developed economies.

Tuesday, January 18, 2011

Rebalancing global current account imbalances

The biggest medium-term concern for the world economy is the management of the global macroeconomic (specifically, current account) imbalances - getting the deficit countries to save and the surplus generators to spend more.

Joseph Gagnon feels that current account imbalances are likely to return to record levels over the next five years and the recent narrowing of imbalances was almost entirely a result of the global recession and that global recovery will unwind this effect. About the fundamental reason for the continuing build up of these imbalances, he writes,

"The primary culprit, in my view, is the development strategy increasingly being adopted by emerging markets — most notably China — of deliberately undervaluing one’s currency by official purchases of foreign assets in order to get net-export-led growth. Most developing economies are now piling onto this strategy in a big way (hence the currency wars), and it is a major problem for the U.S. We all want net exports to grow but we cannot all get it."

About the way ahead, he writes,

"To avoid a return of large global imbalances, economies with current account deficits should cut fiscal deficits more than is currently projected and economies with current account surpluses should reduce official financial outflows and allow their currencies to appreciate as well as take steps to boost domestic demand.

Fiscal consolidation in surplus economies — though necessary in some cases — is detrimental to rebalancing and should proceed at a slower pace and to a lesser degree than in deficit economies. Even in deficit countries, the pace of fiscal consolidation should be slower in economies where the recovery from the crisis remains weak.

Monetary policy should remain accommodative and even ease further in economies where output remains below potential and inflation threatens to fall below desired levels. In developing countries in which inflationary pressures are rising, a tighter macroeconomic policy stance is indicated. However, the form of the tightening should differ based on country circumstances: Surplus economies should tighten via exchange rate appreciation, whereas deficit economies should tighten via fiscal policy."

I am not sure whether Gagnon's assessment of the reasons and the possible solutions captures the full picture. While he offers clarity on the measures to be undertaken by the surplus generators, there is ambiguity about policies to be adopted by the deficit countries. He under-estimates the contribution of the extraordinary monetary accommodation (by way of quantitative easing) in the US to sustaining the imbalances. The resultant capital flows into emerging economies have played an important role in fuelling financial market excesses and over-heating there.

Monetary accommodation, while required to mitigate the adverse impact of the recession, cannot be a substitute to avoid the hard choices required. Given the extraordinary structural imbalances that had crept into the domestic economy (eg, the out-sized prominence of the financial markets), economies like the US cannot restore normalcy without undergoing considerable pain and implementing policies that can reform the domestic structural imbalances.

For a start, debt-laden household and business balance sheets have to contract considerably for any recovery to be sustainable. Currently, apart from boosting aggregate demand and investment, policy-makers are adopting an ultra-accommodative monetary policy for three reasons. One, keeping real interest rates low so as to lower the interest burden. Two, buy time for recovery to take hold by allowing businesses and households to re-schedule their debts. Three, hope that asset values will regain a major share of their values, so that some of the notional balance sheet debts will disappear.

However, all these assumptions may not stand closer scrutiny. Asset values are far down from the boom peaks and are not likely to return to anywhere near those values anytime in the foreseeable future. Further, buying time while keeping an ultra-accommodative monetary stance, may as Raghuram Rajan and others have argued, fuel other bubbles and even more asset mis-allocation. All this would be pumping more steroids on a patient already pumped up with an over-dose of them!

America's persistence with more quantitative easing in the name of expanding credit and lowering real long-term rates (and thereby raise asset values and boost consumption) is similar to China's policy of keeping the renminmbi under-valued so as to keep exports competitive. The Americans say that without this, the economy risks tipping into a deeper recession. The Chinese fear that currency revaluation will reduce Chinese exports, weaken economic growth, and generate social tensions. Both sides are grossly over-estimating the relative impacts and their policies are playing an important role in sustaining the current account imbalances. Further, both are band-aid policies that reveal a reluctance to embrace more fundamental changes required to remedy deeper domestic structural problems.

Micheal Spence has a few excellent suggestions, which may be germane to a more effective resolution of the imbalances. He advocates a pull-back from the quantitative easing policies and policies that increase the share of America's tradeable sector. He writes about,

"... a pull-back from quantitative easing in the US, which is subjecting the emerging economies to a flood of capital, rising commodity prices, inflation, and asset bubbles. Intervention may be needed in fragile sectors of the US economy, like housing, where faltering performance could produce another downturn. But such intervention can and must be far more precisely targeted than QE2. America’s reluctance to target areas of weakness or fragility leaves the impression externally that QE2’s real goal is to weaken the dollar...

global economy will be out of balance so long as the US runs large current-account deficits... that gap needs to be filled by higher foreign demand and increased export potential... The tradable sector accounts for just 30% of the US economy (by value added), and employment growth in the tradable sector is negligible... If exports are to grow substantially, the scope of the tradable sector must expand."

He also makes a subtle point about China's internal re-balancing,

"In the case of China, a key part of its 12th five-year plan is to shift income to the household sector, where the savings rate is high but still lower than the corporate rate. The economy can then use household savings (with appropriate financial intermediation) to finance corporate and government investment, rather than the US government."

Such internal re-balancing can be done only if China liberalizes its labor markets so as to remove restrictions on wage increases and puts in place a social security system to cushion workers against rising uncertainty (and this is one of the major causes for higher savings rate). It has to be hoped that such policies will encourage the Chinese consumers to loosen their purse strings.

Saturday, November 27, 2010

More on the Celtic crisis

Paul Krugman makes an interesting comparison between the relative paths adopted by Iceland and Ireland when faced with similar financial crises. He describes the relative success, till now, of Iceland and the disaster looming on Ireland, as the triumph of heterodoxy over orthodoxy in economic policy making.

In both cases, the crisis could be traced to irresponsible lending by banks and borrowing by real estate and other businesses. And businesses and borrowers in both ran up massive amounts of external debts. When faced with their respective decision-moments, the responses could not have been starker.

Nearly 18 months back, Iceland responded by making "foreign lenders to its runaway banks pay the price of their poor judgment, rather than putting its own taxpayers on the line to guarantee bad private debts". The result was a number of private sector bankruptcies, which also "led to a marked decline in external debt". It also introduced capital controls to prevent sudden capital flight by foreign and domestic investors. It refrained from destabilizing its Nordic social welfare model with the standard fiscal austerity measures like spending cuts.

In contrast, faced with the prospect of huge losses for banks and their irresponsible foreign lenders, the "Irish government stepped in to guarantee the banks’ debt, turning private losses into public obligations". The result is that the debts got transferred from the banks to the Irish Government's balance sheet. At the first signs of trouble, it imposed a series of "savage fiscal austerity" measures in order to restore "market confidence". And followed it with more doses of the austerity medicine.

The "confidence fairy" has responded in the most unexpected manner to the actions of both governments. If the supporters of the "confidence fairy" hypothesis were correct, Iceland should have been ravaged by the bond-vigilantes and Ireland should have been ovewhelmed by a rush in market confidence. The results have been exactly the opposite. The bond markets continue to savage Ireland, whose bond yields and CDS spreads continue to rise steeply despite nearly three years of austerity. However, Iceland has made a smart recovery, both its economy and the financial markets, winning praise from even the IMF.

Its CDS spreads have fallen from 800 to less than 300, whereas Ireland's cost of insuring debt has risen precipitously from less than 200 to over 500 points.

In fact, a testament of its success and the problems of the EU peripheral economies is the fact that Iceland's CDS spreads have fallen below that of even Spain.

And, unlike Ireland, being out of the single currency zone meant that Iceland could indulge in significant currency devaluation to increase the competitiveness of its exports.

In this context, Simon Johnson points to the odds stacked against Ireland being able to emerge out of its debts any time in the foreseeable future. He points to the fact the fact that atleast 20% of Irish GDP is from 'ghost corporations', attracted by Ireland's 12.5% corporate tax rate, that have little or no real activity in Ireland. This effectively means that the real debt burden of Ireland is more than 100% of the GNP and could rise to 150% of GNP in the next few years.

The steep fiscal contraction by way of spending cuts, especially at a time when the economy is set to contract for the third year in a row, will amplify the real debt burden. In the absence of a national currency, it cannot even devalue and increase the competitiveness of its exports. And given the extraordinary rise in asset valuations - property prices rose four times - any chances of asset prices rising to reduce the real debt burden is remote.

Further, this year, the government will run a deficit of 15% GNP, and with nominal GNP falling, it could well remain that high next year, even if the government cuts spending by the 2 to 3% of GNP currently envisaged. In other words, Irish economy would have to grow at close to its highest ever growth rates just to ensure that its debt share stays the same.

In the circumstances, it is certain that Ireland cannot resolve its debt crisis without some form of debt restructuring that forces lenders to take substantial haircuts. But coming in the way of this is the significant exposures of European banks to Irish debt.

It is estimated that the claims of foreign banks on Ireland are at over $500 billion. German banks are owed $139 billion, which is 4.2% of German GDP British banks are owed $131 billion, or about 5% of Great Britain’s GDP, French banks are owed $43.5 billion, which is approaching 2% of French GDP, and Belgian banks are owed $29 bn, or 5% of its GDP. None of these countries are likely to support measures that would effectively force their own banks to take losses on their Irish exposures.

Update 1 (29/11/2010)
Ireland becomes the second country after Greece within the Eurozone to accept a bailout. The 85 billion euro ($112 billion) bailout plan, at an average interest rate of 5.83% (compared Ireland's 10 year bond rate of close to 10%), includes a contribution of 17.5 billion euros by the Irish government itself through money it has already raised. Of the rest, 22.5 billion euros will come from the International Monetary Fund. The remaining 45 billion euros will come from bilateral loans from European nations and two European Union rescue funds set up in the spring.

Of this €10 billion will be used to immediately to recapitalise the banks to bring them up to a core tier 1 capital ratio of 12%, with a €25 billion contingency. The remaining €50 billion will be used to meet the budgetary requirements of the State. Under the Plan, Ireland will reduce its budget deficit to 3% of GDP by 2015.

Update 2 (3/12/2010)
Barry Eichengreen has the best article on the prospects for the Irish economy. It is in one word - brilliant!

Saturday, October 30, 2010

Europe's Tea Party activists - fiscal austerians?

The belief that fiscal austerity in a recession will generate market confidence and lift the economy from its depths counts along with the equally evangelical supply-side belief that tax cuts will always increase revenues as touchstones of conservative economic ideology. As the Congressional elections in the US draws near and with economy floundering at the door-step of a double-dip, the Tea Party activists are waging a vigorous battle for ideological and political dominance.

Across the Atlantic, in some respects, the austerians have emerged as the Tea Party activists of Europe. An austerity fever, nay epidemic, appears to have gripped the continent. In the face of already high and continuously rising double-digit deficits, and weak macroeconomic conditions - stagnant or dedlining output and high unemployment rates - Europe has collectively embraced a policy of re-balancing government finances. Even a cursory examination of the fiscal deficit reduction targets which have been announced by all the economies exposes them as an exercise in deception and dishonesty.

Across the peripheral economies, all the leading economic indicators look dismal, with forecasts for further reduction in output and growth in unemployment. This in turn means sharp declines in tax revenues and rise in deficits. More worryingly, the lack of private demand and near-certainty of corporate spending not being able to bridge the output deficit created by fiscal austerity, means that these economies are perched at cusp of a potentially catastrophic downward economic spiral from which recovery could be long and tortuous.

Following the recent upward revision of its 2009 deficit from 13.5% to 15.5%, Greece looks almost sure of not only not staying close to its targeted budget deficit of 8.1% for 2010 but also overshooting by some wide differential. This would not only require further debt restructuring, following the earlier $150 bn EU-IMF package, but also force more spending cuts thereby increasing the downward pressure on output and tax revenues. In the meantime the mountain of debt will grow, drawing in bond-vigilantes who will drive up the cost of financing that debt, thereby adding to the debt stock and deficits. The result of all this is predictable - sovereign defaults, deep recession (the economy has contracted 4% so far this year), and rising unemployment.

Ireland, which is set to experience its third consecutive year of economic contraction in 2010, is undertaking the most ambitious, almost unreal, deficit reduction program - to cut fiscal deficit from a whopping 32% in 2009 of GDP to a saintly 3% by 2014. Portugal is struggling to meet its deficit target of 9% of GDP, even as the economy continues to weaken. Spain faces the difficult task of slicing its deficit to 6% by 2011 from 11% in 2009 in the face of a slumping economy and the largest unemployment rate in continental Europe. Britain too has implemented unprecedented spending cuts, which look set to tip the economy into a long period of stagnation.

The fiscal austerity prescription in the face of a slumping economy and rising unemployment defies all logic and history is replete with examples that illustrate its folly. The most recent high-profile example was the IMF-driven fiscal contraction that was forced on the East Asian economies in the aftermath of the 1997 regional currency crisis. Then the austerity medicine had devastated these economies and only those like Malaysia, which went against the prevailing consensus, escaped relatively unscathed. Subsequent studies and the IMF itself have on occasions acknowledged the folly of forcing down such policies.

Paul Krugman points to another example from history, post-Depression US, when sustained public spending through the New Deal and other programs drove up government expenditures and the debt stock. However, the resultant economic growth boosted tax revenues and thereby lowered the deficits. Thanks to the recovery, even as the debt stocks rose, the deficits plunged.

Monday, October 25, 2010

The "confidence fairy" trumps Keynes in UK!

Even as a fierce debate rages about the policies required to address the Great Recession across the developed economies, among the major economies Britain has made a decisive choice to embrace fiscal austerity to restore market confidence. The land of Keynes appears to have blinked on the face of massive fiscal strains and chosen to break with Keynesian policies and follow the path of balancing government finances to revive economic growth.

In recent days, France has decided to raise the minimum retirement age to 62 from 60 and the age for a full pension to 67 from 65. Earlier Greece, Spain, and Ireland had embraced deep spending cuts in an attempt to avoid sovereign bankruptcies.

The Conservative Government in Britain last week followed its other European partners by annoucing the country’s steepest public spending cuts in more than 60 years in an effort to eliminate government deficits by 2015. This comes as Britain faces one the worst public debt problems among all developed economies - 11.5% public deficit and 61% public debt. It is hoped that these steep cuts will repair government's fiscal balance, improve market confidence, stimulate the private sector and restart growth.

The proposed measures include a reduction of expenditures in government departments by an average of 19% (£83 billion or about $130 billion) by 2015, sharp cuts in welfare benefits, increase in the retirement age from 65 to 66 by 2020 (saving $ 8 bn a year), and elimination of 490,000 public sector jobs (out of a total of 6 million jobs or 8% of the total) over the next four years. Further, payments to the long-term unemployed who fail to seek jobs will be cut saving $11 billion a year, and a new 12-month limit will be imposed on long-term jobless benefits, and measures will be taken to curb benefit fraud.

This follows an earlier decision to stop paying its hitherto universal child benefit payments ($32 a week for a first child and $21 for each subsequent one) to people earning more than around $70,000 a year. There is also a proposal to accept the findings of the Browne Review on subsidies for university education, which suggests dramatic cuts on university education spending.

The Browne review advocates scrapping of the present system that caps a year's tuition fee at £3,290 ($5,275) in favor of a free-market approach paid for by the students themselves — but only after they graduate and are earning more than £21,000 a year. It is being suggested that the government could then cut about 80% of the current $6.2 billion it pays annually for university teaching, and about $1.6 billion from the $6.4 billion it provides for research. To make up for the shortfall, universities would have to raise tuition to an average of more than $11,000.

On the revenues front, the British Government has already announced plans to levy a one-time 50% marginal tax on bankers' bonuses of more than £25,000 ($40,700). This would be levied not only British banks but also the London subsidiaries of Wall Street giants. The move is more symbolic than substantial since it would raise only £550 million.

Such a hair-trigger alarmist repsonse from Britain is surprising, and far from engendering market confidence may end up rousing market anxiety and even panic. Unlike fellow Europeans like Greece and Ireland, despite its high 11.5% fiscal deficit, Britain is nowhere close to bankruptcy or reeling from any bond-vigilantes. There were no bond-market panics and inteerest rates have remained low. Public debt at 61%, while high, is not so large as to press the panic button. And all these macroeconomic indicators are similar to that in the US (fiscal deficit of 10.7%), which is debating the extent of accommodation - monetary and fiscal - required. Further, there will be serious questions about the need to eliminate government deficits at all, and that too within such a short-time and starting from an aggregate demand shrinkage driven recession.

These dramatic measures carries with it considerable risks and even goes against the grain of historical record of countries which faced similar situations. In simple terms, the spending cuts are made on the assumption that the private sector will be able to able to make up for the 19% and 8% cuts in government spending and employment respectively, over the next four years.

However, this private sector growth in output and job creation to cover up for the government's exit would have to be a top-up on the regular growth. And regular growth itself will have to be large enough to bridge the yawning output gaps that shows no signs of narrowing. In simple terms, Britain will have to grow at its highest rate in the post-war era, close to double digits, just to return to normalcy. What makes this even more formidable is the fact that this momentum will have to get generated immediately and there appears nothing in the horizon among the private sector that could trigger off such a dramatic spurt in growth.

And all this has to start immediately, since any delays would only end up pushing the can further down the road and widening the output and employment gaps, necessitating even more higher rates of growth and job creation. There are serious and well-grounded fears that such optimism may be misplaced.

It is also hoped that these measures will restore market confidence and encourage the private sector to come forward with their investment and spending plans. However, as the evidence so far from Ireland, which has been similarly savage with its spending cuts, shows, such assumptions may fall through. After its initial round of spending cuts failed to enthuse the markets and trigger any recovery and make any dent on its stupendous budget deficit of 32% of GDP, Ireland is set to announce another round of cuts, which would take the total cuts to 14% of its GDP.

As Joseph Stiglitz wrote in response to the British decision, the excessive faith in the confidence fairy and attendant spending cutbacks "will weaken Britain, and even worsen its long-term fiscal position relative to well-designed government spending". He wrote,

"There is a shortage of aggregate demand – the demand for goods and services that generates jobs. Cutbacks in government spending will mean lower output and higher unemployment, unless something else fills the gap. Monetary policy won't. Short-term interest rates can't go any lower, and quantitative easing is not likely to substantially reduce the long-term interest rates government pays – and is even less likely to lead to substantial increases either in consumption or investment. If only one country does it, it might hope to gain an advantage through the weakening of its currency; but if anything the US is more likely to succeed in weakening its currency against sterling through its aggressive quantitative easing, worsening Britain's trade position...

The few instances where small countries managed to grow in the face of austerity were those where their trading partners were experiencing a boom... Lower aggregate demand will mean lower tax revenues. But cutbacks in investments in education, technology and infrastructure will be even more costly in future. For they will spell lower growth – and lower revenues. Indeed, higher unemployment itself, especially if it is persistent, will result in a deterioration of skills, in effect the destruction of human capital, a phenomena which Europe experienced in the eighties and which is called hysteresis. Lower tax revenues now and in the future combined with lower growth imply a higher national debt, and an even higher debt-to-GDP ratio."

It is being argued in some circles that the apprently contrasting responses (atleast till now) on both sides of the Atlantic to addressing the Great Recession comes from their respective different historical experiences and the attendant institutional memories. The memories of the Great Depression and the human sufferings and long-term damage inflicted to the economy is thought to inform the relative acceptance of fiscal and monetary accomodation in the US. In contrast, Europeans are driven by even more recent experiences with government deficits that have resulted in sovereign defaults and episodes of run-away inflation. In particular, it is being claimed that the Conservative Government's decision now is grounded in memories of Britain’s economic collapse in the 1970s, when the International Monetary Fund had to come to the rescue just as it has done recently in Greece.

Joe Stiglitz should have the last word,

"Austerity converts downturns into recessions, recessions into depressions. The confidence fairy that the austerity advocates claim will appear never does... Consumers and investors, knowing this and seeing the deteriorating competitive position, the depreciation of human capital and infrastructure, the country's worsening balance sheet, increasing social tensions, and recognising the inevitability of future tax increases to make up for losses as the economy stagnates, may even cut back on their consumption and investment, worsening the downward spiral...

Britain is embarking on a highly risky experiment. More likely than not, it will add one more data point to the well- established result that austerity in the midst of a downturn lowers GDP and increases unemployment, and excessive austerity can have long-lasting effects... it is a gamble with almost no potential upside. Austerity is a gamble which Britain can ill afford."