Saturday, May 5, 2012

Euro-Crisis: Debt and Austerity

May 4, 2012
Govts need to commit to growth
As Europe's crisis continues, Lawrence Summers says governments should spend and spur growth, while Gideon Rachman says they should tighten belts and pursue austerity. Straits Times senior writer Andy Mukherjee sizes up their arguments.
By Lawrence Summers

ONCE again, European efforts to contain its crisis have fallen short. It was perhaps reasonable to hope that the European Central Bank's commitment to provide nearly a trillion US dollars in cheap three-year funding to banks would, if not resolve the crisis, contain it for a significant interval.

Unfortunately, this has proved little more than a palliative. Weak banks, especially in Spain, have bought more of the debt of their weak sovereigns, while foreigners have sold down their holdings. Markets, seeing banks holding the dubious debt of the sovereigns that stand behind them, grow ever nervous. Again, Europe and the global economy approach the brink.

The architects of current policy and their allies argue that there is insufficient determination to carry on with the existing strategy. Others argue that failure suggests the need for a change in course. The latter view seems to be taking hold among the European electorate.

This is appropriate. Much of what is being urged on and in Europe is likely to be not just ineffective but counterproductive to maintaining the monetary union, restoring normal financial conditions and government access to markets, and re-establishing economic growth.

The premise of European policymaking is that countries are over-indebted and so unable to access markets on reasonable terms, and that the high interest rates associated with excessive debt hurt the financial system and inhibit growth. The strategy is to provide financing while insisting on austerity, in hopes that countries can rein in their excessive spending enough to restore credibility, bring down interest rates and restart economic growth. Models include successful International Monetary Fund (IMF) programmes in emerging markets and Germany's adjustment after the expense and trauma of reintegrating East Germany.

Unfortunately, Europe has misdiagnosed its problems in important respects and set the wrong strategic course. Outside of Greece, which represents only 2 per cent of the euro zone, profligacy is not the root cause of problems. Spain and Ireland stood out for their low ratios of debt to gross domestic product (GDP) five years ago, with ratios well below Germany's. Italy had a high debt ratio but a very favourable deficit position.

Europe's problem countries are in trouble because the financial crisis under way since 2008 has damaged their financial systems and led to a collapse in growth. High deficits are much more a symptom than a cause of their problems. And treating the symptoms rather than the underlying causes is usually a good way to make a patient worse.

The cause of Europe's financial problems is lack of growth. In any financial situation where interest rates far exceed growth rates, debt problems spiral out of control. The right focus for Europe is on growth; in this dimension, increased austerity is a step in the wrong direction.

Systematic comparisons suggest that when economies are demand-constrained and safe short-term interest rates are near zero, policy measures that reduce the deficit by 1 per cent have a multiplier of 1 to 1.5 - implying that a 1 per cent reduction in a country's ratio of spending to GDP or an equivalent tax increase reduces its GDP by 1 to 1.5 per cent.

Essentially, cutting deficits will have a disproportionately adverse effect on GDP because the multiplier is larger than 1 on the growth-reduction side of the equation. This means that austerity measures at the national level are likely to be counterproductive in terms of creditworthiness. Fiscal contraction reduces incomes, limiting the capacity to repay debts. It achieves only limited reductions in deficits once the adverse effects of economic contraction on tax revenue and benefit payments are accounted for. And it casts a shadow over future growth prospects by reducing capital investment and raising unemployment, which inevitably take a toll on the capacity and willingness of the unemployed to work.

These considerations are magnified at the continental level. Slowdowns in one country reduce the demand for the exports of other countries. As a matter of arithmetic, increases in saving and exporting in some countries have to be offset by increases in spending and importing in others. Germany's enormous success in recent years has been achieved by the nation's becoming a large-scale net exporter - it would not have been possible without large-scale borrowing and importing by Europe's periphery. The periphery cannot possibly succeed in substantially reducing its borrowing unless Germany pursues policies that allow its surplus to contract.

Sceptics will rightly wonder how a prescription for more spending by countries that already have trouble borrowing can be correct. The answer lies in the difference between borrowing by individuals and countries.

Normally, an individual helps his creditors by borrowing less; but a person who stops borrowing to finance commuting to his job does his creditors no favour. A country's income is determined by spending, so a country that pursues austerity to the point where its economy is driven into a downward spiral does its creditors no favour.

Yes, there will ultimately be a need to raise retirement ages, reform sclerosis-inducing regulations and restructure benefit programmes; phased-in commitments in these areas would be constructive.

But the prospect for political and economic success in these endeavours depends on growth being restored.

Only if growth is restored can the euro endure and European financial problems be resolved. If there was ever a situation that called for a collective response, this is it.

Going forward, the IMF and international community should condition further support not merely on individual countries' actions but on a common European commitment to growth.

The writer, a former economic adviser to US President Barack Obama, was Treasury Secretary in the Clinton administration.


No alternative to belt-tightening
By Gideon Rachman

SPANISH unemployment is nearing 25 per cent. The suicide rate is climbing in Greece. Britain is in a double-dip recession. Amid all this pain, the cry is growing louder. Austerity policies in Europe are dangerous. Someone has to stop this madness.

Step forward, Francois Hollande, the likely winner of the French presidential election. He is campaigning as the man who will stand up to the austerity ayatollahs in Germany. His campaign is resonating - not just in Europe, but even in the United States, where the grandees of the economics profession, from Larry Summers to Paul Krugman, are lining up to call for an end to Europe's austerity policies. 'Insane,' Professor Krugman calls them, with characteristic understatement.

Mr Hollande says he will replace austerity with growth. Why didn't anybody think of that before? Unfortunately, a vacuous slogan is underpinned by ineffectual proposals. Mr Hollande's programme stresses small, badly targeted boosts to public spending, while virtually ignoring the structural reforms that are the only route to sustainable growth.

Spending on infrastructure - 'shovel- ready' projects, as US President Barack Obama has called them - is, of course, a standard Keynesian solution for an economy that is caught in a downward recessionary spiral. Under normal circumstances, such spending might be a great idea.

In Europe, however, there are plenty of reasons to be sceptical. If building great roads and trains were the route to lasting prosperity, Greece and Spain would be booming. The past 30 years have seen a huge splurge in infrastructure spending, often funded by the European Union. The Athens metro is excellent. The AVE fast trains in Spain are a marvel. But this kind of spending has done very little to change the fundamental problems that now plague both Greece and Spain - in particular, youth unemployment.

Worse, in some ways, EU funding for infrastructure has created problems. In Greece, milking the EU for subsidies became an industry in itself; and political connections were a surer route to wealth than entrepreneurial flair.

As for Italy and Spain, they are not cutting their budgets out of some crazed desire to drive their own economies into the ground. Their austerity drives were a reaction to the fact that markets were demanding unsustainably high interest rates to lend to them. There is no reason to believe that the markets are now suddenly prepared to fund wider deficits in southern Europe. The 'end austerity now' crowd respond that it is the responsibility of Europe's dwindling band of triple A rated countries to go on a consumption binge and so pull their neighbours out of the mire. But the assumption of unlimited Dutch and German creditworthiness is unconvincing - as the market reaction to the Dutch failure to agree a budget illustrated.

Even in France, the centre of the revolt against austerity, it is hard to argue that the problem is that the state is not doing enough. This is a country where the state already consumes 56 per cent of gross domestic product, which has not balanced a budget since the mid-1970s, and which has some of the highest taxes in the world.

Mr Hollande, who is not an idiot, knows all this. That is why, behind all the feel-good rhetoric about ending austerity, the small print is less exciting. In fact, all the Socialist candidate is promising to do is to take a year longer than President Nicolas Sarkozy to balance France's budget. In Europe, even the left cannot pretend that deficit spending can continue for ever. So they are reduced to arguing that governments are cutting, 'too far and too fast', in the words of Britain's shadow chancellor Ed Balls. This is small-scale quibbling - masquerading as a major doctrinal dispute.

For while the Germans are often portrayed as knuckleheaded advocates of endless austerity, their real message is more sophisticated and convincing. It is that the drive to balance budgets within Europe must be combined with reforms that will encourage private-sector job creation.

The scope for such reforms is enormous. Taxes on labour in France are very high. To his credit, Mr Hollande is promising tax breaks for employers who hire young people. But it would be better simply to cut charges on labour across the board. This is one tax cut that really might pay for itself, by creating jobs.

European businesses are also hobbled by red tape. My favourite recent example was a story in the New York Times of a Greek entrepreneur, whose efforts to start an Internet business involved an odyssey of form-filling, culminating in an official demand for a stool sample. High rates of youth unemployment in countries such as Spain and Italy are closely connected to the excessive protections and benefits for workers on full-time contracts - which make employers wary of taking on new hires. As one Spanish businessman recently complained: 'In this country, it is easier to divorce your wife than to sack an employee.'

Pushing through labour market reforms is tough and even dangerous. In Italy, in recent years, two economists advising the government on labour-market reforms have been assassinated. But such reforms are the only long-term route to stronger job creation.

By contrast, calls for Europe to spend its way out of debt are an illusion. There is, of course, scope for argument about the pace of deficit reduction. But in a highly taxed, highly regulated, highly indebted continent like Europe, more state-funded public works would simply build another road to nowhere.


Austerity folk have got it wrong
By Andy Mukherjee

MR GIDEON Rachman's defence of austerity has three elements. He says a 'standard Keynesian solution' might be a great idea under 'normal circumstances'. So presumably the circumstances in present-day Europe are not normal.

He doesn't fully explain why they are abnormal, but goes on to argue that markets demanded budgetary belt-tightening; governments had no option.

Finally, he cites anecdotes - a Greek entrepreneur frustrated by red tape; AVE fast trains in Spain - to suggest that state spending is no cure for inherent inflexibility in the economy.

The point he does not discuss - and the argument that lies in the heart of professors Paul Krugman and Lawrence Summers' analysis - is this: What should policymakers do when interest rates are near zero, which is the case in both the United States and the euro zone today, and still the private sector refuses to borrow?

Such a situation arises only after an asset bubble has burst. Spain, Ireland and the US are in difficulty today because of a real estate collapse. They are in a balance-sheet crisis, which is like a very bad toothache.

If you went to your dentist with shooting, unbearable pain and he advised you to brush your teeth twice daily, he's giving you good advice but at the wrong time.

Making labour markets more flexible and improving the business climate could have been useful in the past; they may be of great assistance in the future. But will they help Europe right now?

What is abnormal right now in much of the developed world is that Panadol hasn't worked: Interest rates are hugging the floor, yet there is no meaningful recovery. Keynesian medicine is not for 'standard' times, as Mr Rachman seems to think; it's for unusual times like today. That is what makes austerity - the exact opposite of the remedy - a crime.

The other point that neither Mr Rachman nor Professor Summers has explicitly considered is that the euro-system design is flawed.

Nomura Research Institute chief economist Richard Koo estimates that private savings in Spain have risen by almost 18 percentage points of gross domestic product since 2007.

Out of this, the government has absorbed less than 12 percentage points by running up its budget deficits. The remaining 6 percentage points have leaked out of Spain and gone to Germany and the Netherlands. If this private capital had not fled, it would have been forced to seek safety in Spanish government bonds. There wouldn't have been a sovereign debt crisis in Spain, just like there hasn't been one in the US.

So when Mr Rachman says it was the bond market that demanded austerity in peripheral Europe, he's only half right.

Yes, the market demanded it because it could: It had the option of 17 'risk-free' government securities, all denominated in the euro, to choose where to park its money after the crisis. In the US, or Britain, or Japan, the bond market doesn't have this luxury. There's only one dollar-denominated riskless security; and only one that is denominated in yen or the British pound. A Tokyo bank that has a yen deposit to repay takes a currency risk when it looks for a safe investment in US treasuries.

The architects of the euro zone should not have given investors the latitude to move money, apparently without any extra currency or credit risk, from one national economy to another.

But all that is ancient history.

To misread this capital movement as a signal from bond markets that greater austerity is needed is a modern myth that German Chancellor Angela Merkel fell for.

It's her lack of judgment that has brought Europe to the brink of a disaster.

[I'd say "Brilliant analysis", but that's like an ant saying an elephant is big. It's true but the testimony of an ant on size is not much of a testimony.]

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