Tuesday, June 29, 2010

The high costs of austerity

But rather than being rewarded for their actions, these countries are being penalised with a rise in bond yields. The economic downturn has been even sharper than if the governments would have spent on stimulus to keep people in their jobs. As a result, the economies of these countries shrunk dramatically ( more than 20% of GDP loss in Latvia and Lithuania) and remain in recession. Wages in the public sector have fallen by 20-30% in several countries. In the meantime, joblessness has risen to two digit reaching almost 20% in Spain!

Austerity prompts strikes and slowdowns which in turn shrink the domestic market, investment and tax revenues. As unemployment spreads and wages fall, mortgage arrears and defaults soar. Property prices have plunged in some countries. Some business owners are even escaping their debts and emigrate.

For States in crisis, austerity is not the only option. It has huge economic and social costs. It does not make countries more competitive: it uses unemployment to lower wages and imports and therefore depresses domestic demand. There is a second option for non euro-area countries which is currency devaluation but it is not pursued as it would delay their planned integration into the euro area as their currencies are pegged to the euro. It would also raise the price of energy and other essential imports, aggravating the trade deficit.

But there is another option which is worth being pursued and would yield better results. In some of these States in (fiscal) crisis, there is high taxation on labour and capital and land are under-taxed. Lowering taxes on wages would reduce the cost of unemployment and increase demand.

The main issue in European countries, notably in the eastern part, over the coming years will be whether economies can cope with heavily taxed wages and inflated housing prices while avoiding an overdose of needless austerity.

Saturday, June 26, 2010

The divisive Toronto Agenda

The G-8 and G-20 meetings in Toronto have a long agenda of complex issues on which rich and developing countries seek a common approach to set out new governance rules. Topics include banking levies, financial regulation, currency controls and many others.

From Toronto, bad news: there will not be at the G 20 an agreement on the levy on financial transactions. The reason is quite interesting: rich countries like US, UK, France and Germany want it but there is a strong resistance from the banking sector; other countries such as Canada, India and China, much less affected by excessive speculation- due to their relatively more traditional and stable banking sector, do not see any reason to penalise their own banks.

On financial reform, the US administration will pursue a 'unilateral' approach. Just before the meetings, the Senate approved a package of financial reform, including a tax on banks worth 19 billion $ to prevent future financial crisis. It includes a list measures including tougher powers for the Federal reserve to oversee 'too big to fail' banks, registration of hedge funds and the creation of a consumer agency to regulate mortgages.

The second issue of contention concerned fiscal policy opposing fiscal consolidation to reduce debt to GDP ratios and the pursuit of fiscal stimulus to sustain recovery. The final statement reflects this compromise: 'Reflecting this balance, advanced economies have committed to fiscal plans that will at least halve deficits by 2013 and stabilize or reduce government debt-to-GDP ratios by 2016' . But Obama - supported (only) by India- warned the eurozone and Germany in particular that early cuts to public spending might undermine the signs of recovery. It is also significant that the final statement stated that Germany and China should contribute to growth in global demand : 'Surplus economies will undertake reforms to reduce their reliance on external demand and focus more on domestic sources of growth'.

The Toronto meeting reflects in fact the strategic division on the response to the crisis between the European 'doctrine' (stability and budget deficit reduction) and the US conception based on maintaining fiscal stimulus plans to sustain the recovery of their economy. The feeling is that nations are concentrating on their own economies ignoring global welfare and aid to the most vulnerable countries. Unilateralism in areas such as financial regulation and trade is unproductive. Uncoordinated financial rules may be self-defeating because of the need for regulatory arbitrage. Does it make sense that the US will pass its new financial regulation law but no agreement on the Basel III rules on bank capital requirements has been reached.

In sum, the outcome of the G-2O meeting has been deplorable, but not for failing to co-ordinate fiscal policy. This is the least of its sins; it has failed on the main issues which are decisive for better global governance.


Saturday, June 19, 2010

The Spectre of the 30s

The lessons from the 30s seem to be forgotten. In 1937, when F.Roosevelt sought to balance the budget, the economy plunged again into a severe recession. And here in Germany, the financial orthodoxy pursued by the finance minister, Heinrich BrĂ¼ning, from 1930 to 1932, led to the end of the Weimar Republic.
There are no sanctions for those- the experts who preach financial rigour and budget balance- who repeat the mistakes of the past. Since the 80s, the dominant economic view repeats the same discourse which led to the depression of the 30s. At that time, J.M. Keynes rejected vigorously what he called the 'Treasury view'. The main argument is that an economy with rising unemployment is badly managed and that mass unemployment should not be tolerated in any economy . The famous British economist made that point in the Mac Millan Committee*, putting forward a set of principles defining a full employment economy: full employment is the primary objective for economic policy; wage flexibility is not a remedy to unemployment; the currency in a country with high unemployment could not be strong unless depreciation of assets is compensated by high interest rates; the State can contribute to restore full employment via an active policy increasing public investment financed through a budget deficit; the Central Bank should help financing spending which will generate wealth in the future.

In recent times, President Barack Obama urged other G20 countries to boost domestic demand and increase exchange rate flexibility to encourage global growth and rebalance the world economy.He said in a letter : “I am concerned by weak private sector demand and continued heavy reliance on exports by some countries with already large external surpluses.”**

This warning seems to be largely ignored by the deficit hawks, which are now prevailing in Europe, Canada and other countries. The myth of 'sound finance' - which is related to a blind faith in free markets- is based on a 'classical' vision of capitalism driven by the search for more savings. As opposed to it, Keynes and other post-Keynesian economists such as Kalecki and Minsky demonstrated that the engine of capitalism is the debt which generates the 'quantum' of money necessary to finance investments.

As in the 30s, the danger of unemployment should deserve greater attention. Trade unions have understood it, not our political leaders.

* See P.Clarke, The Keynesian Revolution in the Making 1924-1936, Oxford University Press, 1988

Sunday, June 13, 2010

G-20: the return to economic orthodoxy

The 'hawks' are back and took over the G-20. The final declaration* of the 4-5 June meeting in Busan states: "Those countries with serious fiscal challenges need to accelerate the pace of consolidation. We welcome the recent announcements by some countries to reduce their deficits in 2010 and strengthen their fiscal frameworks and institutions".

It seems that there has been a shifting attitude relative to the previous Washington communique issued on 23 April which insisted that demand stimulation policies" should be maintained until the recovery is firmly driven by the private sector and becomes more entrenched".

Historical experience in the 30s show that drastic cuts to public spending during a grave recession are not only ineffective in terms of reducing public deficits but also socially harmful. Restrictive fiscal policies - if not conducted wisely and gradually - may have opposite effects, as they might depress further the economy and reduce tax revenues, therefore further increasing public deficits.

So, what should be done? One possibility would be to wait that the economy recovers in order to allow central banks to use monetary policy to offset the contraction of economic activity resulting from budget austerity. But here again the 'hawks' ask for further budget cuts in the face of high unemployment and interest rates close to zero.

One might argue that the situation in Greece represents a serious warning against any further rise in public debt. But this cannot be taken as a general situation. Countries with high public debt are Spain and Greece (leaving aside the specific situation of Italian public debt being largely held by domestic financial institutions and households) ; they belong to the euro area and they have overvalued assets due to huge capital inflows in previous years. The risk is thus a prospect of deflation over coming years. However, for other countries, there is no objective reason to conduct immediately such policies. Ten year bonds in the UK yielded interests of 3,51%, in the US 3,21% and in Japan, 1,27%.

So where does this radical shift toward austerity stem from? the answer is that Finance ministers and governors of central banks of the G-20 are convinced that expenditure cuts would reassure investors. They just care about how world markets would react if the leading economies were not ready to make further sacrifices. But the idea that these sacrifices might be useful or even be harmful for large segments of the society does not count at all.

So the message is that if the leading economies will not pursue these virtuous policies along the lines of the G-20 and other organizations, it will undermine the fragile basis of economic recovery to satisfy hypothetical demands of investors for more austerity.