This weeks posting seeks to look at the issue of
Austerity and whether it is a necessity as a way out of the current crisis. Whilst
Austerity has been the favoured solution for many countries to reduce deficits
now to help stimulate growth, serious questions have been raised as to whether
it is actually undermining growth. Countries such as the UK with control over
its own currency and monetary policy should perhaps not be too concerned at
this point with a rising debt level so long as spending is targeted at the right
areas. Unfortunately for other countries, such as those struggling in the
Eurozone, a lack of economic tools leaves them with no choice but to follow
austerity potentially for years to come.
As we know we are currently in
the worst recession since the 1930s. Many governments (including the UK) have
been running large deficits for many years and have been forced to increase the
amount of borrowing required to fund those deficits drastically due to the
(whisper it quietly) “banking crisis”. Countries such as Ireland, Greece and
Portugal have required bailouts from the EU and IMF because their fiscal
deficits grew so large that the fear of default drove up their borrowing costs
to a level leaving them unable to borrow sufficiently in the market. The
conditions required for them to accept these bailouts was to pursue austerity
to attempt to reduce their national debt as a % of GDP and that, as a result of
this, growth would flow back to these countries. The UK under the existing
government has also attempted to follow an austerity path looking to reduce the
size of the UK deficit and in turn keep the size of the borrowing to a
containable level.
The idea of resorting to large fiscal
deficit reduction in the midst of a recession as a means to attempt to control
the national debt level gained popularity in the early years of the current
crisis due to a paper by renowned economists Carmen Reinhart and Kenneth
Rogoff. In their paper “
Growth
in a Debt in Time” they attempted to demonstrate
that once a developed country’s debt gets to a level of 90% of GDP or above
then this will cause economic growth to slow substantially. As a result,
countries need to work to reduce their debt levels to keep them below the 90%
bound. If they fail to do so, the crisis in confidence can provoke
“very
sudden and “unexpected” financial crises. At the very minimum, this would suggest
that traditional debt management issues should be at the forefront of public
policy concerns.” As a result of this paper many
countries, especially those in the Eurozone and the UK saw austerity as a core
tool to maintain market confidence. The hope being that a narrower deficit or better
a surplus (and as a result smaller Debt/GDP ratio) will then lead to increased
private sector and foreign investment and ultimately to a return to sustainable
growth.
This method is significantly
different from previous traditional measures used in order to return economies
to growth. As mentioned in this blog previously one such method is monetary
stimulus. Through the reduction in interest rates (and other such recent
efforts like QE) it should encourage the private sector to save less and invest
their money in infrastructure (and hopefully not just the stock market!) which
in turn will multiply through and lead to a growth in the economy. As we know
this has already been enacted by the central banks in the UK, US and Eurozone.
The other method conventionally
used by governments in the midst of a recession is for them to spend their way
out of it. A method which has been in use since Keynes at the height of the
Depression. Fiscal stimulus involves
increased government spending and/or a reduction in taxes. The theory is by the
government spending more, through investment in construction for example, it
will multiply through to other parts of the economy leading to increased
spending elsewhere and ultimately to growth. Meanwhile a reduction in taxes should
lead to an increase in the number of pounds in firms’ and individuals’ pockets
with the hope that they spend it on investment or goods and services which
itself will lead to improved overall economic performance.
Fiscal stimulus however is
obviously at odds with the idea of austerity. So is austerity really the right
method or should we be trying to spend our way out of this recession despite
the rising debt levels?
One of the problems with trying to
ascertain whether any policy or method is the correct way forward is the
partisanship of those who promote and criticise each method. At the economists
level those that are pro-austerity such as Reinhart and Rogoff are prepared to
defend their paper and stance despite increasing evidence there may be flaws in
their argument. Meanwhile on the other side are economists such as Paul Krugman
who believes that austerity should not be undertaken. It is hard to find any
middle ground or potentially constructive conversation as neither side seems to
want to meet in the middle instead of vehemently sticking to their guns (and
indeed criticising the other). On the political side, one only needs to try and
read the Wikipedia entry on the
UK
Government Austerity Programme to get a glimpse of
the polarity of the issue. The site has a warning at the top stating the
neutrality of the article has been called into question given its perceived strong
anti-government stance.
The use of Reinhart-Rogoff’s theory
itself has in the past 6 months been heavily called into question. It follows
the discovery that they were missing some data which proved crucial to their
findings. The 90% debt-GDP ratio, used by them as the critical point for
governments, is now seen as quite arbitrary and not a level which can be used
by every country as the perilous point which must not be passed. Meanwhile
there is evidence to the contrary which shows that it is
slow
growth which leads to higher debt levels and not
the other way round. This make more sense because as the economy slows down
governments will spend more in order to try to stimulate it, leading to an
increase in the deficit and, if there is not equivalent increase in GDP at that
time, an increase in the debt-GDP ratio. So where does this leave us?
The reality is it
depends on the country’s individual situation, their access to all the tools
necessary and the markets perception of their ability to recover and cover
their debts.
This week I was introduced
to the writings of an economist called Cullen Roche. Roche has written an
excellent paper around about how money works in modern society under a theory
known as monetary realism. According to Roche, Monetary Realism
“seeks to describe the operational realities of the monetary system
through understanding the specific institutional design and relationships that
exist in a particular monetary system”. The
paper itself is well worth a read for its insights into how the money
system works in the modern world. Even if it is more specific to the US, it
gave me a good insight as to some of the issues faced by other economies around
the globe. One of the more interesting aspects which I gauged from this was
that the US, or a similar economy with full control over its currency and
issuing debt in its own currency, should in theory not need to go bankrupt
(i.e. default on paying its debts) if its debt were to increase too much. Should
there not be demand in the market for US Treasuries being issued (i.e. they
cannot borrow enough to cover their deficit or repay existing debt) then the
Fed could simply print more money to cover whatever shortfall there has been.
This, of course, is only up to a point, but with the US that point would be
relatively high due to the diverseness of the US economy. The big risk is that excessive money printing
will result in a high inflationary environment and potentially a weakening of
the dollar (and resulting increase in cost of imports) which in turn could have
a real impact on the cost of living of the inhabitants. However it is only once
it reaches near to this point that there is the real risk, and the hope would
be that the economy has been corrected before that point and as a result
tightening and a reduction of the debt can then be achieved during a period of
growth.
If we look at the
UK, we can see it operates economically in a similar format to the US. It
issues debt in its own currency, has a relatively diverse economy and has the
power to control its own money supply and currency. The UK government has
officially been following a plan of national austerity. However if you were to
actually look at what has been happening with the current account deficit and national
debt it is visible that the government expenditure is actually growing. The
last year saw the deficit increased to 3.7% of GDP after being only 1.5% of GDP
in Jan 2012. Meanwhile the national debt has expanded from being 73.9% of GDP in
2010 to currently being 90.7% of GDP. Inflation however is now currently at 2.8%
but had previously consistently been above this since the crisis started. So
despite the increased borrowing, inflation has not spiked. The cost of
borrowing for the UK government in the meantime is still only 2.4% yield on
10-year Gilts, down from 3.4% in 2010 when the base interest rate was already
0.5% at that time. As the evidence we saw earlier seems to suggest, there is no
reason to fear such an increase in the debt level for the UK above the
previously thought 90% danger level. A quick look at Japan sees a country with
a Debt to GDP level of over 200% but still with very low borrowing costs and extremely
low inflation if not at times deflation. Whilst I am not trying to use Japan as
a beacon of economic health, it is a useful comparison to show that having a
higher Debt-GDP ratio will not necessarily cause the sort of high (or hyper)
inflation and borrowing costs used as fear by those who wish to curb spending
completely.
From the evidence, I would suggest that the Government in the UK, whilst talking about austerity
now, should take the long term view of boosting spending now, in the hope that
the real austerity and cut backs can be carried out at a point when the economy
is already growing sufficiently on its own. Such examples are with the help to
buy scheme and HS2 projects. Whether these will ultimately be “roads to nowhere”
or will actually drive things forward in years to come can only wait to be seen
and highlights the problems governments have in identifying areas which will
assist real long term growth as well as just short term boost. The past 2
quarters have seen slow, slow signs of growth returning to the UK with 0.3% and
0.6% in Q1 and Q2 respectively, but whether this will gather momentum in itself
in the coming years will depend on continued government assistance now. The key
is that once the UK does start on a path of sustainable growth that this period
is then used to begin to reduce down the debt through increased tightening in unnecessary
areas of expenditure. This depends very much on the political will of all sides
to ignore partisanship and do what is best for the country.
Europe on the other
hand, especially the peripheral Europe of Portugal, Ireland, Greece and Spain
do not have a similar amount of flexibility. Due to the constraints of being
unable to issue debts in a currency under their own control, as well as having no
control over monetary policy, has left these struggling economies at the mercy
of the demands of the markets. True, the excesses during the boom years have
pushed these economies to the state they are currently in. However their lack
of ability to use monetary policy in order to assist in stimulating the economy
and easing the downward spiral have seen these countries fall further into
depression than they might otherwise have done. Any attempts by them to try to
use fiscal expansion as a method to drive their way out would have been met
with a market pushing borrowing costs up to unacceptable levels that the
countries would have no option but to default. In the cases of Ireland, Greece
and Portugal this has already led to each country requiring bailouts from the
EU and IMF. The ECB, needing to play the role a central bank is required to in
these situations, has its hands tied in trying to meet the requirements of
stronger economies such as Germany versus those in trouble. As such they can
only really deal with items on a macro level. This is visible when you hear the
ECB often talk about Eurozone growth as a whole which is held up by the strongest
economies. In the same way talk last week that the
worst
is over is premature in my mind. Whilst the Eurozone as a whole may slowly
begin to make its way towards growth, the troubled economies are a long way off
recovery, as Greece’s continued need for assistance is evidence of.
While Paul Krugman
beats
a drum against austerity, the unfortunate reality for Ireland, Greece and
Portugal is that there is no alternative choice due to the pressures of the
market. Should any of these economies attempt to move away from austerity then
the borrowing costs reflected in the market would only serve to push all these
economies back towards default. Such results were seen by the spike in both the
Portuguese Bond Yields and CDS spread (the market measure of risk of Portuguese
default) at the hint that the
coalition
may split over a lack of willpower for further deficit reduction. Whilst I
agree with Krugman that austerity will not assist these countries in regaining
growth the simple truth of the matter is that due to market forces and the lack
of tools available there is no other option available. The result will be that
these countries, especially Greece, will continue to suffer for many years to
come until ineffective spending is reigned in.
A big difference I
believe in the responses of the different economies to austerity measures
however can be seen in the response of the people and the opposition political
parties. It is no surprise that Ireland is seen as the poster boy of austerity.
As Mohammed El-Erian recently
wrote
“Right or wrong, Ireland will stick with austerity. Efforts to regain national
control of the country’s destiny, the Irish seem to believe, must take time.”
This is reflected in the relative lack of mass protest compared to Spain,
Portugal and Greece as well as in the fact that the main opposition party
Fianna Fail publicly backs the austerity measures. With the 3 most recent
quarters of GDP showing a further contraction in the Irish economy, the
indicators are that it will take time for Ireland to recover but they are in comparatively
better shape than the other troubled Eurozone nations. The acceptance that current
hardships are necessary after the excesses enjoyed by the majority of the
population is perhaps an indicator to the other countries to desist from
political brinkmanship and complaint and to pitch in and attempt to stop the
slide together.
In conclusion, the
evidence to me seems to indicate that austerity, in the true sense of the word, is not going
to help bring growth back to troubled economies. For countries such as the UK and
US, a pull back from unnecessary spending in certain areas should be carried
out, but there is no risk at the moment from an increase in debt levels so long
as the additional spending is targeted effectively. Once the economies are
growing sufficiently, that is the time to reign in further avoidable government
spending and seek to reduce the debt. Unfortunately due to the constraints on peripheral
Eurozone of both market forces and a lack of monetary control there is no
choice for them but to concentrate on dramatically reducing their debt levels
and spending now. The political debate about who was to blame in the first
place will wrangle on for years, but the truth is that everyone in one way or
another gained from the financial excess. The key for now is not to concentrate
on the blame but to implement the solution. Unfortunately, depending on the
country will depend how much control over the solution your government has.
