Today’s ‘must read’ piece of economic analysis comes from Paul De Grauwe and Yuemei Ji on the Vox website. Entitled ‘Panic-driven austerity in the Eurozone and its implications’ it makes a persuasive case that much of the Eurozone’s austerity was driven by bond-market panic rather than fundamental factors and that much of it may have been self-defeating, even on its own terms.
As they argue:
We can now give the following interpretation of how the spreads exerted their influence on policymakers and led them to apply severe austerity measures. As the spreads increased due to market panic, these increases also gripped policymakers. Panic in the financial markets led to panic in the world of policymakers in Europe. As a result of this panic, rapid and intense austerity measures were imposed on countries experiencing these increases in spreads. The imposition of dramatic austerity measures was also forced by the fact that countries with high spreads were pushed into a liquidity crisis by the same market forces that produced the high spreads (De Grauwe 2011). This forced these countries to beg ‘cap in hand’ for funding from the creditor countries.
Furthermore, they report that:
Thus, it can be concluded that the sharp austerity measures that were imposed by market and policymakers’ panic not only produced deep recessions in the countries that were exposed to the medicine, but also that up to now this medicine did not work. In fact it led to even higher debt-to-GDP ratios, and undermined the capacity of these countries to continue to service the debt. Thus the liquidity crisis that started all this, risks degenerating into a solvency crisis.
In other words the austerity policies were driven more by market over-reaction than by real economic circumstances and the results have been higher not lower debt/GDP ratios. This is a pretty damning assessment of Eurozone economic policy making over the course of the crisis.
As the authors conclude:
The intense austerity programs that have been dictated by financial markets create new risks for the Eurozone. While the ECB 2012 decision to be a lender of last resort in the government bond markets eliminated the existential fears about the future of the Eurozone, the new risks for the future of the Eurozone now have shifted into the social and political sphere. As it becomes obvious that the austerity programs produce unnecessary sufferings especially for the millions of people who have been thrown into unemployment and poverty, resistance against these programs is likely to increase. A resistance that may lead millions of people to wish to be liberated from what they perceive to be shackles imposed by the euro.
For one example of the extreme social cost of austerity, one need only read Paul Mason’s recent report on the chaos that is the Greek asylum system.
Of course in many ways, De Grauwe’s and Yi’s analysis is nothing new. Work by Dawn Holland and Jonathan Portes has already shown that:
The direct implication is that the policies pursued by EU countries over the recent past have had perverse and damaging effects. Our simulations suggest that coordinated fiscal consolidation has not only had substantially larger negative impacts on growth than expected, but has actually had the effect of raising rather than lowering debt-GDP ratios, precisely as some critics have argued. Not only would growth have been higher if such policies had not been pursued, but debt-GDP ratios would have been lower.
…financial investors are schizophrenic about fiscal consolidation and growth.
They react positively to news of fiscal consolidation, but then react negatively later, when consolidation leads to lower growth—which it often does. Some preliminary estimates that the IMF is working on suggest that it does not take large multipliers for the joint effects of fiscal consolidation and the implied lower growth to lead in the end to an increase, not a decrease, in risk spreads on government bonds. To the extent that governments feel they have to respond to markets, they may be induced to consolidate too fast, even from the narrow point of view of debt sustainability.
As I’ve noted before, the fact that fiscal multipliers were likely to be extremely high in the Eurozone was noted by the IMF as long ago as October 2010.
Back in the October 2010 World Economic Outlook it argued that whilst the multiplier might be 0.5, that assumed that interest rates had room to fall and the currency had room to depreciate, boosting exports and cushioning the blow to the economy. The Fund warned, 2 years ago, that if these cushions were not available then the multiplier was closer to 1. The Fund went further and argued that if a country’s trading partners were also committed to austerity and retrenching their spending then the multiplier might actually be closer to 2.
Putting this all together, we learn a few lessons:
- Financial markets are perfectly capable of acting irrationally. Market panic drove extreme austerity in Southern Europe.
- Extreme austerity has proved self-defeating – it means debt/GDP ratios are higher not lower.
- Markets, to quote the IMF’s Chief Economist, can be ‘schizophrenic’ – they initially reward harsh austerity measures and then panic when they, predictably, lead to weaker growth.
- The end result is that market panic, followed by policy-maker panic, has imposed huge economic and social costs across Europe.
So, with these lessons borne in mind, what can policy-makers do now? The first thing to remember is that the Eurozone crisis is, at route, about balance of payments issues and private sector debt rather than public spending and public debt.
I summarised a few immediate steps that could be taken in June last year (these being the consensus of a conference I attended):
Fiscal expansion where there is room: In a Eurozone context the key country here is obviously Germany. But Eurozone countries faced with low bond yields, external surpluses and relatively low debt/GDP ratios should be launching targeted, timely and temporary fiscal expansions aimed at boosting domestic demand. This would have important spill over effects into the Eurozone periphery boosting their exports.
Wage growth where there is room: Given the inability of countries to externally devalue by allowing their currency to depreciate then the burden of restoring competiveness falls on ‘internal devaluation’. Stripping away the econo-speak this means cutting real wages in the periphery. Leaving aside the social consequences the economic impact is also very damaging. The burden should instead be shared more symmetrically – rather than just hoping for falling real wages in deficit countries, Europe should be arguing for rising real wages in surplus countries – both to help expand domestic demand there and to provide a boost to the competiveness of deficit countries.
Balanced budget expansions everywhere. Even in countries without the fiscal space for a debt financed expansion, fiscal policy is not useless. Countries should launch taxation funded increases in public investment. If these taxes are levied on the better off with lower marginal propensities to consume then the multiplier of this expansion could be reasonably high.
ECB action. The ECB should act decisively in the short term to end soaring yields in periphery countries by intervening in the bond markets and placing a ‘yield ceiling’ on periphery debts. A credible commitment to act from the ECB could end the problem of soaring yields in hours. This isn’t a long term solution to the underlying balance of payments issues but is an important step in stopping contagion.
Expansion of the European Investment Bank. The EIB should have its capital at least doubled (relatively cheap in the context of the current ‘bailouts’ of Greece, Portugal, Ireland, etc). This would allow around an additional €60bn annually of new lending. This should be concentrated in infrastructure investments and export industries in the periphery aimed at raising their competiveness and supporting their balance of payments.
Eurobonds. In the medium term Eurobonds of some sort (pooling of Sovereign debt so that all members stand behind each other’s liabilities) are probably required but in the short run there maybe problems with implementation. As a first step the EC should issue its own bonds (backed by all EU or Eurozone member states collectively) and use the proceeds to fund major investment and infrastructure problems. This would also have the effect of providing a new source of ‘safe’ assets to the markets.
In the 6 or so months since I wrote that post, only one of these steps (from the ECB) has really be taken. Or, to be more radical, there is also the idea of temporary artificial devaluation’, something I first broached in December 2011:
By imposing a duty on imports and equal subsidy to exports a country can, in effect, devalue its currency without leaving the Eurozone. A, say, 15% surcharge on imports and a 15% subsidy to exports in Greece would be effectively a 15% devaluation in the currency.
As these countries run deficits it would, at first, be fiscally beneficial as the surcharge on imports outweighed the costs of subsidised exports.
This isn’t painless – it would, for a start, raise domestic inflation as the price of imports increased – but none of the current options are pain free. Equally this isn’t a panacea. Support would still be required from the ECB for bond markets and banks would still need recapitalising (possibly something best done at a European level) but I think it is at least worth consideration as a an option on the table.
The idea of (even temporary) duties and tariffs runs counter to the Single Market and would face strong objections from many European policy makers but given the alternatives I don’t think it should be ruled out.
Whatever course policy-makers choose it is clear that the status quo policies are not working and a new approach is required.