After months of mental stagnation I’ve decided to return to the world of blogging with an extra spergy post on the economic policies being considered on both sides of the Atlantic. Before I expand on this subject I want to send a special thanks to economist bloggers Paul Krugman, Brad DeLong, and Matthew Yglesias for inspiring me. I absolutely don’t belong in the same category as them but I feel so much better informed by their blogs. For anyone looking to learn a little bit more about economics or economic theory I highly recommend following these blogs. For additional perspectives from economists you should also consider the blogs referenced in this compelling economist article.
The topic for this post will be the economic policies that are currently being considered in both the European Union and the United States. Before I go further I want to define two terms that I will be using a lot in this post:
Austerity: “In economics, austerity is a policy of deficit-cutting, lower spending, and a reduction in the amount of benefits and public services provided. Austerity policies are often used by governments to reduce their deficit spending while sometimes coupled with increases in taxes to pay back creditors to reduce debt.” (from wikipedia)
Expansionism: “some have linked the term to promoting economic growth (in contrast to no growth / sustainable policies).” (also from wikipedia)
While some time has passed since the debt ceiling standoff and subsequent downgrade by Standard and Poor rocked US markets, the debate remains central to US economic policy. In recent Republican debates austerity has been almost universally endorsed. Governor Rick Perry went so far as to propose eliminating three government agencies, though which three is still up for debate. This stance on austerity has also been endorsed by Republicans in Congress, with multiple proposals to reduce government spending in the short and medium term.
Across the Atlantic, similar proposals have not only been proposed but have been implemented in several countries that were affected by the Eurozone debt crisis. Germany’s Angela Merkel has been one of the most ardent proponents in the Eurozone for an austerity-centered response to debt crisis. The economist states:
Italy and Greece, under new technocratic governments, may now be more serious about living within their means and reforming their faults. France, which has run budget deficits since 1974, is adopting austerity. Spain has introduced a constitutional debt brake.”
In both Europe and the United States austerity has been proposed as a solution to the risk of bond market action on sovereign bonds. I think it is critical to understand a few key elements of what this “bond market action” implies here. When governments seek to borrow money, they auction sovereign bonds denominated in the currency used by those respective governments. Governments then have to pay back those bonds with interest. This interest is called the “yield” and has an inverse relationship to demand for those bonds. So if a bond is in high demand, the yield will be low, while a bond with low demand will have a higher yield.
Ratings agencies, which represent the interests of bond-buyers will give ratings on sovereign bonds based on how likely they think they will be repaid. Even though a nation’s sovereign debt rating can be related to its yield, the two don’t always correlate to one another. When the United States lost its AAA rating from Standard and Poor (the other two major ratings agencies kept the AAA for the US) stock markets lost record volume but demand for US sovereign debt actually went up. As I write this the yield on US 10-year bonds stands at 1.89%, while it stood at 3.01% on July 20th, 2011.
While 2% is considered serviceable, higher yields can cripple a country by forcing it stop borrowing altogether. Greek 10-year bonds have yields more than ten times higher than their US or German equivalent:
At present, Greece would have to pay 34% interest on a ten year loan. This has effectively locked Greece out of selling its debt. It would seem natural then, that the countries that are now bailing out Greece would insist that Greece cut government spending sharply and try to raise more taxes to cut its deficit. After all, if Greece were able to finance its spending without having to borrow money, yields wouldn’t matter, at least in the immediate term. Germany, the biggest Eurozone economy, has led the push for austerity in Greece and other Euro countries with dangerously high yields (Italy, Spain, Portugal, Ireland have all faced high yields).
There is a danger to this logic though, that comes with the effects of austerity. In return for the first bailout, Greece agreed to sharply reduce public spending, including cuts in pensions and wages for public sector workers, yet it still fails to meet deficit targets set by the EU. Germany is now proposing that the EU take direct control over Greece’s government spending, something deeply unpopular in Greece (source). The problem that comes from this arrangement is that austerity has not let to growth in Greece’s economy. In fact, since the first bailout in April 2010, Greece has seen its economy contract sharply:
This is as troubling as this looks, it easily could have been predicted. When you lower spending like Greece has done, you are in effect giving public sector workers/pensioners less money to spend, lowering demand. This weakens economic output across all sectors of the economy, as private businesses adjust to lowered demand by laying off workers and producing less. This does more than just damage the livelihoods of Greek citizens, it actually exacerbates the government’s finances. As Greece’s tax base becomes less wealthy, the government must either raise taxes further (which certainly does not stimulate growth) or continue to run a budgetary deficit just to maintain the status quo.
Greece is not alone in its struggle to grow as the effects of austerity bite, other Euro countries that have recently implemented austerity have seen growth slow:
This graph measures annual GDP growth in the Q3 2011, and with the exception of Slovenia, all of the worst performers had to implement some form of austerity in response to high yields/EU intervention.
It is not just the opinion of amateur bloggers (like me) or angry protesters in Greece that austerity alone cannot ensure debt repayment. Standard and Poor recently downgraded 9 Eurozone countries, and in its FAQ explaining the downgrades stated:
… As such, we believe that a reform process based on a pillar of fiscal austerity alone risks becoming self-defeating, as domestic demand falls in line with consumers’ rising concerns about job security and disposable incomes, eroding national tax revenues.”
The German response to the downgrade borders on intransigence:
German chancellor Angela Merkel has called on eurozone governments speedily to implement tough new fiscal rules after Standard & Poor’s downgraded the credit ratings of France and Austria and seven other second-tier sovereigns.”
This is especially swaying because ratings agencies like S&P have no vested interest in placating debtor states, but instead act on behalf of creditors. Fears over German stubbornness over austerity has led to a recent outpouring of criticism from the world’s economic leaders. IMF head Christine Lagarde, US Treasury Secretary Tim Geithner, and Financier George Soros all warned of dangers of austerity at the recent World Economic Forum at Davos. At a separate summit, Nobel prize-winning economist Joseph Stiglitz warned that Germany was pushing Europe towards a suicide pact, saying:
It is like blood-letting, where you took blood out of a patient because the theory was that there were bad humours. and very often, when you took the blood out, the patient got sicker. The response then was more blood-letting until the patient very nearly died. What is happening in Europe is a mutual suicide pact“
It’s worth noting that Stiglitz had similarly critical things to say about US austerity, pointing out that the US has shed 700,000 public sector jobs over four years. While European austerity has been rightly criticized for its futility, it must be pointed out that Eurozone countries have faced something that the US has not, high yields. One of the most baffling aspects of the aspects of the recent push for austerity across the Atlantic is that, while the US has lost its AAA rating by S&P, its yields have stayed historically low. While it makes little sense for Greece to endure agonizing economic contraction from austerity, it makes considerably less sense for the United States to follow that path. While borrowing costs for the US government are historically low, unemployment remains stubbornly high.
It should be both shocking and perplexing that in spite of this Republicans in Congress have held up virtually every piece of expansionary legislation recently proposed. Republicans have been so opposed to promoting growth through legislation that they nearly blocked a tax cut designed to boost growth from being renewed until they came under intense political pressure and relented.
On both sides of the Atlantic there has been a drive for austerity that has hitherto done little to calm the markets OR promote growth. And while countries with high yields have faced inevitable pressure to reduce deficits, the real tragedy stems from the lack of leadership from countries with the room for maneuver to lead and coordinate expansionary policies. The political systems in Germany and the United States have both been alarmingly inflexible and wrong-footed in their respective approaches to promoting economic growth and stemming the threat of double dip recession.