According to the popular legend Nero, Roman Emperor from 54 to 68 and the last in the Julio-Claudian dynasty allegedly “fiddled while Rome burned” (played his lyre and singing) during the fire in 64 which destroyed most of Rome. His rule (and dynasty) ended 4 years later. The imagery of this out-of-touch and cruel leader strumming/plucking his stringed instrument (rumour notwithstanding) while his city and, soon after, his dynasty collapsed is powerful. Last Friday, Eurostat released the latest unemployment data for November 2011. The results were shocking with unemployment rates in Spain now close to 23 per cent (as at November 2011 and rising) and Greece 18.8 per cent (as at September 2011) and rising. Greece’s unemployment rate rose 4.8 per cent in the first 9 months of last year. Meanwhile, the European Commission is occupying itself with other concerns. Its Economic and Monetary Affairs Commissioner and Vice President, Olli Rehn has been sending letters out to member states indicating that he is disappointed they are falling behind their budget deficit reduction targets under the Excessive Deficit Procedure (embedded in the Stability and Growth Pact) and that the EC would be considering fines.
Even more disturbing were the unemployment data for youth. Eurostat report that the highest youth unemployment rates were in:
… Spain (49.6%), Greece (46.6% in September 2011) and Slovakia (35.1%).
So nearly 50 per cent of willing workers under the age of 25 in Spain and Greece are without work and will remain like that for years to come. That will damage productivity growth for the next decade or more. It is an indication that the monetary system has failed and attempting to reinforce those failures with more austerity will only make matters worse.
The Excessive Deficit Procedure requires that:
In order for EMU to function smoothly, Member States must avoid excessive budgetary deficits. Under the provisions of the Stability and Growth Pact, they agree to respect two criteria: a deficit-to-GDP ratio of 3% and a debt-to-GDP ratio of 60%.
Focus on the “(i)n order for the EMU to function smoothly”. The reality is that these rigid rules and the threats of punitive action have not only led to very damaging fiscal policy strategies in Europe but also conditioned the “markets” to close in on vulnerable nations and the resulting “funding” crises ensures that the official response is even more contractionary than planned.
If you consider the current schedule for action you will see that the EC is expecting fiscal “correction” as they call it to be achieved for many nations this year. Malta was meant to get there last year and Spain by 2013.
The Malta Today article (January 6, 2012) – Malta under pressure from EU excessive deficit procedure – reported that:
Malta is one of five countries that is under pressure from the European Union to ensure they cut the 2012 budget deficit to less than the 3% of GDP limit set by eurozone criteria.
Belgium, Cyprus, Hungary, Malta and Poland are the countries allegedly being targeted by the EC. The UK Guardian article (January, 2012) – Eurozone strains increase with grim new economic data – quoted an EC spokesperson who said that the EC:
… had yet to reach a decision on what steps to take against Belgium, Cyprus, Hungary, Malta and Poland, which are all expected to have deficits in excess of EU limits this year, “but we will do it very soon”.
It is understood that EC Economic and Monetary Affairs Commissioner Olli Rehn sent the Maltese Government a letter on January 5, 2012:
… warning it that it was in danger of missing its 2012 deficit targets and that it could face sanctions for overstepping the EU’s limit.
It will probably certainly miss its 2012 deficit targets given the policies that Rehn and the rest of the Troika are imposing on the Union.
Apparently, Rehn also sent the Belgium government a similar letter pointing out that its projected 2012 deficit would be:
… about 3.25% of GDP this year, and not 2.8% as Belgium projects.
It was reported that “Rehn advised the Belgian government to hold back some its expenditure, setting a 9 January deadline for the country to respond”. It really doesn’t get much more mindless than that.
The Maltese finance minister who is leading the charge in imposing even harsher net public spending cuts than were originally proposed was quoted as saying that:
Unfortunately, despite efforts being taken at European level and by individual European Member States, this turbulence is showing no signs of subsiding … As announced by the Prime Minister in his statement today, in order to be better placed to counteract any impact which may arise as a result of increasing risks in the international economic situation as well as developments within the public finance sector, it has become necessary to undertake a partial review of the 2012 public sector budgetary allocations approved in the recent 2012 budget.
That is in reference to the plan to cut further – as they miss one deficit reduction target because of spending cuts further killing aggregate spending – the geniuses propose even harsher austerity. Projected result – they will miss their targets again.
So I suppose it does get more mindless.
Mr Rehn himself has some interesting expressions for all of this.
In a Press Release at the end of last year (December 30, 2011) which followed the most recent fiscal austerity announcement in Spain (and the recognition that they had failed to meet their deficit targets), the EC Vice President in charge of Economic and Monetary Affairs said:
I regret the sizable fiscal slippage relative to the 2011 budgetary target. It is all the more important now that Spain remains fully committed to the fiscal consolidation path and stays determined to correct its excessive deficit by 2013 as scheduled.
Rehn said he welcomed the “Euro 15 billion or 1.5% of GDP” that the newly-elected Spanish government plans to take out of public spending” and that these “sizable” cuts will “shore up public finances and reassure financial markets”.
He also claimed it would return the Spanish economy “to a sustainable growth path”.
Reassuring financial markets by killing aggregate demand does not motivate economic growth. It is a patent myth that the financial markets are important outside of the latitude that the central bank provides them.
While it is a little more complex in the EMU, given the flawed design that they chose to run with in the first place, it still remains that the ECB could deal the financial markets out of the game immediately. All that would be required would be for the ECB to announce – explicitly – that they were prepared to buy all government debt at a stated interest rate and immediately the so-called financial crisis would evaporate.
The real crisis would take longer to solve because employment has to rise and the private sector has to repair its credit-binged balance sheet through saving. This would require on-going and fairly substantial net public spending support for at least the next 10 years – exactly the opposite to the direction the EC and the Troika, in general are imposing.
As an aside, Spain has also been held out (by progressives) as demonstrating the silliness of the German claim that the southern EMU states (and Ireland) had to pay for their profligacy. Silly – because the Spanish government was mostly in budget surplus in the years leading up to the crisis.
However, what we need to highlight is that while Spain and Ireland both were in budget surplus in 2007 they were only able to achieve that state because their private sectors had indulged in such a large credit binge (to drive the massive property boom). The budget surpluses would have been unsustainable in more normal times.
That should be the progressive slant – even though I recognise the need to respond to some of the more manic Otmar Issing-Axel Weber-Jens Weidmann babble that dominates the German version of economic events.
Where is all this nonsense coming from? There was a rather striking Op Ed at the weekend in the Frankfurter Allgemeine (January 6, 2012) – Die Währungsunion auf dem Weg zur Fiskalunion? – written by Otmar Issing, who is the “father” of austerity economics in Germany.
Issing he has been on the board of the Bundesbank, then the ECB and advises Goldman Sachs. He has been a significant influence on the “hawk’s hawk” Axel A. Weber, the president of the Bundesbank before Jens Weidmann. The latter was taught at the University of Bonn by Weber. The “hawk’s hawk” reference comes from an interesting article in the New York Times (January 8, 2012) – Germany Resists Europe’s Pleas to Spend More.
Issing’s article is about the path to fiscal union which he says is an essential part of a monetary union. He says the following elements are essential:
1. Tightening of fiscal rules – along the lines now embedded in the German Constitution – “the maximum limit for the structural budget deficit of 0.5 percent of nominal gross domestic product, and provisions for an automatic correction mechanism in case of infringement”.
2. Strengthening of EC monitoring by toughening up the SGP – imposing sanctions first then forcing the country to justify something different.
3. Accelerate the debt-raising of the European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM)
He is deeply opposed to any imposition on the “German taxpayer” without the Bundestag having a say – saying he deplored as scandalous the “lack of democratic legitimacy of the implicit transfers of tax money”.
He also attacked economists (“particularly of Anglo-Saxon persuasions”) who were calling for the ECB to purchase unlimited quantities of EMU member-state bonds.
He raises the “moral hazard” argument which is that Greece overspent therefore they should pay!
But moreover, he is against the ECB’s Securities Markets Programme (SMP) which is currently funding European governments. He claimed that it removes the discipline (“control”) that the financial markets impose on public finances and ensures that the said markets will not take the “no bail-out clause” seriously.
He says that without that control politics will drive fiscal policy – which is a strange thing to be worried about given his staunch defence of the need for German democracy to prevail (when he opposes any bail-out funds being imposed on Germany independent of Bundestag approval).
The rest of the article was about the need for “debt brakes” to be respected and the need for the ECB’s (alleged) independence to be preserved in any new fiscal union structure. He was explicitly referring to calls for fiscal transfers to meet the problems arising from aysmmetric demand shocks.
The NYTs article I mentioned above Germany Resists Europe’s Pleas to Spend More provided some additional insights into the German obsession with austerity.
It quotes current Bundesbank president Jens Weidmann as saying that the German government should speed up its own austerity drive:
We must quickly achieve a structurally balanced budget … One of the lessons of the crisis … [is that austerity] … should be postponed as little as possible.
The NYTs article points out that the recent economic indicators in the Eurozone point to a double-dip recession but that has not deterred the German opposition to any relaxing of the austerity.
It states that the:
The central argument is that less spending by government encourages businesses to invest more and consumers to spend more, because they expect to pay lower taxes. In fact, there are examples of countries that drastically cut spending and grew, like Denmark in the 1980s.
On the issue of austerity and budget targets – please read my blog – It became necessary to destroy Europe to save it – for more discussion.
In that blog I showed that even the cyclical budget changes associated with the crisis pushed many EMU nations outside the SGP criteria. If the structural responses had not have initially been stimulative then the situation would have been much worse than it currently is.
Imposing austerity will worsen things because it will further damage private sector confidence.
Larry Elliot’s UK Guardian article (January 8, 2012) – Angela Merkel has the whip hand in an orgy of austerity – touches on this theme as well.
He reports, in relation to the declining indicators and the meetings in Brussels to consider punative action for budget “transgressions”, that:
Countries are expected to suck demand out of their economies through tax increases and spending cuts and when the slower growth that results in means the target for deficit reduction is not met, they will be punished for it.
This is the “language of S&M” applied to public economic policy.
Spain is perhaps the best current example of the predilection for pain. The new conservative government of Mariano Rajoy has inherited a budget deficit running at 8.7% of GDP in the first nine months of 2011 and has set a target of reducing it to 4.4% of GDP in 2012 and 3% in 2013. This involves taking €40bn (£33bn) out of the economy this year by a combination of tax hikes and spending cuts.
The Spanish economy came to a standstill in the third quarter of last year and the crisis in the eurozone means it will almost certainly shrink in the fourth quarter. The fiscal policy planned by the new government will make that recession worse, and a contraction of at least 1.5% looks likely in 2012.
The Spanish government will fail to achieve their budget targets. It cannot reduce its budget deficit by 50 per cent in the next years without a massive private sector spending recovery. That will definitely not happen – households are saving as unemployment continues to rise, firms are not investing because sales are so poor and net exports will not provide the solution as the rest of Europe deflates.
He quotes a leading financial market player who says that:
Since the other sectors of the economy do not appear willing to (fully) offset the reduction in the government deficit, the result is likely to be an even deeper and more prolonged recession … This is pain for pain’s sake because it will further damage market confidence in the long-term health of the Spanish economy and the banking system in particular.
That conclusion applies to the rest of the EMU, Britain and anywhere else where the fiscal austerians are ruling the roost.
In this context there was an interesting Working Paper from the Bank of Spain (its central bank) early in 2011 – Endogenous fiscal consolidations – by bank researchers Pablo Hernández de Cos and Enrique Moral-Benito.
This paper sought to validate the claims that nations like Denmark had grown after a major fiscal contraction. It is not widely quoted by the journalists, presumably because it refutes the findings of the “darlings of austerity” (such as Alesina, A., and S. Ardagna (2010) “Large Changes in Fiscal Policy: Taxes versus Spending”, Tax Policy and the Economy, Editor: R. Brown, vol. 24. NBER. and Giavazzi, F., and M. Pagano (1990) “Can Severe Fiscal Contractions Be Expansionary? Tales of Two Small European Countries”, NBER Macroeconomics Annual, pp.95-122, MIT Press., etc).
But it is a thorough piece of research with very foreboding conclusions.
Essentially the research is motivated by the claims made by economists (and policy makers) that “fiscal consolidation episodes could be expansionary for an economy” which challenge “the broadly accepted Keynesian notion concerning the existence of a positive fiscal policy multiplier”.
They explicity say that the empirical studies which are used to justify austerity:
… are based on empirical analyses in which they first identify periods of drastic and sizeable budget cuts within a panel of OECD countries, and then perform a descriptive analysis of the sample characteristics of macroeconomic aggregates, mainly GDP, before, during, and after the year in which the consolidation episode took place. The main conclusion from this literature is that fiscal adjustments are often followed by an improved growth performance, which is interpreted as evidence of non-Keynesian effects during fiscal consolidation episodes.
The important point to note is that a “positive correlation between fiscal consolidation episodes and GDP growth does not necessarily mean that fiscal consolidations generate economic growth”.
The authors argue that the extant literature claiming fiscal austerity drives growth makes a major error – it “assumes that the consolidation episode is exogenous to GDP” which ignores the causality issue.
They say that it is also possible that the “positive correlation between fiscal adjustments and economic growth may be the result of a positive effect from GDP growth to fiscal consolidation instead of the other way around …”
Their contribution is to conduct the investigation between fiscal consolidation and economic growth within a framework that a allows for the fiscal response to be endogenous – that is, reactive to the state of economic activity.
… the main aim of this paper is first to tackle these endogeneity issues in order to investigate whether there is a causal effect from fiscal consolidation to GDP growth in the short run (i.e. non-Keynesian effects of fiscal adjustment episodes).
I won’t go into the technical details of how they do that but the methods are standard – that is, not controversial.
And what do they conclude?
They say their main conclusion:
… is that endogeneity biases are chiefly responsible for the non-Keynesian results previously found in the literature; hence, fiscal adjustments are found to have a negative effect on GDP growth.
That is, the studies that provide justification for imposing fiscal austerity in the belief that it will generate economic growth are fatally flawed because their research design assumes causality is only one way.
Overall, the paper concludes that once you control for “endogeneity biases”:
… fiscal adjustments are found to have a negative effect on GDP growth.
These results are being borne out every day all around the world. The US is growing and unemployment is falling because their failing polity cannot get their austerity act into gear as yet. The economy is still enjoying the fiscal stimulus (although it was never large enough).
Many economies in Europe are declining fast and unemployment is rising because they have imposed fiscal austerity on vulnerable economies. Spending creates income. Cutting spending destroys income. Private confidence is not engendered by cutting public spending – exactly the opposite.
There is a time when fiscal consolidation occurs without damaging growth. It is when growth becomes robust enough to turn the automatic stabilisers around – so that they start to boost tax revenue and reduce welfare spending.
The reason the “slippage” is occurring in the EMU is because the automatic stabilisers are undermining the discretionary cuts in net spending being imposed by the Troika. But that is no surprise. It is exactly what we would expect. By imposing pro-cyclical discretionary cuts, the governments are ensuring the counter-cyclical automatic stabilisers will kick in hard.
Tax revenue falls, welfare spending rises (if it hasn’t been hacked) and budget deficits rise – slippage.
Exactly the opposite happens when discretionary net spending is increased – the counter-cyclical discretionary net spending stimulates growth which turns the automatic stabilisers around.
The Bank of Spain research paper finds exactly that. Again – no surprise. The German ideologues provide no credible evidence. Just mantra.
2012 will be a bad year for Spain and the rest of the beleaguered EMU nations. The sad part is that this is a totally fabricated crisis and the leadership could ameliorate the consequences with some sensible decision-making.
They could start with the obvious first lesson of macroeconomics – spending equals income equals output which drives employment.
If the non-government sector won’t lift its spending then the only sector that can solve the problem is the government. Cutting into the government contribution to real GDP growth not only undermines that growth but feedbacks onto the non-government spending decisions and ensures that firms and households become even more conservative. That is what the data is telling us in Europe at present.
As I noted in my twitter account yesterday – “2012 Madness – 25% Spain workforce unemployed and EC is discussing fines for nations with deficits over 3% GDP”. I exaggerated – Spain has only 23 per cent unemployment! But it is still mad – as mad as playing and singing while Rome burned.
That is enough for today!