European problems and the austerity-means-disaster myth

Posted by Harald Uhlig on 7 April 2012

Is it time to relax in Europe? Things look better than at the end of 2011. Greece got an “orderly default”. The ECB is providing banks with nearly unlimited cash to buy the bonds of their governments. Yields on 10-year Italian debt declined from 7.3% to 5.1%, and yields on Spanish debt declined from 6.7% to 5.8%. Sweet!
But not so fast! Things are gradually turning south again.
·         Greece is now stuck with an unsustainable yield of 20% on its traded 10-year bonds.
Markets are betting on another default. It will be a nasty one, with bonds now under British law. A valuable opportunity to wipe the slate clean and have Greece default down to truly sustainable levels has been squandered.
·         Goodwill in northern countries to help out in, say, Spain and Italy, has been wasted by a two year focus on the entirely tangential issue of a Greek bailout.
·         The private market in European sovereign debt has been severely damaged and undermined by first having the ECB and the IMF buy large stakes in Greek debt, and then next insisting that they shall not lose money on their positions.
Essentially, the only private buyers out there are now the “private” banks, which get a hefty subsidy for these purchases per the Draghi-three-year repo offers.
·         Inflation is edging up to 2.6%, the economy in Germany is running hot, debt markets have been wrecked, good will in northern Europe has been squandered, and a resolution of the debt crisis and the banking crisis is not in sight.
The best cases may be: Ireland (which seems to get its house in order), Portugal (with its new austerity-demanding government, but struggling against an unsustainable 10-year yield of 12%) and Italy (where Monti is popular and on the right track – but how long will that last?). The worst case is Spain. They did not even wait until the ink was dry on the new Merkel-conceived EU fiscal pact, proving it to be entirely irrelevant. Spanish yields have edged up the fastest and exceed Italian yields now. From the Spanish perspective, that’s just as well: better get the bailout, before anyone else and while the money is still there! The fiscally responsible governments will be left out to dry.
Praying for redemption
The ECB is now stuck with one trillion Euros of long-term lending out there, without telling the banks to get rid of their toxic sovereign debt. That would be the only strategy that would save them! But the private markets in these instruments have been killed, see above. In case things still look dire down the road, markets believe that the ECB will apply more of that morphine to the comatose patient, inflation be damned. What a disaster! Perhaps, the politicians responsible lie awake at night, praying that the economies in Europe will pull out of this slump on their own, as they normally do, and that governments will become fiscally responsible, as they normally don’t. Let me pray with them, that their wish be granted, but I do not believe in the tooth fairy either.
Dispelling the austerity-means-disaster myth
So let me help the forces in favor of much-needed fiscal restraint, by examining a key argument, which shapes public debates, which gets repeated in many-a-newspaper, but which is a myth. What is needed is a considerably more enlightened debate, in order to be able to choose sensible economic policies. The myth is this: fiscal austerity means disaster, because growth policies require fiscal spending.
Now, of course it is nice to borrow money from others and sprinkle it generously over your citizens. Once that flow stops, one should not be surprised that your citizens are unhappy. But what has been borrowed normally needs to be repaid later. A much more interesting discussion is: ‘What about extracting these resources from your own citizens, and then sprinkling them back on them?’ What about that old Keynesian idea of having some your citizens dig holes and letting others fill them again? Might that be doing wonders to your economy?
There is some wondrous stuff going on indeed. Here is a little example. Imagine some beautiful island somewhere, where its citizens do not need to do much to live a happy life. There is an apple tree for each citizen, and exactly one large apple drops at noon, enough to feed that citizen for the day. All you got to do is pick it up and eat it. The citizens lie on the beach otherwise. GDP in this economy would be one apple per day. Now, enter a government. Let’s say, that government taxes away the entire harvest every day. But it then hires its citizen back and pays them one apple for, say, lying on the beach. They would have done so anyhow, but now they get paid for this “service”, courtesy of their generous government. Magically, GDP now doubled! The services of the government are accounted for by how much they cost, and they cost an apple in this example. It would be easy to keep going and actually triple or quadruple the original one-apple-per-day GDP. Now imagine some imposition of fiscal austerity – say, eliminating the government altogether. Yes, GDP comes crashing down: it will fall by 50% in this example. The citizens, however, are not worse off: they still get to eat the one real apple per day just as before. Indeed, if the government requires them to do something onerous for their salaries, like sitting around in a government office rather than lying on the beach, they would overall even be better off without these government jobs! Moreover, if the tax imposed on citizens is a labor tax on collecting the apples, then high tax rates may prevent them from collecting the apples in the first place: another reason to cut back on government spending.
I am not suggesting that Greece or Italy or Spain pay its government employees for lying on the beach or sitting idly in their offices. But it may be worth asking why the government share has to be so large in the first place. It may be worth asking how much truly valuable services get lost, if these governments spend less. It may be worth asking how much added dynamics these economies can unfold, once the looming burden of high future taxes get removed. Being cut from the government handouts must feel horrible for the affected individual - that is also true in the “apple-tree” economy above! The transition is tricky and requires careful thought. But that should not cloud the perspective on the overall benefits of fiscal austerity, even if standard national income accounting tells us that GDP declines.