Are labour costs all that matters in reducing prices?

A month ago, Eurostat published the 2012 data concerning labour costs in the EU. Attention should be drawn to the following graph:

(Click to Enlarge)

As the reader may observe, of the crisis-ridden countries, only Ireland is (barely) over the EA-17 average, while the rest of the countries, although they have been accused of high labour costs and the need for a more competitive economy are facing much lower costs than the "stronger" economies of Europe. Then, in the following chart we can see the change in labour costs compared to the change in real GDP for 2012.

Although not many data can be seen above, it is the case that a decrease in labour costs and a decrease in GDP go hand in hand, although labour costs appear to be lagging with respect to GDP change (see Italy or Cyprus). Economic theory states that for a nation to become more competitive, it either has to decrease its costs of production or depreciate its currency. In the Euro Area case, the second option is unavailable, thus the "need" for the first. Nevertheless, too much emphasis on the reduction of labour costs does not yield good results. 

It is doubtful that anyone would dare state that Greece or Portugal or Spain are more competitive than Germany. Yet, German labour costs were €30.4 per hour compared to €14.2, €12.2 and €21 respectively. If a person knowing just the economic theory described above and the labour costs per nation was told that Germany was the leading exporter in the EU then he would be rightly confused. It is not that Germany has a weaker currency either. In theory, a euro is a euro anywhere in Europe (well, other than Cyprus, that is).

Thus, since Germany is the leading exporter of goods it does either of three things:

1. Buys raw material at cheaper prices

2. Has a better reputation and creates better goods

3. Sells with less profit

Better reputation and quality of goods is not a thing that can be attributed to labour costs. On the contrary, when workers are paid better, it is to their best interest to create better goods. Thus, decreasing labour costs would not assist in neither better reputation nor better quality. Selling with less profit may be an issue, yet it is one we will never find out, as finding out what the profit margin of every company in Greece or Germany is, appears impossible. Then, all we are left with is producer prices. According to Eurostat, Germany's industrial producer price index (which indicates changes in the ex-works sale prices of all products sold on the domestic markets of the various countries, excluding imports) stood at 108.4 compared to 112.9 for Greece, 111.8 for Spain and 111.1 for Portugal. 

The producer index signifies that the German producer is able to purchase goods at lower prices than his Spanish or Portuguese counterpart. Rising prices do not have to do just with labour costs though. If we assume that raw materials are bought at the same prices (i.e. oil, ferrous and non-ferrous metals, etc) given a world-wide market, then all we have left are procedures, costs and productivity. Thus, of the constituents of prices, the only one which is influenced by the state of the economy is costs; which at the end does not even matter that much. 

Productivity is wholly different subject though. Eurostat calculates labour productivity per hour worked per year and the results are impressive. Germany's stands at 42.3, while Portugal's at 16.8, Italy's at 32.5, Spain's at 31.3 and Greece's at 20.3. This means that a German worker actually produces more than double of what a Greek or a Portuguese one does. As a result, the labour cost of a worker in Germany is approximately the same as for a Greek worker if we account for the fact that the former produces more (with the added advantage that the German firm produces more). 

Thus, the issue is not how to decrease wages, but how to to make workers produce more. This is not an easy subject. The main issue here is what makes a worker produce less. Is it because he is just lazy or because the whole system does not allow for more production? If obsolete equipment and stagnant procedures are to be blamed for this (again, as economic theory states), then a renewal of equipment and less bureaucracy would benefit the economy more than any reduction in labour costs would. If all workers in a country were lazy then we would not have any production at all, thus, although it is true that some people are lazier than others, the case is that if you have to work, you will eventually become as productive as your job requires you to be or as productive as it allows you to be.

We can all agree that a contraction in GDP leads to lower labour costs. Yet, we should not forget that it also leads to lower demand and thus less income for any firm. In addition, increasing productivity is a much better way to lower labour costs, increase production and subsequently income. Thus, although the current focus is on decreasing everything that may be decreased, the state of events indicates that this approach has been on the wrong: if productivity is increased then any periphery country may be able to sell more goods, both in the domestic as well as the international market, at a much lower price with much greater profit.

The quick lesson is this: if productivity is increased via increased investment in new and better equipment, then both effective labour costs will be lowered and the country's output as well as the firm's profitability will be increased.

We could have seen this coming. Or couldn't we?

A Black Swan in "Petra tou Romiou" in Cyprus. Photo by XristonPn

The handling of Cyprus's troubles will go down as one of the worst in economic history. Not only is one systemic bank forced to liquidation but the other has been treated as such (and will probably end up as such) since the infamous Eurogroup announcement on March 16th. Then, as the world was trying to accept the results, many began defending the handling of the situation, calling it necessary, moral and fair.

The basic premise of the "defense" is that people should have seen this coming and take the appropriate measures to counter it. Yet, what all of them fail to see is that nobody had ever warned about such things before. The most notable article on this was Peter Spiegel's one concerning a confidential memorandum on a haircut which would be "involving more foreign depositors and bond holders". Yet, this was not the outcome of some economic or political forecast of any kind. This was the result of a journalist doing his job (and doing it very well), at a time where nobody expected such decisions. There were some other articles which appeared in the press by the time the Eurogroup decision had been reached but these were the whole deal: a debate by Charles Goodhart of LSE arguing against bail-ins, an article in Bruegel which compared the similarities between a Cyprus and a Danish bail-in, a Reuters article presenting the possibilities for the Eurogroup meeting, another SSRN paper proposing measures to prevent such a bail-in, one on the NYT questioning whether such proposals might actually be feasible and one by yours truly explaining why a deposits haircut was a terrible idea. Note that the earliest of this articles (the NYT one) was just published on January 10th, with all the rest (except the SSRN paper which was again in late January) published a couple of days before the haircut.

Again, this was not the result of any economic analysis which predicted such an outcome. At most, it was an examination of what might happen, based on media reports which were more volatile than most speculative trades. Any person who calls himself an investor would not dare decide on such information, much less a depositor who has almost no idea what to do even if he understands this information, especially if most of his money are already tied up in time deposits. In all the aforementioned articles (other than the Peter Spiegel one), nothing specific on who would participate in such a haircut appeared. (Just notice the difference between the two Eurogroup decisions: the first was a levy on all depositors in all banks while the second was a levy on uninsured depositors in the two large banks). What happened next was what Nassim Nicolas Taleb would describe as a Black Swan: 

1. The event is a surprise (to the observer).
2. The event has a major effect.
3. After the first recorded instance of the event, it is rationalized by hindsight, as if it could have been expected; that is, the relevant data were available but unaccounted for in risk mitigation programs. The same is true for the personal perception by individuals.

We cannot fully understand the effects of the decision on Cyprus yet, thus although point 2 may be out of our reach at the moment, yet, point 3 is what we should be focusing on. A notable example is Jean Pisani-Ferry who stated the following after the first Eurogroup decision was made:

All those who say Cyprus tax is robbery, have a look. No reward w/out risk. Savers could have deposited in Germany.bit.ly/15aaw7v
— Jean Pisani-Ferry (@BruegelPisani) March 16, 2013

The link provides a summary of the accounts a Russian bank was (is?) providing in Cyprus, with their respective interest rates. Yet, it appears that no earlier statements had been made on Cyprus, either warning about the eminent collapse or of the increasing interest rates, which by the way were always high even before Cyprus's entry in the EU or the Eurozone. As for the seriousness of the argument that savers should have deposited in Germany it appears that although there may be many pensioners with more than €100,000 in a bank (which may be nothing more than saving €100 per month for several years), the idea of sending their money abroad is almost incomprehensible if they never had a background in investments and especially if they use that money in their everyday lives, or they are tied in time deposits.

People have taken the chain of events in Cyprus even further as Barnejek now proposes that abolishing deposit insurance would be good for the bank health. Again, we have a failure to understand what we can forecast and what we cannot. In a discussion after my asking what we should do if a similar crisis occurred in the 2030's and we had no deposit insurance the argument was that we shouldn't worry about a future crisis. Abolishing deposit insurance would supposedly make banks stronger and people would be more careful on their choice of bank. Nevertheless, I would like to remind the reader that we tend to forget fast and the "this time it's different" motto will be heard again when the economy is booming. Who would be willing to go through 200+ pages of annual reports to understand whether a bank is good or not or even if one would be willing to do so how many of us have what it takes to really see through these? If we all could then Warren Buffett wouldn't be the only billionaire investor.

Then, the argument about making banks stronger would perhaps hold for some time after the recession, although it is the case that banks have very strong balance sheets when the economy shifts from recession to growth (Minksy had mentioned this back in the 1980's on what he called the financial instability hypothesis). Then as times are good, banks fund more loans of less and less quality, resulting in trouble again (again, Minsky is the originator of these theories). Then, when it hits the fan, and they lose money or are at the brink of doing so, people start paying attention to what their bank had been doing before and complain that we should have seen this before (just remember the Madoff scheme which lasted more than 40 years-in which case people could actually foresee trouble.). If we have no deposit insurance then as soon as news of financial distress hit the market (regardless of being justified or not) a bank run will occur destroying the bank through a huge outflow of liquidity. Thus, if (or after) trust is replaced by suspicion, any rumour that a bank is not financially well will in fact destroy it. A better alternative, the creation of a fund similar to the FDIC, has not promoted thus far. (Roger Lowenstein provides a short history of the Deposits Insurance Scheme in the US here).

In addition to the above, it has been suggested that the bail-in wasn't something new and if we kept our eyes open we could have seen it in a 2010 proposal. Well, first of all, a proposal for a directive is not the same as a directive. Just because 1 million Americans asked for the construction of a Death Star does not mean they are going to get it. If the documents which leaked 2-3 weeks before the event were classified as confidential then how was that public information? There was an outflow of deposits from the Cypriot banking system yet, this was more out of concern and reaction to rumours (which also proves the point made in the previous paragraph) than of predicting the outcome.

In retrospect everything appears to be easy, yet were where the voices of concern from Cyprus Central Bank officials when the Bank of Cyprus or Laiki Bank invested in Greek bonds? How about from Bundesbank officials when German banks did the same? (Yes, German banks got rid of much of those bonds later although it is doubtful whether this was done through BuBa pressure) As a former member of the BoC board states the decision to invest in them was considered good and profitable for the bank at the time. It would be unrealistic to believe that directors (and especially the CEO) of a bank would choose a terrible investment on purpose as this is not to their best personal interest: the bonuses they received were based on bank performance meaning that if the bank was doing bad then they received nothing. Nevertheless, it would also be unrealistic to assume that these choices were not terrible or that the directors used good risk management rules (as German banks did at the time). Yet, could they have seen the PSI before? Not a chance.

It is not just that there was no precedent in Europe. Those bonds were at their worst rated as A3, paid a significant amount of interest and were considered zero risk by everyone. Many (including yours truly) would like to see a post dated prior to 2009, stating that Greece, or any other country in the EU for that matter, would face so much trouble that a bond haircut would occur and that the risk premium was high. Yet, I have serious doubts on whether anyone was able to do it (and first of all, I admit that I could not see such a thing happen in a million years).

We should all be very careful in promoting policies which are based on "we could have seen this" arguments, since most of the times we wouldn't be in a bad situation if we could have really seen it coming. This is not providing an excuse for everything though: the Greek, Italian and Portuguese governments had been overspending for at least the past 10 years and Spain and Cyprus were in a housing bubble which was doomed to burst sooner or later. Nevertheless, the timing of such bursting, including its outcome are mostly unknown as I have argued before. Prevention should not be confused with vague forecasts of disasters. "This time it's different" has about the same validity as the "we could have seen this coming" premise and any policy based on our ability (or willingness) to see the future is doomed to fail.

Are Keynesianism and Monetarism the same?

Note: The author would like to thank Frances Coppola for reviewing earlier drafts of this article and and providing excellent insight on modern monetary theory (of course any mistakes are mine). It is with her assistance that I have realized that both Keynesianism and Monetarism are, in way, obselete. What follows is an argument of purely theoretical value intended to show that other than purely ideological obstacles, Keynesianism and Monetarism are suggesting the same thing and any further discussion is redundant.

John Maynard Keynes and Milton Friedman, other than being the two most influential economists of the 20th century were the originators of two schools of thought which have sustained a debate for a full 50 years (Friedman published his "A Monetary History of the United States 1867-1960" book in 1963). Although both schools of thought are in agreement that the aggregate demand curve (i.e. output) is downward-slopping they are in disagreement about what causes the curve to shift.

Monetary Theory

Monetarists use the quantity theory of money in their view of aggregate demand: 

M*V=P*Y (1)

with M being the quantity of money in the economy, V the velocity of money (i.e. the average number of times per year that a unit of currency is spent on final goods and services), P is the price level and Y is aggregate real output (or equivalently, real income). Using the above identity, monetarists argue that in order for output to increase, a rise in the money supply has to occur. (for example, if V=1 and P=2 are constant, then in order for Y to increase M has to increase). The monetary policy transmission mechanisms are summed up in the following table (Click to Enlarge):

Source: Frederic Mishkin, Economics of Money, Banking, and Financial Markets, 9th edition

Keynesian Theory

In the Keynesian framework

Y=C+I+G+NX, (2)

with Y being output, C consumer expenditure, I is planned investment expenditure, G government spending and NX being net exports (i.e. Exports-Imports). In the Keynesian view, if the price level (P) falls, while M is constant, the quantity of money in real terms is larger, thus causing the interest rate to fall which in turn makes investment grow. Thus, output (Y) grows as well. A similar argument is made by saying that after the interest rate falls, currency depreciates, net exports increase thus output increases again.

The main difference between the two theories is that Keynesians believe that factors other than the money supply are also important in causing the aggregate demand curve to shift. More importantly, it is the change in Y which causes the change in M. Increasing the current state of output depends on factors include manipulation of government spending and taxes, changes in net export and changes in consumer and business spending.

Two sides of the same coin

The Keynesian premise states that increased government spending or a reduction in taxes makes people have more to spend than before; either because they give away less in taxes or because increased spending increases their income. Here, the debate of crowding out private spending occurs (i.e. if the increase in government spending will induce a decrease in other parts of the output equation, notably private investment and spending, thus leaving it unaffected). Nevertheless, crowding out only occurs when the economy is in full capacity and not at any other level (the only other possibility is when the state effectively steps in to take private sector jobs, yet this is irrelevant of whether the approach is one or the other). However, what most monetarists do not observe is that the case of government spending not being done by issuance of government bonds (i.e. borrowing) but by printing new money, is practically the same as increasing money supply in the first case of the above picture (although in the modern economic system either borrowing or printing would be more or less the same). Thus, if increased government spending is done via the printing machine then the monetarists' argument of crowding out the private sector cannot hold as it would necessarily have to hold when we use the monetarist doctrine (in which case crowding-out does not happen as theory and practice state). This means that both the Keynesian and the Monetary doctrine are in fact promoting the same issue, albeit with different ideology.

Either increasing government spending or increasing the amount of M in the economy would have the same result. Printing money would equal increasing government spending (e.g. build more roads) since you actually have to use that money somehow and not just have them lying around; and you cannot throw it over the country with a helicopter (well you can, but it's not a very good policy!). Thus, unless we speak of creating money and giving them to the banks so they can increase lending (which again is not good policy as it is subject to the whims of the banking system),  printing is the same as increasing government spending (one may argue that the money can be used to finance the same amount of spending as before, yet this will also affect the economy albeit indirectly through decreased supply of government bonds).

It appears that Monetarists cannot accept that changes in consumer and business spending also affect output. This is somewhat against their own logic once again: Note that in identity (1) the quantity theory of money states that "keeping all else constant" only M can change Y. Yet, an increase in consumption (keeping M constant) means that the average times a euro is spent over a year (i.e. V) increases. If V increases then (keeping everything else constant) it means that either P or Y have to increase. Nevertheless, if P (the price level) is affected only by the money supply in economy (according to the monetarist theory), then it cannot be increased without an increase in M. Thus the only part of the equation which can be increased is Y.

The point here is that inflationary pressures will occur whatever the approach may be. Yet, this is exactly what policy should be aimed at: as real interest rates increase and nominal rates decrease during a recession (just have a look at Japan currently or at the US during the Great Recession) the only way to induce spending is by increasing these rates. Both theories provide some good tools for this although they present it differently:

1. Monetarists say that an increase in the money supply will increase output.

2. Keynesians say that an increase in government spending or a reduction in taxes will do that. 

Source: Wheelock, D. 1992 "Monetary Policy in the Great Depression.
What the Fed did and Why"

Nevertheless, when we replace "government spending" with "government spending via increasing money supply" instead of borrowing then the Keynesian doctrine is identical to the Monetarist one. Krugman and DeLong point out that in a liquidity trap government lending will not cause interest rates to rise. In addition, Krugman comments that the IS-LM (Keynesian) model equals the Modern Monetary Theory one once a country finds itself in a liquidity trap. The argument here is that the two approaches are the same not just in a liquidity trap setting but in recessions in general (in a liquidity trap it would be actually easier to go through with fiscal stimulus since it does not require the same amount of commitment as a monetary expansion). Then, since crowding out effects do not occur during a money supply increase if we trust the Monetarist view on the subject, we are forced to conclude that they do not also rise even if the channel is increased government spending.

In practice, both theories should work well in a recession as long as the government steps in to cover for the private sector's unwillingness to invest or consume; both are also expected to be inflationary and cause private sector crowding out at times where the economy is operating at full capacity (or if supply-side inefficiencies occur). Thus, what is left when all economic arguments lifted is pure ideology: is a large government sector better than a small one? And the answer, similar to all issues of economics and life is, it depends...

Economic Stories: The Tale of Austerity

Joe was an average man. Medium build, medium weight, dark hair and eyes. Not married yet, but wanting to settle down. He had a steady job and a steady, average salary; he was a government employee at the Ministry of Finance. Joe liked doing what everyone of us does: have a pint of beer with his friends, enjoy a good meal and watch some TV at night. In fact, Joe was a creature of habit: he did the same things, with the same people over and over again and he enjoyed it. He had strict habits with regards to his personal finances as well: he always saved 10% of his salary for a rainy day, had 30% of his salary go to the loan installment for the small apartment he had recently purchased  and used the rest for his everyday needs.

Most of Joe's friends were also in the government sector. Mark was working as a mailman and was a father of two sons, Andrew was a newly-wed accountant in the same department as Joe and Susan was a single mother, a school secretary. All of them usually met at Bob's Bar, just down the road from where they were staying and they were Bob's most faithful customers. It was because of them and others like them that Bob could earn a decent living; for he had his expenses as well. Every month Bob had to pay a large amount of money on electricity, water and licenses for running the place, not to mention the 2 waiters he employed. In addition, although he possessed a small brewery in the back of the bar and produced his own beer, he had to pay for the wheat, barley and hops required for production. 

On that particular day, Joe and the others were waiting for Andrew when they started talking about the rumours that had been raging in the news. 

"You know", said Mark, "if what they claim is true, then we might face a 15% cut in our salaries. Things will get harder you know."

"That is true, yet it is not us that I fear for. We are still going to get some salary, and with or without difficulty, we are going to have to adjust ourselves to that. It is those who depend on us, like Bob for example." commented Joe as he ordered four beers.

"I heard my boss talking today, and he said that if this is true, that our country has a lot of debt accumulated, it cannot be taken lightly. A pay cut will only be the tip of the iceberg" said a fearful Susan "Who knows what might happen after?"

At that point Andrew came in. As he took his seat, he looked more upset than usual, and his fast talking proved that. "It is true. The pay cut is official. As of this month we will receive 15% less money than we have. I know this for sure because this is why I've been late. We had a meeting concerning these developments" and with an exasperated voice added "darn! I was hoping to get that down-payment for our house in a few months. What am I going to do now? My wife will be so upset that we will not be able to finally get a house."

Bob was getting them the beers himself and had overheard most of Andrew's monologue. With a shrewd smile he tried to joke around the subject "Don't worry about it Andrew. You guys were already getting too much money anyhow. It's not like you are going to be left on the streets you know"

"Even if that's correct Bob" argued Joe "which I assure you that its not since we are all making average salaries here, and" pointing to Andrew "he can confirm that, that is not what you should be worried about. It is the fact that now, less money will be in the economy than before. Which means that as people get worried about their finances, they will spend less. Thus, the income of every other person in the economy will also fall"

"Nah, I don't understand these things anyhow. I just sell my beer and hope people are having a good time"

"That's the point Bob. There will be much less beer going around after this"

"But look around you. Everyone is having such a good time. Why should they need less beer? You need more beer when things go bad anyhow!" he chuckled.

"Oh well, I guess we 'll have to wait to see about that"

"You kids enjoy your beer and don't think about anything else. Things will be good" said Bob with a reassuring smile.

Everybody put in an effort to talk about something else during their time there. Andrew was trying not to think about his new house, Joe and Mark were forcing themselves to forget about the loan installments and Susan put on her best show, trying not to show her fear that she and her son would not have enough to get by after paying the rent and every other bill next month.

As expected, all four of them started defining expenses as necessary and not-necessary, just after the announcement, and even before the reduction in their salaries occurred. Who could blame them? Two of them had children to take care of, one had taken a loan to buy his apartment and another was about to get one in order to move in a new house with his wife. Things were beginning to appear bleaker for them and thus they had to act in order to reduce the effects the cut would have in their lives. Obviously, the regular visit to Bob's Bar was deemed unnecessary for them and thus they reduced it to scarce gatherings. They were actually proud they had arranged that their gatherings could take place at someone's house in order to reduce expenses even more.

After a long time without visiting, the four friends decided to have a gathering a Bob's Bar, for old times' sake. The bar, which was usually crowded at that time, was only half full. When the owner approached their table he seemed more worried than any time before. 

"What happened Bob?" asked Andrew "did people stop liking your beer?"

"Nah, that's not it" sighed Bob "It's just that people are now more...erm, stingy, with their money. People who used to come here and order 4 beers now only get two because they are trying to save up. And its not just my idea. Many have told me. People are afraid that there will be more cuts soon and they try to prepare themselves for that"

"You do remember that I happened to warn you about this don't you?"Joe said.

"Yeah, and I thought about that too. But it looks like you got trapped there as well. Your visits here much less than before and you always leave after a short while. What happened?"

All four looked at themselves and all around trying to find something to say. Mark was the first to break the awkward silence

"I guess we were also caught up in this Bob. It's not something we really wanted. We all had fun coming here. I guess.. I don't know. We just fear that things will get worse and had to pull back from our habits"

"All of us have families and loans and we have to put them first" added Susan"We were out of options"

"You know, I am not the only one saying this. John and Mary who own the bakery just across the street have been telling me that even their customers have been much less than usual. These cuts did more damage to us than they did to government employees!" said Bob, sitting down with them.

"Let me take a guess here Bob. Has your income been down by more than 15%?" asked Joe

"Of course! I have only been working at three quarters of what I used to do. Maybe 80% if I get lucky. And I feel bad about Jonathan, my waiter. I cannot afford to keep him employed full time so I had to make his employment part-time" Bob sighed. "He's a student and I really feel bad about this. But what could I do? Janice, the other waitress, has a family and she has to support them. Terrible situation really."

All 5 looked at each other in silence again. Bob couldn't keep down any more as he finally found someone he could talk to and started talking again:

"You know this goes back too. Remember Frank, the farmer I buy the barley for the beer from? Well he is facing difficulties too. His clients stop ordering like they used to. It seems like if you guys get a 15% reduction, I get a 25% one and poor Frank loses even more than that. Things are not going well"

Joe looked at him and said "Well, it does make sense. Think about it this way: if you are depending on us, and we decrease our beer-drinking, then you face a 20% decrease; imagine what will happen to Frank who is depending on you, and other breweries to sell his goods. When they do not see enough clients it is sure that they will reduce their orders. Most of the times, since I am guessing that all of you have some sort of inventory in both beers and their raw materials, the reduction in orders from Frank will be much higher than what your reduction in sales has been." and after pausing for a second he continued "Sorry to be the bearer of bad news but this situation will not end up very well you know. You are an honest tax-payer I assume right?"

"Of course" roared Bob "been paying my taxes honestly for the past 30 years"

"Well you know that our country gets the money it needs from two ways: taxes from honest tax-payers like you and by loans" said Joe and looked at him. "And the taxes they receive are linked to what you earn. Do you see where I am going with this?"

"Don't tell me that...!"

"Exactly. If you earn less, then the government earns less. Thus if the government earns less, it has to get a loan to keep on paying those in its payroll and cover other expenses it may have such as rent for buildings or electricity bills and such"

"But who lends the government that money?"

"Basically banks" answered Andrew "but it's not their money they are lending. It's money they have sitting around. That means my deposits and yours"

"But isn't that illegal?"Bob asked somehow startled by this discovery.

"Not really because, you see, banks are actually playing around with odds. They know that everybody will not come at the same time asking for their money, thus it is to their best interest to lend out as much as they can. Then they lend money to to regular people like our friend Joe here, who wanted to buy an apartment and use the rest of that to lend the state. Always at an interest though"

"Yes but doesn't that mean that banks can lend our country whatever it needs based on our savings? We are all patriots right? We can lend our country if it needs the money"

"But banks and legislation does not work that way. Banks cannot simply give your money to anyone looking for a loan. This would be a recipe for disaster. The banks simply lend the state under the cause that the state will pay back and that the banks will get some interest from it. They are only allowed to lend the state because the state is considered as impossible to run out of money. "

"Yet, they have to be careful"Joe said, taking on from Andrew,"if they reach a point where the state cannot repay them then they will lose all that money."

"So they wouldn't be able to give me my money if I asked for it right?"Bob finished the sentence.

"Exactly. And how can the state earn more money?"

"By taxes"Susan replied "Or by paying less money to the people it employs"

"But if you pay less money to the people you employ then you are doomed to get less money as taxes" Bob gasped."Then how can they do it?"

Susan smiled dryly "I think it's all about timing. Had they done this a few years ago then trouble may not have been so big. Unfortunately they didn't. We are humans, and as such we refrain from thinking about bad things until they have reached the point of no return. Now, the solution, although it appears to be extraordinary strange is to actually increase spending, hope that tourists come to leave their money here, or that foreigners will start demanding more of our domestic goods so we can export them and have money from abroad come in. Otherwise we are lost"

"Tourists and foreigners? How can we depend on other people to save our country then?" asked  Mark after finishing his beer. "Isn't it better to rely in our own powers?"
"Yes, he is right" Bob hurried to agree.
"It is obviously better if we can do it ourselves", Joe interrupted "but who would be willing to say that when the state has been over-spending, the correct way to counter that would be by increasing spending and providing initiatives for investments and consumption?"

"What do you mean spending and are incentives for investments and consumption Joe?" asked a confused Mark.
"Well, you see, spending is actually what the government does when it is building new roads or buildings or when it is paying us who are in its payroll. And then you will have to ask where the government expects to find that money aren't you? Well, here's the trick: all it has to do is to temporarily spend more money and simultaneously increase taxes a while."
"Increase taxes?" Bob looked at him startled "But then we wouldn't have anything!"
"Hold your horses Bob, and let me explain. Let's have an example. Suppose that you were earning 1,000 per month before the cuts in our salary happened. Now, with a 20% decrease you would be earning 800 right?"
"True. Go on."
"Then, if the state charges you a 25% tax you would have to pay 250 at first and just 200 afterwards, leaving you with 750 and 600 after tax proceeds respectively. Now, if the state instead of decreasing what it spent, had increased them by 10% we can easily say that your income would be, say, 5% higher right?"
"Yes..."
"So you would be earning 1,050 before tax. Now let's say that the state increases taxes by 5% to 30%. You would be earning 1,050, paying 315 for taxes and earning 735, a bit less than before, but still much more than what you are making now!"
"But wait a minute. This isn't good for the state. It increases its spending by 10% and then receives 5% more for it. It's still 5% down. How can it make up for that 5% loss?" argued Mark.
"Ah, but you were not paying attention to the mathematics! Do you remember how much money the government was making from Bob before?"
"Yes, 250"
"And how about now?"
"315"
"So how much more is the government making now?"
"That would be 65"
"You know, that 65 is a 26% increase from 250. Thus, using this little trick, the government is actually making much more than it is spending, which can be used to reduce its existing debt."

 "I have to two questions for you then. Why isn't it doing this all the time, and why isn't it doing this now?" Mark asked, after sipping another beer.
"Your first question is relatively simple: it cannot keep on doing this because, if everyone keeps getting more and more money then inflation will be huge. You know what inflation is right? It's when prices rise over time. Well this works as follows: if we all get 1,000, then the price of a beer is let's say 2. But if we suddenly all earn 2,000 then the price of the beer will rise to 4! You see where this is going right? If the government keeps raising our income then at a point you would need 1,000 to buy a bottle of beer, and yet that 1,000 will not essentially be worth more than the 2 we are paying now!"
"But the government will be taking some of that amount back!" said Mark
"True, but taxes cannot grow indefinitely. Imagine, who would be willing to work if the state takes 80% of your income? Not to mention that once you cannot pull that strategy off anymore, because you have reached a huge amount of taxation, your only other alternatives are to either keep on printing money and make a bottle of beer cost 100,000 or declare bankruptcy. In addition, this sort of strategy will not work indefinitely as it works just when interest rates are very low and not when the economy is doing well. Yet, the good thing about this strategy is that even though it may not increase consumption by that much (remember that in our example earlier we had gotten a 10% increase while Bob only got a 5% one?) it helps banks make loans because it increases people's savings. More savings mean that banks will be able to hand out more loans and thus increase consumption as well. Depending on the level of the interest rates, money in the economy can increase a lot."
"Oh, I see..."

"Then you ask why it is not doing this now. The reason for this is that to doing this requires money; something our country does not have. If a nation has its own sovereign currency then things are quite simpler. It can just print more money and try to implement the solution I described above (although I remind you this only works when the economy is doing really bad). But, if it does not have this opportunity, then the only alternative is to either increase taxes to get more money to repay its debts or to decrease the money it is paying. The first solution is relatively easier on the taxpayers but unfortunately politicians' views do not make this consistent. For example, if the president wants to look good for re-election, the government can just announce that tax rates will be reduced. This means that we cannot be sure that such policies will succeed. Yet, as you may notice the same holds for spending cuts as well. But, what makes the spending cuts look more favourable is that they have immediate effects in reducing government spending, while tax increases may be delay the influx of money. Unfortunately, as our friend Bob here has witnessed, these cuts also have a significant effect on everyone else in the economy, meaning less money for them too."

"Then why is our country not getting more money?"asked an eager Bob
"Remember what we talked about banks and lending a while ago?" replied Andrew. "Well, banks and other institutions only lend the state money when they believe that it is creditworthy and that it will repay them. Just like you and I would not be willing to lend someone 1,000 if we thought he wasn't good for them or just like the bank does when it gives money to Joe here in order to buy a house. So, if the banks do not think that the state will be able to repay them they choose not to lend it. The problem is that we are all as good as our state."
"Meaning that a single company cannot possibly be doing great if it is based in a country that is doing bad" continued Stacy. "Then, after the country does not look good, banks feel the effect fast: due to the cuts people like you and me do not earn as much as we did before and we start not being able to repay our loans. This also happens when times are good but can you imagine what it means when 10 or 15% of the bank's customers stop repaying their loans? The banks do not have enough money and they are close to failing as well."

"You see the banks are caught between a rock and a hard place: they either lend the state money, which they are afraid they will lose or they do not and watch their clients fall back on their loan installments"

"You remember a few years ago when things were going great?" Andrew continued "Well, everybody was seeing their businesses flourish, receiving high income and unemployment was really low. Everybody was spending like there was no tomorrow, and I do include ourselves in that. Banks encouraged that behaviour as well: account overdrafts, too much lending and at good interest rates, every person had to spend more, more and more. Yet, after the wheels turn and we are at the low part of the circle, what happens? We panic because we were not wise enough to think that this could not go on forever. Even those who were wise enough to put some money aside are still not feeling too good about this. Too much prosperity causes people not to think. Thus, our government kept spending more and more."and after pausing he added "but this is not the time or place for reminiscing. I just hope that this cut will be the final one, because as people will be financially wrecked if this continues. You can see how things will work out if we get another 10% decrease right Bob?"
"God knows I 'll have to fire a waiter for sure to keep up; and I am not even sure I will be able to continue having the bar. I hope those who run the country will be wise enough to wise know what they are doing to us..."

"I 'll drink to that hope Bob" said Joe raising his glass