Thursday, 2 August 2012

The need for austerity and growth

If one had been reading my articles regularly it might appear that I have not been a proponent of austerity measures. However, this is not the case. I do believe that austerity measures should take place in the countries that need it (e.g. most South European countries are in desperate need for a rationalization of their policies) BUT they should be manifested over the realm of several years, so as not to have dire consequences in the countries' economies.

The ECB officials (and their German counterparts at the Bundesbank) state that the reasoning behind hard measures is that they will not help a country which is not prepared to sacrifice a lot in order to be helped. This may be a valid reason but, with severe austerity measures employed, the countries are no longer competitive, as they face a strange situation with a demand which keeps going lower and lower while producer prices are rising. Recent statistical data from the ECB indicate this phenomenon in several countries. For example, while Greece has been struggling with austerity measures in the last year and a half, industrial producer prices in the domestic market have never stopped rising. The same holds for Spain, Italy and Cyprus. The latter is on the top of the EU list with a 9.1% rise in industrial producer prices since May 2011. Thus, while demand is shrinking, prices refuse to fall.

In the supply&demand world of economists it is obvious that prices will have to fall in order for demand to rise. Simple? Not very much. You see, this does take some time. When, for example the euro was introduced in 2002 the prices in local currencies had centuries of supply&demand experiences and thus at they were considered to be in equilibrium in most times (with the possible exception of recessions). However, after the introduction of the euro things changed. An increase in the level of prices occurred, in both goods and services, which was a result of rounding up. Extreme examples of rounding up (but yet not very rare) were for example rounding a good to a 4 euro price instead of a 3.5 one which was the normal conversion price.

A paper published by the ECB in 2009 indicates such price behavior as perceived inflation. Quoting (page 137)"However, there is a measurable break in this relationship at the time of the introduction of the euro. In all EMU member countries, perceived inflation dramatically jumps upwards, implying a shift in levels in the distance between inflation perceptions and HICP (Harmonized Index of Consumer Prices) inflation rates. While a temporary gap between actual and perceived inflation is not unusual (for instance, similar changes in the distance between both inflation measures can be observed for the United Kingdom in 2000), the magnitude and persistence of the increase in perceived inflation are remarkable." Then in page 138: "A more notable result is that the persistence of inflation perceptions has increased dramatically in almost all countries after 2002.Furthermore, there is evidence that in some countries the influence of expectations on perceptions has increased. That is, inflation perceptions by consumers appear to be increasingly affected by their own inflation expectations, while putting less weight on official price statistics."

I do apologize if I am boring you with technicalities, however this just indicates that prices have yet to be stabilized in the Eurozone, as a result of the Euro changeover. (a more technical paper can be found here) Hence, a crisis like the one we are now experiencing combined with the austerity measures undertaken by many countries will help stabilizing prices, most likely to a lower level. Nevertheless, such a procedure should be slow and last several years and not be rushed by taking measures which will worsen a country's competitiveness.(Well, it will anyhow since prices adjust slowly, but the procedure will be unnecessary difficult for citizen if it is faster than normal)

P.S. Latest news say that the ECB plans to buy Spanish and Italian bonds jointly with the ESM. Draghi says that the ECB will do all it can to save the euro. Hmm that would be the 50th time I have heard something similar! The difference between action and theory is the difference between masturbation and sex guys.

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