Why Austerity Doesn't Work as Expected

Proponents of austerity appear to have the impression that the whole supply and demand issue (as discussed here) holds and prices adjust automatically to any fall in demand. Truth is, this does not appear to be the norm in real life. Inflation data from Greece indicate the following:

The three vertical lines indicate the three austerity packages passed by the country's parliament. The most shocking observation is that prices did not fall not even after the third austerity package. Data show that the first reduction in prices occurred in January 2013, i.e. 2 years and 8 months after the first austerity package (in May 2010). In comparison, data from the other countries which have been struggling with austerity show similar patterns:

(Vertical lines again indicate austerity packages. Gaps indicate lack in data.)

As the graphs show, Ireland has been luckier than Portugal in the sense that prices were falling before the austerity package came along. However, we cannot infer that the austerity package has indeed caused the reduction in the inflation rate. It is more likely that the reduction had been caused by something completely different and the packages may have helped to prolong this phenomenon. As the above graphs indicate, all sample countries had an inflation reduction in 2008, which is probably the outcome of the sub-prime crisis in the US.

Increased inflation indicates that people can afford less with a given amount of money. Then, as unemployment increases, the amount of money circulating in the economy is reduced. Thus, reduced money in addition to increased prices means that consumption is much less than expected. Then, as consumption falls, GDP falls and the vicious cycle continues. This self-perpetuation of contraction is a notion very similar to the Debt-Deflation Theory of Irving Fisher, which appeared in 1933(!) in the aftermath of the Great Depression; it is more recently presented the other way around (i.e. borrowing and boosting growth can result in less debt) by DeLong and Summers about a year ago. According to Edward Hugh a version of this has appeared in Spain and we can almost be sure that this has happened (or will happen) in probably every other Southern country.

The big question here would be why are not prices lowered as soon as producers witness a drop in consumption? Well, the world does not really work that fast. First of all, a producer cannot fully distinguish a permanent drop in sales from a non-permanent one unless some time passes. The reason for that is that sales fluctuate significantly over time (e.g. seasonally or over business cycles). Then, even though sales drop, the cost of producing (i.e. raw materials, etc) does not; the producer's supplier is further back the chain and will need an even larger amount of time to realize a drop in consumer demand. Only when the producer reduced order sizes over a long period does the supplier note the change. In addition, a drop in producer prices (as can be seen below) does not necessarily mean that consumer prices will also be reduced since the transfer mechanism takes a significant amount of time to understand that this reflects a permanent reduction. As it appeared, oil prices started an upwards trend in early 2009 so the producers were right in not reducing their prices significantly (the reduction can be largely attributed to an oil price reduction of more than 50% in the fourth quarter of 2008).

The above arguments have been one of the reasons that Moody's (and every other ratings agency for that matter) has been unwilling to increase the ratings of any country in which harsh austerity measures have been implemented. It appears that the agencies have a clearer view on the subject than politicians and policymakers. Lately, it has been suggested that the UK downgrade by Moody's is more of an opportunity than a calamity. The rationale behind this suggestion is that it provides policymakers the incentive to realize that austerity measures are not helpful to the economy. In Moody's words the UK's "most significant policy challenge is balancing the need for fiscal consolidation against the need for economic stimulus". The same would hold for the rest of Europe as well.


Although the debate on Fiscal Multipliers has been raging over the past months Simon Wren-Lewis is correct to note that their sign (i.e. that it's positive) has never been argued. Yet, for some politicians (like David Cameron who still believes that "(...) we are making the right choices. If there was another way I would take it. But there is no alternative." ) nothing of the above holds as it is too "complicated" to see that austerity measures bring more trouble to the economy than increased public debt.

If each nation has the politicians it deserves then people surely deserve the outcome of their (irrational) decisions...

Fiscal Multipliers Explained (and Proved)

The Panic of 1837, blaming the Treasury Policies of Andrew Jackson

The IMF spokesperson, Mr Jeffrey Rice, said the following in a Press Briefing in Washington about 10 days ago:

(...) there's been a lot of discussion of this fiscal multiplier, which is probably something very few people had heard of until some months ago.(...)

I have shown the inaccuracy of Mr Rice's statements in a previous post and have no intention of doing the same again. It appears that the publication of Oliver Blanchard and Daniel Leigh's IMF paper about the problems of forecasting multipliers has caused more stir than it should, because it essentially does not say much. Quoting from their conclusions (page 19): "Our results suggest that actual fiscal multipliers have been larger than forecasters assumed. But what did forecasters assume? Answering this question is not easy, since forecasters use models in which fiscal multipliers are implicit and depend on the composition of the fiscal adjustment and other economic conditions."

What has not been noted in the existing literature of comments about the paper is that it does not really estimate multipliers or anything similar. It just points that the estimations concerning these multipliers, when the IMF staff were making them in 2008, can be proven wrong, ex post. (For those interested the IMF staff assumed a multiplier value of merely 0.5. We will see later why this does not appear to be very valid)

Thus, what we may infer from their comments is that the previous models of estimating multipliers had been wrong, yet they are not proposing how these errata can be fixed. In fact, they are not actually even saying how a multiplier actually works or how it affects the economy. Since many economists and politicians do not appear to understand the rationale of fiscal multipliers, I have decided to play the game on their own terms.

Let us consider the following model:

In each country the yearly output is measured by GDP=G+C+I+NX where G stands for government spending, C for Private Consumption, I for Private Investment and NX for Net Exports (Exports - Imports). We assume then that G is increased by €X billion. The amount of G here is unimportant to the result we are about to reach.

First of all, we have to understand where the €X billion chunk of Government Spending goes to. Wikipedia states that Government spending is the sum of government expenditures on final goods and services. It includes salaries of public servants, purchase of weapons for the military, and any investment expenditure by a government. Thus, we may safely conclude that this amount goes right into the consumers' pockets in forms of salaries, or other payments towards companies or individuals. 

Then, what do these consumers do with that €X billion "given" to them by their government? As usual, they have two options: either spend it or save it. There is also the option of repaying their loans but this falls in "saving" part for reasons which are not the purpose of this article. We may assume that this €X billion amount is saved or consumed in any fraction we can think of. Here we will note it as s*€X billion where is s signifies the amount saved in banks or other institutions (hiding under the mattress is not an option here!) and (1-s)*€X billion the amount consumed.

As it may have become visible through this analysis, Private Consumption will be increased by (1-s)*$€ billion. Then, if we believe neoclassical economics, i.e. David Ricardo or Alfred Marshall, all savings are used in the form of loans to entrepreneurs by banks and thus Investment is increased by s*€X.

What can be seen here is that through the standard measures of GDP, Government Spending is calculated twice. Once as spending by the government in the G part of the equation and then partly as an increase in Private Consumption (in C) and an increase in Private Investment (I). The total increase of C and I equals €X.

Now imagine if Government Spending was to be decreased by €X. The total contraction of GDP would equal €2X in the above example. (In the real world this amount might be slightly exaggerated or underrated, since other issues may also arise. For example the economy's rate of growth would cause the effect to be less but a further decrease in consumption as a result of people's fear about the future would contract GDP even more.)

For the skeptics, let us assume that neoclassical economists are all wrong and that the fraction of G which ends up in banks does not find its way to the entrepreneurs. Then the an €X increase in G would mean a (1-s)*€X+€X increase in GDP, which is still greater than €X. The decrease would go the other way around.

Are we forgetting something here though? If the reader was careful during the above analysis the fact that in the definition of government spending transfer payments, such as social security or unemployment benefits are not included should have rang a bell. Now, think about it again: transfer payments are being employed the same way as government spending, i.e. given to people for them to consume or save. Now, have a look at the following data compiled in an older post:

Now I will not even suggest that all of this money goes unnoticed in measuring Government Spending for GDP (although probably most of it does). Yet, even if 40% of the above amounts goes unnoticed and as already mentioned, people consume or save that amount, then an €X cut in the benefits would mean a 0.4*X*(1-s) reduction in consumption and a 0.4*X*s reduction in investment. In total, even though these amounts are not measured in GDP their effect appears to be of great importance.

The above are in accordance to empirical findings by the IMF (have a look at this article, pages 41-43) which now estimate that fiscal multipliers are in the range of 0.9 to 1.7. (This admittance that the multipliers were actually higher than they had expected, did not actually gain much publicity, only in the form of articles like Is the IMF short for I Must Fail?) Although the 0.9 number does appear to be rather too little based on the previous analysis, it may occur if the change in spending is little and the country experiences strong growth (although it would be tremendously difficult to achieve such low values for rapid changes in the level of spending) the 1.7 one appears to be more in the line of the above simple model.

Conclusion: Government spending is affecting GDP more than we believe. This means that we either have to alter our understanding about it or change the way we measure GDP. The former is much easier. I think...

Note: The above calculations would only be important if the amount slashed off the budget is significant. A country's GDP will surely reflect a 1-2% reduction in spending, yet nobody is going to notice a 0.0001% reduction in G when the natural growth rate of an economy is about 1%. On aggregate that is...

The misunderstood effects of a default: A Guide to Politicians and Policymakers

Although I had thought that the issue with Cyprus was very similar to the one with Greece, Portugal and Ireland it appears that it isn't so in the eyes of some. From what I can see on some websites, it appears that the case is not so clear for one reason or another. For example, denying aid to the island has been an issue in the German parliament over the past few weeks. Notably, Angela Merkel's coalition partners the FDP have raised their voice in opposing a bail-out scheme. Even in Merkel's own party (the CDU) there appears to be some hesitation. Yet, it appears that they are not so against it as they used to be, if we believe Spiegel.

From my point of view, it appears that some politicians are not really thinking this through. For their sake, let's take a walk through this once again. Just to make it simple for them I will not even use country names so that it will be easier to be used as a formula in the future.

We have two options:

1. We give money to [insert nation here]

2. We let them default

Consequences of Option 1:

The nation receiving the aid would have to be very careful with its public finances. Thus it will inevitably have to make some budget cuts, including cuts in wages and salaries. However, these cuts will have to be implemented slowly. If they are rapidly employed on the economy they will cause a severe contraction (for a simple thought experiment on fiscal multipliers have a look at this) and thus increase the debt-to-GDP ratio significantly, making the debt unsustainable. This would mean that a debt haircut must be implemented which will mean that either private investors (with banks being the majority) or assisting nations (or both) would lose money. If a haircut is to be avoided then further assistance in the form of extending the debt period and significantly lowering the interest rates is to be given. Yet, this would also mean money lost and since losing money is not good for reputation we can agree that the best way to deal with option 1 would be to give the nation the money it needs but make gradual fiscal corrections in order for its debt to remain sustainable. In addition what would be an even better idea would be to directly bail-out banking institutions and force them to invest these money in their government's bonds, but that might be too much thinking. So let's stick to what is easy: If we give money then we have to be sure that change is being done gradually if we do not want unnecessary losses.

What should be mentioned here is that the ECB could also be given the authority to deal with the issue of financial aid. As it has large quantities of money available it can readily assist any ailing nation without any other nation's assets being in danger.

Consequences of Option 2:

If the nation does not receive any aid then it will survive for as long as it can with what money it has left and then declare bankruptcy. The issue is what happens next. The definition of default is when a nation cannot pay the interest on its debts. Then, sooner or later this will also mean that it will also cease to pay its debt (the technical term for that is insolvency). What happens then: well first a debt restructuring for foreign creditors occurs, which means either debt restructuring or debt cancellation. This is in essence a haircut which ends up in loses for the nation's creditor. Then after this huge mess where the state itself has to decide which creditors to ignore and which to honour, another issue arises: how is the nation going to get new money to finance its needs (including the needs of its banks)?

There are only two options for that: either receive money from external sources or print more of its national money. For a country which is in the Eurozone, however, the latter cannot be done. So other countries have to decide again whether to lend it or not. If they do decide to lend the nation then they would be inconsistent to the decision they have made before (when not choose Option 1 instead of Option 2, and suffer the complications of these decisions if you are going to give money after all?) so they will most likely choose not to lend it money again. To which, the already defaulted nation has to respond with exiting the Eurozone in order to print its own money.

Thus, choosing not to lend money to a nation in danger of default leads to their exit from the Eurozone. 

Is this bad? Well it depends. First of all we cannot have conflicting policies: either we assist all nations in need or we do not assist any. So if we assist one we have to assist all the others as well. Second, we have to figure out whether we want to preserve the Eurozone or not. David Cameron stated that the UK should have a referendum on whether it would prefer to stay in the EU or not. If one country exits the euro then it will only be a matter of time before every country which faces the dilemma of inane austerity and a Eurozone exit will choose the latter over the former.

When we analyze it deep enough it boils down to whether we want to maintain a common monetary union or not. If we do then the only solution is to assist all countries needing a bail-out. If we do not then why do we bother having this discussions at all?

Youth, Politics and Incredibility

European Leaders on Vacation. Can you spot a young one? Picture Credit: Euronews

 Recently, the Cypriot Ministry of Finance had reevaluated its estimation on the country's fiscal deficit. The new estimation assumed that the 2012 fiscal deficit would amount to 4.5% of GDP, instead of the 3.5% it had originally announce. Now, as the negotiations with Troika are supposed to come to an agreement, new evidence show that in the January-September period of 2012, fiscal deficit amounted to about 3.27% of GDP, instead of 3.08% over the same period in 2011. Note: 2011's deficit reached an astonishing 6.3%.

Although I have credited incredibility as the main source of trouble for most of the EU-periphery, it looks like no-one has learned anything about what I have been saying for months. It is a political tradition in the South to promise things you cannot deliver. And people have always known about this, yet the times when they actually chose to do something about it were extremely rare. People, especially politicians, have very short memories. It looks like they cannot even remember what they promised, promoted, supported last week if this goes against their interests. The worst thing about this situation: People always followed and supported them.

It is really annoying to find people nowadays who are still blinded by ideology. And ideology based on what? A politicians ideas and slogan? I am not at all against believing in people. Far from it. But following people, and especially obsolete political parties, blindly is what got us to this situation. 

People (especially the young) do not believe (much less trust) their governments anymore. Why should they? What has changed over the last 10,20 or sometimes even 30 years? Just the faces. The same ideas, the same persistent ideologies, the same arguments we have heard for thousands of times over the course of our lifetime and that we have grown so accustomed to that we have even stopped paying attention to what they say. 

Why? Because all they do is talk. Assigning blame to one another, talking about what should be done, about what they should have not done, talk, talk, talk. As for action: none.

I do not know whether they have heard that actions speak louder than words. Well, they do really. Most of the people in the EU are now looking at their governments with mistrust. They know they supposedly are there to serve them but what do they do: they serve themselves. 

People in governments, especially those older than 50, are still reminiscing of a time where the world is not as it is now. When they could promise and not deliver, when incompetence did not matter, where people believed and admired politicians in spite of their inability to rule. Well, this is over. The world moves forward and it seems like they are getting left behind. 

It is not just them, however. It is their voters as well. People who are of a certain age, who are too old to protest, to do anything else but work. People who did not have the same access to information and world events, like we now do and who are too stubborn to change their mind, not because they have some good arguments for their beliefs, but because having those belief has so defined them that they can no longer change.

From what I hear, you have to be at least 25 years of age to be elected in the parliament, and over 35 to be elected as a Prime Minister/President. Yet, the majority of nation leaders are much older than that:

• Mariano Rajoy - Spain: 57
• Mario Monti - Italy: 69
• Antonis Samaras - Greece: 61 
• Demetris Christofias - Cyprus: 66
• Pedro Passos Coelho - Portugal: 48
• François Hollande - France: 58
• Angela Merkel - Germany: 58 

In comparison, Sweden's Prime Minister was only 42 when he was elected, Denmark's was 45 as was Norway's. Even more impressive, Finland's Prime Minister, Jyrki Katainen, was just 40 years old when he was elected in 2011, having before been voted as the best Finance Minister in Europe by the Financial Times in 2005, when he was just 34.

I would not support that every young person is better than any older person. Yet, as you may see from above, the political scene in the South needs immediate youthification. And this are just the ages of the nations' leaders since I could not get my hands on the Parliament's average age or the average Cabinet age in each country . I am sure that we will find that most of them are near (if not) retired as well.

The problem is not so much age as persistence to a failed system and false (or belonging to a different age) ideologies. Youths usually lack experience yet they more than compensate for that with drive, determination and the belief that they can change the world. As the older generation sits back, protesting in their armchairs that the world would never change, the youth try to make the change. 

The young ones do not possess the pessimism surrounding most of the older generation. They start life with enthusiasm and will to achieve something to make the world a better place. Yet, due to this political mechanism under which politicians are elected only when they reach retirement age, pessimism and inaction are substituted with more pessimism and inaction. 

The situation reminds me of a George Bernard Shaw quote (although a bit modified to suit the situation):

 

The old look at the world and think "Why?" while the young look at it and think "Why not?".