Austerity Strikes Back

The tale of the hard-working North vs the lazy South has been cited again and again during the past couple of years, mostly from Northern politicians who saw the on-going crisis as an opportunity to promote their own agendas. At the core of this "argument" was the self-assuring conviction that "we do not need them (the South), they need us". Through an array of measures mostly aimed at austerity in order for state financials to regain their vigor, the North is surprised at the increasing debt-to-GDP ratio in the short-run and is accusing some of the South for not pushing through enough reforms.

As has been explained before, when GDP goes down, debt has to decrease by much more in order for the debt-to-GDP ratio to remain constant. Yet, this will obviously not be the case as the economy contracts much faster than the GDP can be reduced. In addition, when policies are based on austerity, results are usually much harsher for citizens than when they are not. Even though many have failed to see it at the time of implementation, austerity measures in the periphery also affect the North. The simple rationale behind this is that the North was (until now) basically exporting while the South was largely importing goods; the heavy reliance on each other was more than evident as in 2010, no country in the Eurozone had less than a 57% share of intra-EU exports.

Yet, many continued to think that a heavy reliance on exports was a sign of a "vibrant economy" which would lead to higher wages and higher domestic demand. The brief answer is a big fat no. You see, the issue here is that heavy reliance on exports means heavy reliance on the well-being of your neighbours; if your neighbours are poor it means that they buy much less from you than if they were rich. Simply put, reliance on exports means that if they go down, they take you down with them. 

The issue is not new. Some of us have already discussed this in detail, and warned that this situation cannot go on forever. We were (unfortunately for the citizens of the North which are not to blame for the mistakes of their governments) correct. The latest data show something quite startling: Retail trade in December 2013, the month which generally signals the peak in consumer spending, has decreased by 1.6%, compared to November.

In monthly terms, Portugal and Spain were the leaders in the drop, although this did not come as a surprise. The "surprise" is that Germany, Austria, Belgium and Finland have also seen a sharp drop in retail spending. What is even more astonishing is that on a year-to-year basis,  Germany, Belgium and Finland lead the race in the drop. As if this wasn't enough bad news, the bank de-leveraging procedure which has been going on in the periphery appears to have started in the North as well. Germany, Austria and France saw total bank loans to non-financial corporation reduced by 1%, 1.1% and 1.5% respectively, and even if this is not large compared to what happened in the periphery (and Slovenia with the extraordinary 23.8%) it is indicative of the worsening situation in the region.

As a result of de-leveraging and the decrease in spending, inflation in the Eurozone has dropped to 0.7% on an annual basis. Even though just 4 out of 28 countries experience deflation, the rest are barely above 1%; only Austria is close to the ECB mandate of 2%.

North's problem can be reduced to two simple words: no demand. You see, as others also note as well, while banks are not currently in a large need for de-leveraging and are more than willing to lend their excess funds, they cannot do it in their domestic markets as people, in contrast to what most monetary authorities would suggest, are not willing to borrow even at near-zero rates. Less borrowing means less spending, or in economic terms less demand. This results in deflation, which in its turn ends up being a self-perpetuating situation (unless this is stopped as Irving Fisher noted in 1933). As consumption comprises more than 2/3's of GDP, output falls when consumption is reduced.

The situation has begun evolving in Finland where output decreased by 1.1% in November 2013 compared to the previous year, with the same thing occurring in October 2013. The 0.4% contribution to GDP growth led by net exports in the country in 2012, is unlikely to be repeated until demand in the South picks up. With the main forces of the decrease in the 2013 GDP being domestic demand and inventories (both driven by consumption and demand) the path appears to be same as Germany where net exports are expected to take growth down with them in 2014. Even though the country's trade balance has also fallen in December, the effect of local demand, which fell by 1.6% has taken its toll in factory orders in the last month of 2013.

As the gains from trade are not translated into higher domestic demand (either by credit or directly), these have to be tunneled somewhere: housing prices in Germany have soared by at least 25% (in some cases more than 35%) since 2008. The Lehman story has taught us that housing bubbles are not a good thing; actually Deutsche should remember its experience better. With the rest of the Eurozone decreasing imports and domestic demand where does the North expect to ship that 20% of GDP in intra-Eurozone exports and how is it going to sustain the level of GDP currently obtained if domestic demand is also shrinking?

What Have We Learned From The Crisis So Far?

Just like Paul Romer once said "a crisis is a terrible thing to waste". A crisis is good for several reasons: first of all it makes you understand what you have been doing wrong and allows you to fix it; whether you are willing to accept change is nonetheless something completely different. Second, it makes you get rid of your prejudices and third it makes all those theories which we have been bombarded over the years and had no connection to reality fail spectacularly. Just everything in life, we can learn a lot more from a difficult situation than from an easy one. What follows is an extract from what I believe were the most important revelations of the crisis:

1. Prices are sticky

If we exclude a small interval in 2009 in Portugal, Spain and Ireland, inflation has not been low in the countries where most of the attention has been over the past 2-3 years. The 2009 incidents can be attributed to the sub-prime lending crisis and not the European one; when the government spending cuts, reductions in wages and salaries and increases in taxation occurred, the inflation rate did not fall as spectacularly as many had expected. In fact, in cases like Greece, deflation (which should be the natural outcome of decreased money supply in the economy) did not occur until more than 2.5 years later. The trend one might argue, has been negative in Greece. True, but this does not mean anything: if austerity was to work as it was meant to be, what we needed was deflation not disinflation.

2. Wages are Sticky - Unemployment is not

Source: A Cross of Euros

The graph above hardly needs any commenting. Employment has been steadily falling in all 4 countries while wages have been falling just in Greece and increasing in all others. Even the decrease in Greece is not as large as the decrease in employment which fell by 20% whereas wages by a mere 7%.

3. Lower GDP means higher debt ratios

I cannot even remember how many times I have said this over my blogging life (but here's an example). There is nothing more mathematically obvious than this and yet it has been largely ignored by most. If a country's debt is 100 and it's GDP is 80 the the ratio is 125%. If GDP falls to 70 then the ratio goes to 143%. How more obvious can it get? That is the reason why Greek debt has been on the increase despite the 70% PSI (which forced Cyprus to bankruptcy) and various other attempts to decrease it.

4. Even if we get deflation, it increases the real value of debt

The point of austerity was supposedly to decrease spending and simultaneously decrease prices and costs. As we have seen in points one and two, this does not really happen. Yet, what we also forget is that deflation is bad for banks as well. Let's say I borrow 100 from my bank at a time when my salary is 10 per month. Because of the austerity measures and the decrease in wages and prices I now earn 8 per month. No big deal one might comment since all goods prices have decreased; all but the loan installment though. If I had been spending 5 and paying the other 5 to the bank, with a 20% decrease in wages, I will now be spending 4 and paying once more 5 to the bank, for a total of 9, 1 unit of currency more than my salary! This is nothing new really. Irving Fisher knew this in 1933 and many others, such as Mervin King the former governor of the Bank of England, made even more research on the subject. What got economists confused was that deflation is good in a simple recession but not at all good when we have a banking crisis in addition to a recession. When a recession occurs, deflation is a natural outcome which helps the economy recover; when we have a banking crisis, the already deteriorating balance sheets are better off without the added pressure of deflation forcing more lenders to default on their loans.

5. Fiscal Multipliers are greater than one in recessions

Don't take my word for it; just look what other researchers have done. Data from the 1930's are consistent with "(..)the idea that the impact of fiscal stimulus will be greater when banking system are dysfunctional and monetary policy is constrained by the zero bound." In essence, financial crises cause spending multipliers to increase by much more than their original values (multipliers in the sample varied from 0.4 to 1.9) with this making their effect much higher on the real economy.

6. People and consequences are all in the short run

How would you feel if you had no money today and someone tried to console you by saying that you will have some money 3 years from now? Not too much of a consolation I am sure. People do not live waiting for the long-run to materialize. Despite economic modelling, they cannot postpone all of their consumption for the future even if they want to; they will simply die trying. Similarly, looking at the long-term does not assist a country which has a 28% unemployment rate and whose people are fed up with policies. The time-frame in which politics occurs in the short run, whether we like it or not and this is what we have to deal with. 

Would the European South be better off had there not been for such policies? Most likely yes. But we should not forget the benefits of the euro in such circumstances. The only reason southern countries did not face a "textbook" triple crisis (banking crisis, sovereign crisis and currency crash) is that they did not have their own sovereign currency. In this case, having strong countries in addition to weaker ones helped in stabilizing the currency and not let it take a free fall (even though it had been depreciating over time).

Did these countries deserve to find themselves in such situations? Most likely yes, yet, in most of the times the punishment was much worse and much more prolonged than the sins committed. Knowing the above would have made it easier on the citizens of each country. Summing up, we have had the opportunity to learn from this crisis. Yet, as already said, whether we are willing to do so and whether we will not repeat such mistakes when we may be forced to face similar trouble is something that is completely up to us.

We Can Have Growth But No Stability

One of the questions I have been asked lately was quite simple and yet it appeared rather hard to answer: "Why do we need growth every year? Why are economists so obsessed with growth and not with stabilizing output to approximately the same amount every year?" The question is usually asked by people who do not view capitalism as a good economic system but are too unwilling to make a change. As a former professor of mine once stated, the best thing in the world is to be a contrarian in a capitalist country; you get to keep both your money and your ideology.*

To be fair, economists do focus on growth. They do it because what they have studied has promoted them to think like that and they consider it so obvious that they waste no time in thinking on why it matters. In fact, we all somehow assume growth is good, we are just unsure why. The simple explanation is that growth is good since it creates more demand, more goods and most importantly more jobs and more money. This is a purely economical (and simplistic) explanation and one which will undoubtedly come under some criticism on the grounds of what people should really focus on or what they should do in their lives (which is really beyond the scope of this article). Still, as far as economics are concerned, growth is assumed to improve the well-being of every individual. 

Ideally, the best outcome of the combined action of policy and markets is full and stable employment. Yet, unless in the cases of war or re-building what the war has destroyed, we have never experienced full employment, and I doubt whether we could ever do that again (unless in wartime). The problem is that if we try to stabilize the system at a level far lower than full employment we would be having more unemployed than we could ideally have and this would create frictions in the markets. Stability would be meaningless if we have too much unemployment; simple logic states that we could do better by improving something. Nevertheless, even a stability scheme would not be sustainable even at full employment for the following reasons:

1. Changing population

Imagine that we have a country with a population of X million people of which Y are in the labour force (obviously Y<X). The unemployment rate is currently 0. During this time, aggregate demand is stable on average. Now imagine that the population rises every year. Unlike conventional economic models, real people do not start working as soon as they are born; they usually cannot do that until they reach a certain age. Thus, the family has to provide for their expenses, which means that although population has risen over time, aggregate demand is still the same as the family still gets the same income (inflation might cause income or demand to rise but this is not a real rise). Thus, assuming that the person will enter the labour force when he or she turns 18, as soon as that age is reached the person enters unemployment. The reason is practically simple: as long as you have stable demand you have no reason to increase your costs by hiring an extra person.

Now, let's assume that it's not just 1 person who enters unemployment each year but Z and they are in fact more than those who retire if we have a positive rate of population growth. Then, by the time firms realize that they have to employ more people to get more income, the number of unemployed increases. Given that such decisions about demand do not really come up so easily (and in addition, every other firm has to act the same way if they want to get back the amount they spend) and people are occasionally picky about what type of job they would like to do (the essence of search and matching theories) growth would be present and unemployment would fluctuate as population rises. 

2. The variable change in demand

In addition to the previous, demand is never stable even in case of full employment. As population changes, be it either growth or decrease, demand is altered every time. This is especially true of specific product demand. When demand is unstable, firms change output to fit it and thus both unemployment and total output fluctuates. Obviously, if the fluctuations are not large then there is no trouble in the system; unemployment may fluctuate but on average it will be stationary. Yet, if fluctuations are so large that the average cannot be maintained then we can forget about the system's stability.

Then question then becomes: why is demand so variable? Is it just because population changes or is there something else hidden behind it? The answer is both: increasing population leads to higher demand and falling population to less demand. Yet, as already stated, increasing population also comes with an increased unemployment rate until the new demand is settled in the economy. Although this may be considered as transitory unemployment, its duration cannot be specified. Decreasing population on the other hand presents the opposite: as demand is lessened, then firms have to scale down their production and thus unemployment is again increased. In both cases, it can be argued that the markets will work in such a way that unemployment rate will be stable in the long run; yet whether this really holds and how long is this long run is debatable.

3. Nature
Do you remember the last time someone predicted a flood? An earthquake? From what we know, nobody has, and it's quite doubtful if anyone will ever be able to do so. In fact, even if we were able to predict them, although human casualties would be minimal, material damages would still be large. We cannot move plants and other infrastructure as fast as we can mobilize people. Hurricane Katrina caused $81 billion of damages in 2005, with Hurricane Sandy causing an additional $68 billion in 2012. If we were in a system in which stability and predictability were the main characteristics then any deviation would wreck panic in the hearts of people. Which brings us to the most important of the factors:

4. Human Psychology
Recent experience indicates that people can either get excited too fast and too much about something (e.g. asset bubbles) or become afraid of something just as fast (market crashes). As the current system (or any system for that matter) functions with people acting within it, it is as stable as its constituent parts. Given that human behaviour ranges from one end of the spectrum to the other, how can we expect a system which is comprised of humans to be stable? More so, people, when acting in large groups fall victims of group psychology of either exuberance or hysteria much faster than when acting alone; in larger systems, the mood swings would be even greater, with larger consequences on them.

To illustrate this, think of person who is not really affected by austerity measures, or who is affected just a little bit. This person may believe that if his income is cut by 10% then he should cut his expenses by 15-20% so that he could save for a rainy day. Now imagine what happens in the economy when 10% of the population decides to do just that (for a tale on what happens this provides an example): demand falls, unemployment rises and a vicious cycle is initiated. This was one of the reasons austerity has not been successful; people fear about the future and tend to react strongly to an event.

Although some could argue that booms may increase demand by just as much crashes reduce it, the truth is that crashes do not really push it down that much. Although human beings are prone to large mood changes (just think of yourself: do you feel the same two days in a row? Doubt it. Most of the times we do not even feel the same in two consecutive hours) we are also prone to optimism and hope. It is against human nature to keep down and do nothing for a substantial period of time and that is how we got to develop from living in caves to exploring space. As Cullen Roche puts it, a measured optimist is the best world view.

Returning to the original question on growth and stability: we cannot stop growth and neither should we try to do so. It's what made us progress through the ages, what brought us the tools we are using now. Stability cannot occur in any economic system as long as it is run by people. Even in traditional economic modelling, population growth equals economic growth. If the system has what it takes to succeed then it will, no matter how many oppose it; if it does not the it will collapse sooner or later. Stability cannot be enforced on a system comprised by people exactly because people are unstable. While many economic models in the literature usually provide for a steady state in their analyses  they never take into account any shocks which could come from within the system, such as agent irrational behaviour or declining population.

The fact is, we need growth for stability as well as for incentives. If we are to grow with a stable rate of, say, 2% per year, then a shock which would contract GDP by 7-8% (note: this shock does not even count as a depression) would mean that we would face high unemployment and deteriorating social standards. Since we cannot eliminate the possibility of a large shock occurring all we can do to safeguard both ourselves and the economy from its impact is have as much growth as we possibly can, before and after the shock. The more growth we have before, the less destructive the shock will be and the less difficult it will be to overcome it and we focus on growth after its occurrence. We do not just aim for stability because stability provides no incentives to create, innovate and develop. For that, we need growth as we also want to be sure that when bad times come (and they will, for sure) we will be less affected by them.

To sum up, stability is something we cannot hope for in a human-based system, at least not in the way we commonly seek it. What we can do to make the most of it, is not criticize growth but try to stabilize that; this will act both as the prevalent force for development as well as a cushion for bad times.

*My personal view on the subject (in case anyone cared) is that although capitalism is the best system we have had until now (or better yet, the only one which survived) it still has plenty of room for improvement. We have gone a long way from the uncontrolled system in the early 1900's where the rich could practically manipulate everything they wanted. Nevertheless, the current system is far from perfect; we should aim for a better future by continuing to improve on our existing structure and not by demolishing it.

Reinhart, Rogoff and Persistence on Austerity

Big news online yesterday were that researchers were finally able to replicate Reinhart and Rogoff''s (henceforth R&R) results on debt-to-GDP ratios and growth. As it appears, the authors did some serious mistakes including leaving several observations out of their sample (for no apparent reason) and some significant coding errors in Excel. Although many (including the authors) could argue that mistakes happen, it is not that often that these mistakes dictate fiscal policy in the world. The Guardian, for example, questions how many people have become unemployed due to this mistakes, while Azizonomics presents several occasions where such researches have been quoted by politicians, in defense of their actions.

The grander question would of course be why did politicians and economists place so much attention to one specific paper in the first place, especially when results were never so extreme. Let's us assume for a second that their results hold (presented below) and study them carefully.

Source: The Wall Street Journal

What notably hits most readers is that the average growth rate of real GDP when the debt-to-GDP ratio exceeds 90% becomes negative. What most did not consider was their methodology: R&R give equal weight to all countries after they had averaged their growth rates for any bracket. Thus, using this methodology means that real GDP growth has almost a 50-50 probability of being positive or negative. Then, this means that although there is no real GDP growth on average, it is very likely that we will have some nominal growth (which will in fact assist in repaying debt, if we are talking about the Eurozone).

Edward Hugh makes a another significant point: it all depends on the country and how developed it is. This would mean that it is easier for a developing country to allow her debt burden to increase, although it would be quite rough for a developed one (whether countries are allowed to print money or control monetary policy is of course another issue).

This prompted yours truly to make a little research of his own. In the following charts the reader may observe the average real GDP growth of a small sample of developed countries for 10-point debt-to-GDP brackets up to 200% based on annual observations (where brackets are absent no data were found in those-data range is dependent on the country).

United States

United Kingdom

Spain (quarterly data)

Italy

Germany

France

As not to bore the reader with too many charts, the following presents the average of the averages, based on the R&R methodology. 

The data indicate that not only does a debt-to-GDP ratio of over 90% not decrease growth, but even as it increases over 100%, real GDP growth appears to persist, even on extreme levels. Although the dataset employed above uses data from 1949-2011, WWII could have something to do with the initial periods where debt was extremely high and growth persisted. Yet, this argument seizes to have any rational base for debt burdens of up to 120% (or higher depending on the country) or periods much later than WWII (as the specific case of Belgium and others indicates).

In addition, Arindrajit Dube argues that the above mentioned paper exhibits problems with causality. It not that debt causes growth, it is growth (or no growth to be fair) which causes the debt burden to increase (after a debt-to-GDP ratio of 30%). His "exercises" appear to be sound both economically as well as mathematically, yet although mathematics and statistics indicate a specific pattern, the truth is not so simple.

As with most things in life, it lies somewhere in between. In distinct cases (in which statistical aggregation is not helpful) both could be significant in predicting their future paths. In Dube's analysis, it appears that a decrease in the growth rate will cause an increase to the debt-to-GDP ratio. The question could be what caused this shock? If this is exogenous (e.g. a recession caused by bank failures) then Dube's analysis could be true. Yet, if a state wishes for some inane reason to increase its debt burden (say to increase social benefits for voters to like their government) it may have any effects on GDP depending on the way this is measured:

An increase in benefits has no direct impact on output as they do not constitute any part of it, yet it affects both consumption and investment. Thus, even as the debt burden will be increased, the growth rate of GDP will also be increased. Nevertheless, if a government insists on such policies, it may shift causality is on the side of R&R once more: debt can cause growth (or contraction). The mechanics behind this are simple. The government cannot sustain the increase in debt forever thus it will have to use some kind of consolidation for it to be sustainable, and through the mechanics better described here, it will negatively affect growth rates.

The simple conclusion is that people should be extremely cautious of non-replicated results. More importantly, when these results affect policy people should be even more cautious on how they use them, as they affect the lives of millions. As Richard Feynman, after having been led astray on the neutron-proton coupling constant by reports of "beta-decay experts" stated, "since then I never pay attention to anything by "experts". I calculate everything myself."

P.S. For those interested in the spreadsheets just send me an email

GDP is falling down...

Eurostat published its latest statistics on Q4 2012 in the Eurozone. Nothing that we did not expect actually: Portugal -1.8%, Cyprus -1.0%, Italy -0.9%, Spain -0.7%. No statistics were published regarding the state of the Greek economy.

These results indicate that during the last three quarters the Eurozone had a contraction in each and every one of them. (I would remind you that the definition of a recession is two consecutive quarters with negative GDP growth. And we are experiencing three...)

What many did not expect though was the following:
Germany: -0.6%
Finland: -0.5%
France: -0.3%
UK: -0.3%

We all thought that the German economy was impervious to such things as recessions right? Well, let me remind you that this was a not-so-unexpected phenomenon. I have explained that the recession would have a very important effect on the German exports (which are about 60-65% to countries within the EU, and specifically within the Eurozone) in this article published in mid-November. Wolfgang Schäuble was said to secretly prepare for this downfall in the last days of 2012 by "cutbacks to prepare for a weakening economy and possible fallout from the euro crisis" (for details read this).

It looks like this time is now here for Germany. I have no other explanation for persistence in plans which do not work than obstinance and illusory beliefs and views of the world. If Schäuble is allowed to do the same with Germany as he proposed (and unfortunately pulled through) with Greece, Spain, Portugal and Cyprus the Germans are in for a much worse fate than they expected. 

And this will only be the beginning...

Ireland and False Promises

Anyone who has been watching the news over the last 4 years will definitely remember the case of Ireland. A very strong economy, booming at the time, faced significant constraints in 2008 due to the large exposure of banking institutions to sub-prime loans abroad, in addition to a housing bubble burst in the country. Thus, in order for the Irish to be able to save their banks, a joint IMF and EU loan of about €85 billion was granted to the nation. The terms were the usual: austerity and even more austerity.

The result: as of 2012, only 1% growth in GNP instead of the promised 4% in a 2009 forecast. Government debt is 120% instead of the forecasted 79%, investment fell about 4% instead of rising by 9% and the only reason unemployment has fallen is because 350,000 people have fled the country. (I am really beginning to wonder what the people behind the forecast were thinking when they calculated the numbers).

Protests against austerity measures. Source: William Murphy/Flickr under CC 2.0

The case of Ireland resembles the cases of both Spain and Cyprus: a housing bubble bursting and bank bailouts which forced the nation to assume extreme levels of debt. The result will also be the same: austerity measures, destroying any potential for growth over the next years, people facing extreme difficulties in their everyday lives as even though wages and pensions are falling prices do not follow the same route, and the "upper" class not having to worry about any of these.

Bank officials are still earning six-digit incomes every year, and politicians have seldom seen their wages diminishing over this period. According to the Irish Times, politicians most people have never heard of, are entitled of a €2.2 million pension. Had this occurred at any other period of time, we would have just thought it was because the economy is booming; at the present time it appears as a ridicule to the efforts of the innocent people bearing the cost of the banks' errors.

We are moving towards a pure capitalist society where money comes first and everything else second. At least that is how our leaders behave. We have to pay for the mistakes others have done. I heard a saying once that an insane person throwing a rock in a well will need 40 sane people to get it out. This is what is essentially happening in Europe now. We are paying for wrong decisions, poor judgement and false ideologies. Politicians cannot see the way we do because their incentives are different. In a discussion with Constantin Gurdgiev he stated that politicians face the same incentives as bankers; he was right. It does not mean anything to them whether 99% of the people are paying for the sins of the other 1%. Simply because they will get their money and benefits anyway. And if they manage to do something good for the country as well then even better; if they do not who cares?

The distinction between politicians and those who elect them is growing larger and larger. This inevitably leads to the former believing that they are masters of the game and the latter hoping that the game will someday change. The only way for this to change is to have the politicians more liable for their actions than they are now. I have already proposed a scheme for this, with the goal of aligning the politicians' and policymakers' incentives to those of the people who elect them. The issue is who would be brave enough to apply it?

We all know that having to suffer for the banks' mishaps is unfair. Yet, the banks should not have allowed us to spend so much in the first place. It all goes back to a vicious cycle of banking policies, supervision and the notion that the state will always be there as the lender of last resort. New banking supervision rules should be made so that no systemic collapse can occur when a banking institution fails. Given the size of the banks in the modern day a simple solution would be to split them into separate institutions. Yet, what politician or policymaker would be so determined to do so given that their incentives tell them a different story?

Greece will not make it?

German economists seem to believe that Greece's burden of public debt will not be sustainable and fears of a Grexit are bound to resurface. To these bad news, they also add the sad forecast of a mere 0.8% growth in Germany during 2012 instead of the original 2%. On the bright side, unemployment in the EU27 and EA17 has not risen during August.

Source: Eurostat

Although the whole of Europe indicates a stabilizing tendency in unemployment, individual countries are not doing so well. In Greece unemployment has risen by 7% over one year (June 2011 and June 2012), in Cyprus 3.7% (and they have not even officially signed the bail-out treaty), in Portugal 3.2% and in Spain 3.2% (to an astonishing 25.1%!). Greece and Spain were also declared champions of the youth unemployment with the percentage reaching 55.4% and 52.9% respectively.

Well, I guess when a quarter of your population is not employed and more than a half of your youths are unemployed things are going to get a lot worse. For this, we can blame the austerity measures imposed by Mrs Merkel. I do not know what they had in mind when she and the group of accountants and economists which formed the Troika decided that slashing expenses would be good to an economy. I guess not much. When GDP goes down, debt as a percentage of GDP goes up, even though it may not increase in absolute terms. Now the German economists are afraid for a situation which they have created themselves: Greece is going down and it is taking everyone with it. Even if Greece collapses with not many consequences (which I seriously doubt), Spain will not be so kind.

Over the second quarter EU27 and EU17 GDP have also been reduced by 0.1% and 0.2% respectively. This means that if the next statistics indicate that GDP growth is again negative, Europe will have officially entered recession. Thus, a problem which was (erroneously) considered to be an issue of the EU-periphery has taken an EU-wide dimension. This also makes me eager to see whether EU public debt has increased over the second and third quarters, an analysis which has yet to be published. 

Source: Wikimedia Commons

What the German economists are now promoting is "orderly bankruptcy proceedings for member-states". Thanks guys, I guess you are very fond of European integration. This solution is of the kind "let them bankrupt I do not care". No form of solidarity in their statements whatsoever. I do not know if German economists ever think about the consequences (they obviously have not thought about them when austerity measures were pushed through in Greece; and are going to be implemented in Cyprus as well) however, if Greece goes bankrupt the effects will be harsh on Germany. Especially since the next one to go will be Spain. 

Integration and not harsh measures are needed for us to steer clear of the crisis. Yet, what is being promoted are measures which do not assist in solidarity amongst nations. I guess this is the only time when politicians should be making more decisions than economists. At least they have the to worry about being re-elected. To whom are economists accountable for bad advice and forecasts? Nobody.

Incentive Compatibility Problem

Direct quote from Paul Krugman article in the New York Times more than 2 years ago:

"When I was young and naive, I believed that important people took positions based on careful consideration of the options. Now I know better. Much of what Serious People believe rests on prejudices, not analysis. And these prejudices are subject to fads and fashions. ... For the last few months, I and others have watched, with amazement and horror, the emergence of a consensus in policy circles in favor of immediate fiscal austerity. That is, somehow it has become conventional wisdom that now is the time to slash spending, despite the fact that the world’s major economies remain deeply depressed. This conventional  wisdom isn’t based on either evidence or careful analysis. Instead, it rests on what we might charitably call sheer speculation, and less charitably call figments of the policy elite’s imagination — specifically, on belief in what I’ve come to think of as the invisible bond vigilante and the confidence fairy."

Hmm, this does sound a lot like what the Troika has been trying to pull in Europe over the last couple of years doesn't it? To be honest, was young and naive until a few time ago. That was when I believed that people in power and in a position where they could influence policy knew what they did. Unfortunately this was not the case: Most of the politicians, policymakers, economists, specialists and experts have absolutely no idea what they are doing. Take a look at what is happening in Europe nowadays: the Troika proposes, with their experts, specialists and economists not thinking about the consequences such a thing would have on each nation's economy, and politicians, policymakers, economists and specialists in the nation accept it with no arguments. Even if they propose any arguments, they are usually either of the "won't do any reforms" or the "instead of these measures how about these harder ones?" kind.

The scenario boils down to three things: 

1. Economists, specialists, politicians, policymakers and etc do not think at all about the consequences

2. They do not care about the consequences because although they may affect them, it is unlikely that they will end up starving or without a job.

3. Both

Which of the three seems more possible?

Well you guessed it. Either the latter one or a combination of the two. It is always easier for someone to make a tough decision about slashing salaries and bringing the economy to a rapid recession when he/she knows that her/his salary will keep getting in his bank account at the end of each month. Obviously, most members of the parliament, economists, policymakers and others earn much more than the average wage. They reasoning is that they should provide an important job to the society and thus they should be rewarded. However, there seems to be an incentive compatibility problem.

Obviously, when a general wage cut occurs every person receiving a governmental salary should be affected. However who is more affected with a 10 or 15% cut? The one who makes 1000 euros a month or the one who earns 5000? I guess having to live with 4500 or 4250 euros beat trying to live with 900 or 850! Obviously, the one receiving the larger salary is doing something more than the one earning the lowest.  Still, a 10% decrease in wages is very hard for people who are not in the high income scale. The wages of public servants (those in the higher tax brackets that is) should not be awarded as a lump sum. They should be awarded based on their performance, as well as the performance of the general nation (in their area of expertise obviously). This would allow for them to think twice before they accept or condemn policies which are prone to throw GDP down the drain.

What should be done, is that nothing more than a 5% decrease every two years should occur. If the South wants a more effective public sector it is better off limiting entries than reducing salaries that much. This would allow an economy to exit the recession and not make the debt unsustainable, provided of course that they try to limit budget deficits to a minimum.

Terrible Calculations and Crisis History

In Thursday's article I gave some of the views Nobel laureate Joseph Stiglitz had on Europe. Notably, that austerity measures are causing the crisis and not the other way around. Who could disagree with that? A simple logical deduction will lead us to that. Let's see now the order things happened in the EU:

1. Sub-prime lending crisis in 2008, led by US banking and investment firms, and marked by the Lehman Brothers collapse in North America and the Northern Rock bankruptcy in the UK. (other financial institutions also failed in the EU, yet no-one was large in size). The sub-prime lending crisis had nothing to do with the now sovereign debt crisis. (it may have been the thing that pushed Greece over the cliff but this was not the cause that brought the Greeks at the brink of disaster. The Greek economy was unstable for years)

2. Greek scandal concerning the size of debt, deficit and GDP of the nation. (debt and deficit had been deflated while GDP inflated. Curiously, nobody was ever sentenced for this fraud) Greece opts for a bail-out from the EU and the IMF and the first austerity measures were put forward in the country.

3. Seeing that the debt-to-GDP ratio of Greece climbed even higher, regardless of the austerity measures (again, think about this: €100 debt with €100 GDP makes a 100% debt-to-GDP ratio. €100 debt with €80 GDP makes a 125% debt-to-GDP ratio. Unfortunately this was too much mathematics for the Troika and the expert economists to understand) the EU policymakers and Troika decided to give the Greek debt a haircut. The haircut consisted of 30% of the face value at first (i.e. for every euro the borrowers held they were going to get 70 cents) and then another 70% of the remaining later (i.e. instead of the 70 cents they were holding they were going to get just 21 cents).

4. This led to a significant shrinking of assets for the banks exposed to Greek debt (many of the Cypriot, Spanish and Italian banks as well as many German ones which curiously managed to sell most of their bonds), and with the new regulation raising capital reserves from 8% to 9%, banks were is serious need for money. 

5. Since many banks did not have sufficient capital reserves to allow them to function, they opted for a government bail-out. As banks are not really like any other firm (look here for more details) the nations had little option but to try and save them. However, the banks' needs being large, and the nations' debt being high made it more difficult for them to refinance. Thus, nations themselves needed to opt for a bail-out since their banks were dragging them along to the bottom.

Had the Greek haircut not occurred in such extremity (for an alternative read here), banking needs would have been lower and nations would not be in such a difficult state. Thus, the rough austerity measures could have been milder and with a longer time-span than now. This would have allowed nations to increase their GDP slowly, while simultaneously reducing their deficit and debt, which would mean that none of the current events would be happening. Although I am an advocate of the austerity measures in order to rationalize the budget, having too much too rapidly will only cause trouble in an already troubled economy.

P.S. The new idea now is that politicians and policymakers will offer more austerity with different measures than the ones the Troikans are proposing. Case study: Cyprus. The counter-measures proposed by the Cypriot government include a 9-11% cut in public servants wages (nothing of the kind was mentioned in Troika documents) in order for the Troikans to agree for the non-abolishment of the 13th salary (a bonus salary paid at the end of each year). Again simple maths: €1000 monthly salary is €12000 a year. A 9% cut would mean that €1080 euros are cut from the worker's salary each year. (provided that the 13th salary does not suffer the 9% cut as well). So in essence, the worker is giving up €1080 to receive €1000. (€1170 if the 13th salary suffers cuts as well). You may imagine what happens at the 11% level. 

Clear case of stupidity and obsession with an idea: the 13th salary should not be abolished, thus we are offering extra cuts, so that the 13th salary will remain but the overall hit would be larger than the one proposed by Troika. Hmm, one wonders who it is the officials work for. Troika would be much better in running Cyprus than its politicians.

Greek debt revisited

Over the last days, new publication concerning the state of Greek debt have been published by the rating agencies. Specifically, both Moody's and Fitch expect this year's recession to reach 7%, next year's about 3% and 2014's will be practically zero. Public debt is expected to reach 180% in 2014 as well, with unemployment rates soaring to 22.8% by the end of the year. Alas, it seems like troubles will never end for this country!

In addition, a German magazine, stating anonymous source within the Eurozone, has stated that another Greek haircut is being considered. (for details, click here). According to the same source, at the same time, the IMF proposes a plan which promotes debt restructuring for the public lenders, which hold about 2/3 of the now €330 billion Greek debt. So, by simple math, if debt is 164.9% of GDP now, Greek GDP has to be around €200 billion. This would mean that if the new plan proposes restructuring the debt until it reaches about 120% of current GDP, no less than €90 billion euros will disappear into thin air!

Need I ask which of the now ailing governments would be willing to take such losses? Obviously none. Very few nations in the EU have the resources to handle this. Even more, extending the Greek debt by 2 years will have an additional €20 billion cost for Greece's lenders. 

Some of the regular readers (hmm I may be flattering myself!) of this blog may recall, I have already proposed that the Greek austerity and reforms program should be extended by 1 year and not by 2. Why is that? Simply because a two-year horizon would allow the Greeks to be more lax, than a 1-year one. While benefits of an extension are obvious, the truth is that over-extending the austerity program is bound to some incentive problems. Although I believe that Samaras is the best politician the Greeks have had for many years, his popularity has started to fall, given the perpetuation of the Troika talks concerning the €11.9 billion austerity measures, as well as the measures themselves.

Thus, what other alternative is there? What the IMF proposes, although a nice idea, would be difficult to implement especially given the current circumstances. What needs to be done is shift focus from austerity to growth. The reason why the Greek debt is growing as a percentage of GDP is because the latter is diminishing at a fast pace. Debt can be haircutted a million times and still not be sustainable if GDP keeps becoming lesser and lesser. The solution lies not in reducing the debt, but in increasing the GDP.

The European Investment Bank has recently agreed to facilitate Greece with a package of €750 million over the next few months, aiming at energy, transport, education and SME's. This money should be distributed to Greece as soon as possible and put to good use. This kind of stimulus package should be able to promote some growth in the country's economy during this and the following year. In addition, measures promoting growth should exist on the 2013 fiscal budget; measures which would actually promote growth not merely social benefits and other transfers. 

Once focus is shifted from austerity to growth and GDP moves from decreasing to increasing, more austerity meausres should be promoted to keep costs down. In the opposite case, 1 or even 2 extra haircuts may be needed in the not-so-distant future.

What is GDP?

After several discussions and arguments recently, I discovered that although most people are bombarded with statements of the "GDP has retracted by 1%" or "the banks' assets are greater than the nation's GDP" kind, many do not have a clear image of what GDP is, or what it counts. To begin with, GDP is short for Gross Domestic Product, was developed by economist Simon Kouznets in a UN report in 1934, and has been the main measure of a country's economy since the Bretton Woods conference in 1944.

GDP is calculated as follows (based on the expenditure method, meaning that every good or service has a price and is therefore measurable):

GDP = Private Consumption (C) + Gross Investment (I) + Government Spending (G) + (Exports - Imports)

Now let's see what the components of GDP are (most of the definitions used here are from Wikipedia):

1. Private Consumption falls under one of the following categories: durable goods, non-durable goods, and services. Examples include food, rent, jewelry, gasoline, and medical expenses but do not include the purchase of new housing.

2. Investment includes, for instance, business investment in equipment, but does not include exchanges of existing assets. Examples include construction of a new mine, purchase of software, or purchase of machinery and equipment for a factory. Spending by households (not government) on new houses is also included in Investment. In lieu of the common use of investment, i.e. purchase of financial products, these are not considered as investment but as savings.

3. 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. It does not include any transfer payments, such as social security or unemployment benefits.

4. Exports are gross exports within the year measured and Imports are the gross imports within the same year.

What some people believe is that GDP is some sort of state income, which is distributed to people in some way. This is far from true as GDP is merely a rough measure of the economy's ability to produce and not any sort of income, although it is measured on an annual basis. As economist note, the main driving force of the above equation is Private Consumption (C). If for example, due to a prolonged crisis, people are afraid to go out and shop, since they believe that they will need the money later on, or if their income has fallen, C will go down and drag GDP will it. Similarly, in a crisis, Investment usually falls, as less people are likely to buy new houses and less firms invest in new equipment. Imports usually fall as well since people, faced with less purchasing power than before due to their unwillingness to spend, or lack of income, are less eager to purchase foreign goods.

The only part of the equation which is really a matter of government is G (Government Spending). That is the reason why in most nations where budget cuts are implemented, in the form of wage reductions, GDP falls. However, as one may observe, transfers from the government to the people (e.g. social benefits, pensions) are not included in the definition for government spending. Nevertheless, this does not mean that it these will not affect GDP, since a reduction in pensions, such as the one currently occurring in Greece, affects GDP indirectly, as pensioners with fewer money will spend less and C will drop.

As a matter of fact, GDP is neither a measure of welfare as it can only measure what is measurable and lacks an ability to quantify quality. Although sometimes it is used as such, even Kuznets himself has separated the ability of GDP to measure an economy's production and its use as a measure of welfare:

"Distinctions must be kept in mind between quantity and quality of growth, between costs and returns, and between the short and long run. Goals for more growth should specify more growth of what and for what." (Kuznets, 1962)

Greece's Progress

Many are always accusing the Greeks for the situation their country currently faces and their lack of action for the persistence of financial problems. However, a recent IMF study begs to differ:

As you many see from the above table (it is also in page 93 of the IMF study) Greece's primary deficit is expected to be 1% of GDP this year (i.e. 2012), move to an 1.8% surplus in 2013 and having surpluses until 2030. This would mean that over the next years, Greece will essentially be paying its existing debts, without having any deficits other than the repayments! Gross refinancing needs will drop from 34 billion to 14 billion over the next year meaning that it will essentially take much less money to refinance debt. 

However, the need for debt restructuring may occur, as it is expected to reach 167% of GDP this year. At least this time, I hope that the troika decides better than hair-cutting the debt again! (for an alternative solution to the Greek haircut read this). The Greeks have suffered through severe austerity measures too rapidly, which forced the country's GDP to contract vastly and that is why the debt burden as a percentage of GDP has increased so rapidly (allow me to explain. If debt is 100 and GDP is 100 then debt is 100% of GDP. If the GDP contracts - as is the case with Greece - to 80 then the debt would be 125% of GDP)

The 2.5 billion they are currently requesting is nothing compared to another haircut (or worse a default) which would make financial markets (and especially banking institutions) even more chaotic. European leaders seem like impatient children, who want to see debt reduction and positive growth from one moment to the next instead of thinking that such a procedure requires much more time.