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

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.

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)