Understanding ECB Comments: How Central Bankers (Should) Think

Central Banking should come with a warning: Anything you do, will be the cause of major criticism. When I usually see reactions on comments by ECB officials, it usually of the "they know nothing/understand nothing kind". The job is not easier for the US Federal Reserve either; it has a long been a while since I've heard no reactions to policy changes. When the Fed initiated QE, Cassandras said it would drive inflation rates sky high; it didn't. When tapering started, Cassandras (different ones I hope!) complained that it would have a severe effect on the economy; still nothing. Yet, while the usual aphorisms on Central Bank statements and actions have been going around for a while, what is usually the problem is that do not see things from their point of view: that of a person/institution who have a great effect on the economy.

Whether we like to admit it or not, Central Banks do have a lot on their minds. When times are good they have to be careful to prevent bubbles from forming and when times are bad they have to act in order to make them better and be careful not to make them worse. A clear example of the Central Banker's power and the strong grip he or she has on the economy, are reactions to verbal statements. When Alan Greenspan spoke of irrational exuberance for the first time in 1996, markets tumbled; when Mario Draghi gave the "anything it takes to support the euro" speech in August 2012, this is how the Forex Market reacted:

It is really not a question whether the Central Bank has an effect on the economy, it's about how big it is and the answer is that it's huge. Even if policies do not drastically change market conditions in the short-run  (they usually change them in the medium-run), comments and speeches do have a stronger effect since they affect investor confidence. This is why Central Bankers are very careful of what they say and this is why they should (and do) never speak of bad news.

As we know, the ECB, through its Board, has denied that deflation is a problem. Jens Weidmann has stated that the drop in inflation is nothing but temporal. Whether he actually believes that or not, is something we will never find out. Now, dear reader, imagine what would happen if the ECB or it's board began to talk of deflation being a problem in the Eurozone. As a first reaction, markets would drop and the euro would rise making exports harder. Investment would gradually be reduced and the whole economy would enter a vicious cycle of decreased consumption, drops in wages and less investment. More so, the whole procedure could actually be initiated just by the Central Banker admitting that deflation exists, as most people "know" that deflation is a problem.

Then, with regards to ECB reactions and comments, what would the reader, an ordinary citizen of the Eurozone prefer: a Central Banker denying the existence of deflation thus allowing the markets to continue without paying attention to what he says, or a Central Banker admitting or warning about the dangers of the current deflation and forcing a deflationary cycle on the economy? If you ask me, the former is much better than the latter, if only for employment reasons.

Who knows: maybe the ECB does know something more than we do when it comes to deflation. If not, then measures to counter deflation can be expected at the next meeting. Still, too much truth can actually harm the economy at times. In fact, I would even go as far as claiming that a Central Banker should act like Titanic's orchestra: even when the ship is shipping (s)he should calm everyone down and tell them that it's all going to be all right.

Real Life Effects of Deflation

Deflation is defined as the decrease in the level of prices:

As economic theory dictates, the causes are a fall in the money supply, in addition to (in the short-run) a fall in wages and salaries.

Compensation of Employees (aggregate) Source: ECB

Just like any other economic happening, there are those who claim that any type of deflation is disastrous and should be avoided at all cost while others believe that it is wonderful (since it lowers prices) and we should embrace it. As usual though, they are both wrong. The answer, simply put, is that it depends on the severity, duration and the overall state of the economy at the time when deflation is manifested. What follows are three points on the effects of the current rates of deflation on the real economy of the Eurozone.

1. As long as deflation is not severe and not persistent then the effects on consumption are small.
There is no person who would be willing to forgo a month's consumption of food just because it would get cheaper next month. Parents do not tell their children "you will not attend university now because it will be 2% cheaper next year". We have some basic needs which we will continue to satisfy as long as the deflation rate is not so severe so that an apple will be worth 50% less tomorrow than it does today. Prices fluctuate every day and a deviation of 1-2% per annum for a short period of time (e.g. 1-2 years until an economy gets back on track) does not really change our incentives for non-durable consumption.

Nevertheless, there is an effect on what we call durable goods (e.g. houses, automobiles, etc) but these are just a fraction of what we purchase (approximately 1/3 of our purchases are of durable goods). Even though 1/3 may appear to be large, remember that the reduction in price is more severe in some sectors than in others; automobile prices have not dropped by much (if any) while real estate prices have sunk compared to 2006. In addition, when a person has lower income than before, the first thing he stops purchasing is durable goods, not everything else. Thus, the drop in durable goods consumption can be seen as a natural reaction to the overall drop in confidence, investment and subsequently wages. Still, if deflation persists and becomes even higher in 2014-2015, a large drop in the consumption of durable goods might signify a reduction in investment, resulting in more wage losses and thus creating a vicious cycle.

2. Deflation has a stronger effect when households and non-financial corporations are heavily indebted.
The reason is simple: given that aggregate wages have dropped, prices also drop, triggering another round of wage drop and so on. Although this is an issue for durable consumption as discussed above, it is also a problem when it comes to debt as it takes more money in real terms to repay the amount owed. Thus, if in a country most of its citizens are over-indebted (see all periphery countries) deflation is bad because it makes repaying that debt even harder. Not only that, but it also creates a "death spiral": the more people try to repay their loans, the less they consume and thus prices and wages fall even further making the real amount they owe even higher. This is exactly what happened with austerity policies: less spending means less consumption thus less income for the state, leading to higher deficits and debt and forcing new austerity measures once again.

3. Deflation equals lower prices but it does not mean it's good for us.
This is one of the most common fallacies ever: if prices fall then it is great. It is most of the times but it always depends on the reason prices fall. If they do because raw material are cheaper or because of a productivity rise then great. But if they happen because people have less money than before then your purchasing power is most likely hurt in the short run (prices usually do not respond fast to shifts in consumption, even if those are permanent). In addition, if we shift from inflation expectations to deflation expectations then what we will see is less and less consumption, leading to lower wages and then lower production. This is the time when deflation gets serious as, with higher rates, we can actually see the economy reach a halt.

What should be noted is that the severity of deflation has a direct effect on the magnitude of the above. If deflation is at a very moderate rate of 1% per annum for a year or so, then most likely its effects on consumption and loan repayment will be very small; more or less of the same extent of what happens in the economy during every other recession. Only if deflation persists, becomes larger and is embedded in expectations will we need to seriously start about the future of the economy.

In order not to come to the worrying part though, policy (here's looking at you ECB) should be re-addressed so that confidence in the region is re-instated. Otherwise, we will soon see if markets can adjust fast enough not to cause any major casualties.

CEO compensation and Worker Job Security

That CEO's are earning big money is nothing we didn't know about. Yet, the size of their paychecks is at times enough to make those who are not earning 6-figure salaries furious. In the list of the top 15 earners for 2013, the lowest CEO compensation is at $36 million. It is true that their earnings fluctuate with the earnings and general performance of their firms. In fact, they have done a wonderful job tracking the S&P 500 especially since the 1990's:

As the reader may observe, CEO compensation was not following stock market development right from the start. In fact, for the first 10-15 years since the 1960's, the upward trend in compensation was not an outcome of a strong stock market; the S&P was on a long downwards trend during that time. Yet, in modern times, CEO's more than made up for their losses. In 1978, the CEO-pay-to-worker ratio was 26.5-to-1; in 1995 it went to 136.8-to-1 and in 2012 it was 202.3 times the typical worker's salary as the EPI reports (the peak of this ratio was in 2000 when it reached 411.3-to-1).

The difference is astonishing. Most of us would (rightly) think that we have overemphasized the importance of a CEO: she/he may be worth a lot and have much more worries than the average worker, but try working a day without him and another without 200 typical employees and see which is more important for the firm. Still, what is more interesting is not that, since the 2000 peak, the ratio of CEO pay to average worker has decreased, but the timing and reason behind that. For example, look at the following table from the same publication:

Note the two highlighted numbers: CEO compensation has actually decreased in 2011-2012, by approximately 7.1% while the decrease for workers has been a much lower 0.6%; the ratio of earnings during that period narrowed by about 6%. The problem here is worker wages are also falling during a crisis. Thus, even though CEO compensation is falling, the fall is reduced from the worker wage reduction (this is the same as debt-to-GDP ratio analysis where if GDP falls even when debt falls the ratio may remain unchanged). This isn't just the case for the US mind you; the same gap (albeit not so exacerbated) also exists in Spain (where higher salaries continued to grow through the crisis, with 2009 being the only exception) and most likely every other EU nation. As the article on Spain notes, there are two possible explanations: either CEO salaries were the first to go down so the first to go up, or firms are focusing on people who, in their opinion are bringing the greatest value in the organization.

Defendants of CEO pay might argue that since their compensation varies widely through time, indicating more risk, it makes sense that these people get more money in return. Yet, when there is mostly an upwards trend, a few points indicating a decrease hardly matter. In fact, Kaplan notes that the historical average of CEO compensation is in the mid 1990's: the figure for 1995 is 6,303 and the ratio at 141.1-to-1. Thus, even though CEO compensation has been falling since 2000 the fact remains that at its peak it was much higher than expected. Just like the dot-coms at the time, it was a bubble itself.

A more important point is that their compensation, although decreased at times of recession (contemporaneously as the data show; see 2007-2009), the value of their money was not reduced by as much, given the deflationary pressures of the time. Yet, the defendant might comment that worker wages increased during that time. This is the most interesting part of the analysis: it appears that, in 2007-2010, worker wage was increasing (a total increase of 5.6%), while CEO compensation fell by 11.8%. In contrast to what many might believe, it appears that worker compensation declines only long after the event, indicating that wages are sticky (for details see this). The bad part here is that unemployment isn't.

In fact, unemployment in the US soared to 10% from less than 5.5%, in 2008-2010. It was only after unemployment peaked, at the start of 2010, that firms decreased wages. This brings out a more important topic: that after all, worker wage is not only volatile, but workers also face the extra uncertainty of becoming unemployed. For the CEO's higher pay means that the cost of being replaced is accommodated, as is the cost of higher volatility. The problem is that the cost of being replaced isn't covered by the wage increases of the average worker.

This doesn't just happen in the US though; it is also the case in Spain, and Greece and other countries. The point is that we compensate CEO's for the higher risk of getting fired or higher volatility in earnings. Still, the wages they earn are sufficient enough for their children to live in luxury. The average worker not only does not earn that much, but also faces the increased probability of being fired at a time when it is most difficult to encounter another occupation, just because of wage stickiness.

What we have been arguing basically reduces to one of two options: either we start thinking that we are overpaying CEOs or that we are underpaying workers. I'll leave it up to you to decide. But if you ask me, lowering the ratio to the early 1990's levels would be much better.

Targets of Inflation: Nominal Wages

Hard rules have always been a favourite of the economic community. They are easy to use, provide a clear indication of whether policymakers should act or not, and are usually very easy to interpret; that is why there exist so many: Taylor rule, inflation targeting, Evans rule, and so on. Lately, market monetarists have also been advocating NGDP targeting and other hard monetary rules, which as regular readers may remember, did not impress me that much. Lately, I got my hands on a paper by Gregory Mankiw and Ricardo Reis, which promotes the idea of assigning a weight for nominal wages when the Central Bank is targeting inflation for stability.

The main idea behind their modelling is that the Central Bank wishes to minimize the variance of output. Simply put, the less volatile output is, the less inflation we have. After a rigorous mathematical treatment, they reach a very similar conclusion as past paper of  theirs (quelle surprise!), namely that "a central bank should give substantial weight to the growth in nominal wages when monitoring inflation". Yet, there are two things which strike me as odd. First, why should the Central Bank aim at minimizing the variance of output and second, even if their conclusion holds in a boom does it still hold in a downturn?

When it comes to the first question, think of it this way: suppose we have an economy in which output grows by 3% per year, which is what most developed countries aim at and what most have achieved in the past. In year one, output is 100 and in year 10 output is approximately 130.5, with variance over the 10-year period being 105. If one would like minimize variance then the simple answer would be to keep output stable. Yet, although variance would be zero, growth would also be zero. And if population growth is positive then GDP per capital would also fall. What is more, the inflation rate would not really be zero.

In a closed economy, when everything is produced and consumed within the country, controlling for inflation is much easier. Yet, such economies are scarce in the world. Food and energy prices, as Mankiw and Reis correctly note, are determined internationally now with each country's central bank trying to do its best given circumstances created by others. A notable example of inflation from internationally-defined prices is the stagflation experience of the 1970's: oil prices rose by 2.5 times in a year and 15 times in a decade forcing inflation to sore in every developed and oil-dependent country in the world.

But even if, for argument's sake, we accept that the central bank could somehow control for any international discrepancies what happens with growth? Should we sacrifice it for inflation's sake? If population grows and inflation is zero then real rates will rise and we all know what happens when that occurs; it has been evident in both the Great Depression and the European Sovereign Crisis. Deflation is much worse than inflation, especially when citizen welfare is concerned.

Obviously, many will comment, minimizing output variance does not necessarily mean that it will be zero. Yet, what will the target be? We do not know exactly how much output variance makes the inflation rate 2%, 3% or 5%. In addition, what will happen when we have growth, by more than we have expected and it messes up with our estimations? Should we raise rates and freeze money creation or just let it be? The reader may think that I am sliding off subject. Yet, if the starting equations are not correct then one can be sure that the conclusions reached by them are also incorrect. But let's move to the real topic: are nominal wages a good indicator of inflation?

The answer is not really, especially in a recession. Have a look at the next two graphs, obtained from here:

As can be seen, in no country does inflation walk hand-in-hand with nominal wages. The only country which appears to support the notion that nominal wages move with inflation is Spain, albeit whether we can extract a good answer when 3 out of 4 of the countries do not abide by the rule is something quite debatable. Obviously, the CPI is not an excellent measure of inflation; yet whether wages would improve its accuracy is something which I honestly doubt. The only rationale I could accept for including wages in the equation would be that it is just as sticky as prices in a downturn. Yet, this holds more in a recession than in a bubble. When we have growth it is usually prices which rise faster than wages, although the latter manage to catch up eventually.

Mankiw and Reis (page 26) mention that "if nominal wages are falling relative to other prices it indicates a cyclical downturn...". This is exactly what is not happening. Wages are not falling, at least for a long while. In Greece, wages were increasing until early 2010, actually rising more than the CPI. In the next sentence we see that "when wages are rising faster than other prices, targeting the stability price index requires tighter monetary policy.." . This was, nevertheless, the case in Greece in 2008-2010. The country was in a recession and wages were rising. If we adhered to their hard rule then tighter monetary policy would have quite literally financially destroyed the country.

The very essence of sticky prices and sticky wages is that in recessions, they will not respond to changes in the economy by as much as we expected them to. When we wish to target something stable then another stable variable is a good proxy. Yet, when growth and variance of output are in question, we know that they are unstable and more so we do not wish for their stability, thus, a stable variable is not of much good in tracking changes. The CPI is far from perfect; yet targeting wages will not improve our estimates of inflation and neither will it bring more stability in the economy. As the European sovereign crisis indicates, targeting wages will give us the wrong signals. Unless we like deflation and contraction that is.

The 1920's all over again: The Greek Transfer Problem

Germany in the 1920's: The Transfer Problem
Keynes, in 1929, stated that the problem of German reparations after World War I could be reduced into two issues: the Budgetary Problem (i.e. how to extract the necessary amount from the country) and the Transfer Problem (i.e. converting the German money received into foreign currency). The fact that Germany had been borrowing abroad for domestic capital purposes temporarily solved the problem, yet the situation could not hold for ever. Thus, the only potential resolution of finding the funds to cover for the Budgetary Problem would be to increase exports by a significant amount; a feat that could only be achieved by shifting factors of production from other employments to the German export industry.

The only reasonable explanation for Keynes was that Germany had to reduce her costs of production first, as supply of labour was more than enough at the time. Using this rationale, solving the Transfer problem would mean that German gold-costs of production relative to such costs elsewhere would have to be reduced either through increased efficiency, lowering of interest rates or lowering efficiency wages. As the first two did not appear to be available for change (efficiency was high at the time and lowering interest rates, i.e. cheap money for Germany, was not an option) a reduction of the efficiency-wages in Germany was the only alternative left.

However, such a reduction in efficiency wages would make the extraction of the funds needed for reparations (i.e. the Budgetary Problem) much more challenging. In addition, lowering money-wages would be to no avail if:
i.   Output could not be exported
ii.  Demand elasticity for Germany’s goods was less than one
iii. Germany’s competitors reduced their efficiency wages pari passu
iv.  Foreign customers imposed tariffs on German goods

This lowering of money-wages would not mean that real-wages would be reduced by the same amount as home-goods prices are expected to fall. On the other hand, efficiency could also be reduced in response to the wages which could trigger an even larger decrease in money-wages and so on.

The mechanisms which would provide for such a decrease in wages were two: the fall of the German Mark’s exchange rate (which was prohibited by the Dawes scheme) or by allowing the Reichsbank to enforce deflation, which would curtail the activity of business and throw people out of employment, so that when sufficient amount of workers are out of employment they would accept a reduction in their money wages. In Keynes's own words "Whether this is politically and humanly feasible is another matter".

Greece in the 2010's
On May 2nd, 2010, the IMF and the Eurozone authorities (Troika) agreed on a bail-out loan of €110 billion. The influx of funds, which was mainly employed in bank recapitalizations and debt restructuring, came with the need to increase government revenue, while simultaneously reducing expenses so that future installments could be met. Given that Greece did not possess a national currency to devaluate (much like Germany in the 1920’s) the additional three options had to be assessed; greater efficiency, cheaper money or lowering the money-wages.

Blue line: Corporate Lending Rate. Orange line: Mortgage Lending Rate

Although interest rates decreased slightly, they remained a relatively high level compared with the rest of the Eurozone, perhaps indicative of the fact that Greece is still at risk. Issuance of sovereign bonds was not an option for the country since she had been out of the markets since April 2010, thus, no opportunity for cheap money was not available. Increased efficiency was an issue considered in the country, yet, due to over-crowding in the government sector, lay-offs were implemented, both as a measure to increase efficiency as well as a measure to decrease government spending. Thus, the only remaining alternative was a reduction in money-wages.

Reduced government spending meant reduced state stimulus in the economy; thus, the Budgetary problem had to be resolved as less available money would have to compensate for the same amount of state revenues (to meet debt repayments). The challenge was no less tempting than the one faced by Germany in the 1920’s and the necessity to create additional income to compensate for the increased installments which had to be paid in the following periods, drove the economy to the only other alternative: deflation.

Not possessing a national currency (much like Germany could not devaluate hers) meant that the nation would either be forced to borrow from abroad to repay her current installments (which was infeasible for Greece) or increase the trade balance in favour of exports. In Keynes's mind, this could only occur if money-wages were reduced; as we have seen before indicate that before, money-wages in Greece decreased, although they were much stickier than most expected.

The shift of factors of production in Greece the borrower’s price of Imports relative to Exports is consistently rising over time, which leads to decreased export prices and increased import ones. This is consistent with the Keynesian premise that factors of production need to shift from industries which focus on domestic goods to ones which focus on exports, consequently decreasing export prices as a result of lower efficiency wages.

Import over Export Prices

Conclusion
Since Greece was unable to devaluate her currency to accommodate for the flow of goods in her economy after the first bail-out, the transfer problem deteriorated the nation’s finances, which promoted a shift in the factors of production from home-goods to export-goods, albeit at a significant cost to the country’s economy: unemployment has exceeded 26%. Consequently, the Budgetary problem of extracting a significant amount of funds from a reduced amount of wages in an economy, arose; this in its turn provided the need for debt restructuring, both in the sense of reducing the debt burden as well as making debt terms more lax. 

Why should we pay attention to this? Simply because this has been largely ignored by most economists when the design of the Greek restructuring plan took place (and every other EU bail-out before or since, to be fair) and led to consequences econometric models were unable to project. In addition, since none of the countries which received a bail-out has been able to come out of it successfully yet, (although Cyprus has some hopes since new bank loan offers have already began) the matter presented here should be of extreme interest both for any future bail-outs that may be needed (Slovenia is likely candidate for example) as well as for re-examining where policy went wrong in the Eurozone. Past experiences with austerity when countries had their own sovereign currencies had nothing to do with what was (and is) asked of the bailed-out member: a depreciation of the exchange rate when there is no exchange rate to depreciate. This is what has mainly been the cause of the severe contraction of the Eurozone economy has been the inflexibility of the economy (see also here) which is a result of stickiness in the short-run and the lack of sovereign currency to depreciate. In its turn, this forced the shifting of factors of production from one sector to another while at the same time created an army of unemployed.

To paraphrase Keynes, it appears that such policies were deemed as politically and humanly feasible in the 2010's EU. Unfortunately, the costs were both miscalculated and neglected.

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.

Work Hours, Job Turnover and Aggregate Demand in the US

It has been said that our perception of the world economy has changed. We are no longer constrained by limited goods like we did in the early- and mid-20th century; in fact, we have more goods than we have ever had in the past. Our economic understanding has shifted from supply problems to demand issues (not all economists adhere to this, but the flat earth society still exists doesn't it?) and our view of crises has been exactly that: a sharp drop in demand causes an abundance of goods and services remaining unsold, resulting in losses for corporations which, given their worsening economic situation have to let go many employees, if not all. This vicious cycle can be easily seen in any economy where austerity has been defining policy in the past couple of years with politicians unfortunately still adhering to flat-earth remedies (an excellent review of this shifting of ideas can be found in Tom Streithorst's Post-Scarcity Economics).

What has come to be an increasing worry is whether the US can really break out of the current secular trend of falling demand and continue on a path where demand is higher and more stable. In the case of the US, many appear to be pessimistic on whether this could be implemented. While others argue that the time of a permanent decrease in demand has come, others (like yours truly) believe that demand could actually be increased. Despite the camp the reader chooses to abide with the truth is that data are not so terrible as many present them. Job turnover has averaged about 3% per month, much lower than the early 2000's 4%, yet still quite high.

Job Turnover Rate. Source

In addition, real wages which had been falling ever since the 1970's, according to the Federal Reserve, show a clearly increasing trend since the mid-1990's, despite some ups and downs during the years.

Source: CPI and Wages

The unemployment rate has been decreasing since 2008 (although quite slowly) yet the most alarming issue is that the number of hours worked by the average American in the past years has been steadily increasing. While on average people were working 54.3 hours per week in 1979, in 2012 this has increased to 60.0. The trend seen in the next chart is more than obvious:

(Weekly compensation divided by Hourly compensation. Data can be found in the BLS website under codes LEU0208183700 and LEU0258178300 respectively.)

A most straightforward question which comes to mind is why do people feel like they need to increase their working hours if their real wages are increasing every year since 1996? The turning point in the graph was 2007. The reader will notice that between 1992 and 2007 working hours had fluctuated in the 56-57.4 interval without ever going past it. Yet, when the late-2007 crisis occurred, a jump in the graphs could be observed: between 2007 and 2009 people were working 1.5 hours more per week. In addition, labour productivity was also increasing in the 2007-2012 period which means that it wasn't that Americans were producing less than other periods in their history so they had to work longer to make up for it. Then, was this trend due to high turnover or high unemployment? Was it due to increased worry about what the future would bring or a willingness to save for debt repayment? My opinion is all of the above. It's not that easy to see everything around you shutter and not be willing to work some more in order to secure your job.

Source:BLS

This, however, comes at a cost. The more people are afraid, the more they are willing to postpone spending for the future, thus making the situation even worse. It is a sort of citizen-imposed austerity, with the same results as the state-imposed one. People work more, spend less, and watching unemployment rise and others around the world (e.g. Europe) facing difficulties makes them willing to live on a shoestring. As people get more and more afraid they fell victims to their employers' whims and requests as they are "willingly forced" to work longer hours out of uncertainty about their job stability and their future employment prospects; this uncertainty manifests as fear and spreads like wildfire through the economy.

Although the increasing trend in the number of hours worked is worrying there are remedies which can assist in making things better. Many still believe that even if people are finally persuaded to spend more, demand will never reach the heights of the pre-2008 era. I would respectfully disagree with them: data are not supportive of their claims and opportunities are still plenty. Unfortunately, they are still plenty because not all is good in the US.

Real personal consumption is increasing ever since the 1940's, despite the sharp drop during the recession. Yet, as commentators indicate, the crisis has taken its toll on the people: real household income had decreased by 4% in 2011 (data for 2012 are not yet available) and the poverty rate reached 15% or 46.5 million people in the same year, up from 14.3 in 2009 and 13.2% in 2008. Thus, there is plenty which can be done to boost demand, with most of it includes some sort of government intervention; either direct or indirect. Underprivileged members of the society could be given better education (in a country where some universities have endowments of over $1 billion, only 27% of the population has a bachelor degree) and more importantly a better chance to work somewhere that offers them the opportunity for personal and professional growth.

Many a policy (e.g. tax breaks for corporations hiring them, subsidies, scholarships, etc) could be implemented in order for the underprivileged to overcome their financial difficulties, yet these are beyond the scope of this article. What matters is that if income is increased by just $1000 a year on average then an additional $46.5 billion would be available for spending. This might not seem like much compared to the $9.5 trillion of total spending per year, yet the effect of these would be further increased over time with the increase in bank credit and accumulated jobs which would further stimulate the economy. In contrast to austerity's vicious cycle we would experience a virtuous cycle which would reduce the poverty level, increase real wages, decrease the total hours of work and in addition create more jobs and boost consumption, thus making the economy grow.

Those who fear that aggregate demand will fall in the future may be proven right if nothing is done to prevent such a turning of the events and the US will be one of the first countries to witness a permanent abundance of supply over demand, resulting in worsening economic circumstances. Regardless of whether we call it Keynesianism or Monetarism (which are in essence the same) the truth is that markest appreciate assistance in times of crises. I am not arguing that they would never get out of the crisis on their own, yet why should we force ourselves through the torment of a long-lasting depression when we know the doctrine which would help us overcoming the problems?

Austerity and Wages: The Real Data

From what we can see very few have actually bothered to see the effects of austerity measures in the lives of people. Thus, after some (very light) data mining I present you the effects that these austerity measures had on the Greek and Irish economies. Unfortunately, we do not have the opportunity to study other nations for the time being, as data only go as back as June 2012. Yet I will contrast the results for Greece with those of Germany during the 2006-2012 period.

Note: All results are inflation-adjusted (i.e. real) and account for gross wages (y-axis represents aggregate wages in the economy)

Real Wages in Greece

In the graph above, the two vertical lines represent the first two austerity packages the country passed, one in May 2010 and the other in February 2012. According to the data, the real value of the country's wages began to fall just before the 1st memorandum and is continuing its downwards slop up to day. In contrast, have a look at real wages in Germany:

Real Wages in Germany

Here, real wages only took a slight fall during the late 2008 crisis, but have resumed their upward trend in 2010, rising substantially over the past couple of years. If the Greek data are not enough let's have a look at the next graph:

Real Wages in Ireland

As anyone can see, wages in Ireland have also taken a tumble over the past 3 years. The straight line represents the 2009 budget which was aimed at salvaging the Irish banks and reduced government spending so that the debt burden assumed would be sustainable. The point of contrasting the aforementioned two countries with Germany is not to blame the latter. It is merely to point that Germany is here a case where policies have worked well while Greece and Ireland the cases where terrible policies did not have the results expected by policymakers. Worse of all, the result expected had no relationship with reality whatsoever. 

As economists, we expect that once the public's purchasing power is lowered then prices will fall as a result of less demand. This is actually what is being taught in Economics 101 in every university in the world. (see graph below)

Simplistic economics: Lower demand (Demand 2) means lower price (P2).

What economists in the IMF and the EU have failed to see is that prices do not change so fast. In fact, they may not change at all during the short-term (depending on how you measure short-term of course. Here, I assume is it as less than 2 years). In fact, an article in a Greek newspaper stated that prices in the economy just showed a declined. The date: February 6th, 2013. One could post data on inflation in Greece but these would be redundant. Real wages represent the current state of the economy much better and with greater insight on the public's purchasing power.

Since people do not behave as economists believe they do (and no economist has ever thought about changing the models or defining "rationality" in a different way) it is obvious that real-life effects will differ significantly from what is expected in theory. Greece and Ireland appear to have been nothing more than economic experiments; so that economists can learn that the world does not function the way they had thought. Unfortunately, it takes more than just one nation for economists to understand and admit mea culpa. The same situation is about to happen in Cyprus and has already happened in Portugal, Italy and Spain.

Did the authorities have an alternative? Yes: induce less rapid austerity measures, so that the reduction in government expenses would not cause such extreme responses, making a more gradual move from over-spending to under-spending. Now, let's assume that they did not know about this and they had to make a mistake to learn about it; now that they have learned, will they do anything fix this situation?