15 December 2011

The Hole-ly Trinity

Another 'historical' European summit fails. Haven't I posted this before?

Europe’s leaders cannot understand the Eurozone’s economic, banking, and sovereign-debt crises. They cannot resolve them as, in many ways, they are the crisis.
"At the root of the euro upheaval is a balance of payment crisis caused by the cumulative effects of a 13-year-old one-size-fits-all monetary policy and a fixed exchange rate for a collection of disparate countries in very different stages of economic and structural development." David Marsh, WSJ December, 2011,
There is a persistent belief that budget indiscipline is the main cause of the crisis (despite Spain and Ireland having budget surpluses in 2007). This makes it impossible for Europeans to accept a fiscal authority that treat all its subjects equally, financed by a simple euro bond with mutual debt sharing. Instead, there is now a Fiscal Compact that paradoxically insists on removing power from both Euro states and European citizens whilst imposing are even more responsibility and guilt for the results of having less power

The European Union system is dominated by one school of economic thought. It is determined to prevent other schools of thought ever being presented to the electorate. It outlaws them by asking for constitutional changes for balanced budgets and near-zero structural deficits with punishments and outside supervision for states that break, voluntary or involuntary, the agreement. Disagreeing economists will be silenced by the statement: "it's unconstitutional". No political party will be allowed to present an agenda that differs. Governments will be not longer accountable to their people but as law-breakers to an 'European court of Justice'. There is nothing just or democratic about it.

Europe's very own 'Impossibility Trinity'
The Eurozone had an illusion of convergence when it created trading imbalances financed under another illusion that the bonds of the trading deficit economies could be treated as close substitute for those trading surplus economies (Germany). When it became very apparent that individual members were solely responsible for their own sovereign debts, a debt crisis followed.

To solve this, the compact fiscal pact now tries the 'balanced-book convergence' illusion, in terms of agreed sovereign debt and government budget limits. Those hit harder by a recession will be forced to carry out pro-cyclical policies that deepen their own recession. Those that refuse will be sent to the European court of justice - a 'Death Star' ran by lawyers and bureaucrats zapping out troublesome economies. They will be forced to beg for mercy and understanding from the stronger economies of the euro-zone at a time when they are least able to provide it.

EU Death Star II
by @teacherdude
The new Compact Fiscal pact will deepen the original euro flaw. It sets one part the Euro Zone on a completely different development path to that of the other. The Eurozone, peacefully or not, will tear itself apart.

The plan is that reducing sovereign debt, shrinking an inefficient state, eliminating cartels and vested interests and lowering wage cost and benefits will all improve competitiveness. Reforms can help growth, but austerity and deficit reduction may not be the way to do it. With unequal power relations between creditors and debtors, the only thing that "Expansionary Austerity" expands is austerity.

The idea that Austerity might work is based on the view that government debt is the cause of everything - recessions, unemployment, inflation, higher interest rates, trade deficits. It is more or less a belief. The links are not that obvious. Early naive simplistic Keynesian models portrayed government budget deficit as a counter cyclical measure to provide a short-run stimulus to economies (neglecting stories on deficit financing). Later macroeconomic models viewed government debt in terms of a public and private sector competition for funds that crowded out private investment. This was then all pushed to one side by a theorem, first mentioned in the 19th Century by Ricardo, that ascribes no effects. If true, it makes fiscal policy redundant.

Ricardian equivalence
The reasoning is quite simple. An increase in government debts imply increases in future taxes. As everyone in the economy recognizes this, an increase in government debt is treated as the same as an increase in taxes. A stimulus to the economy (e.g. a lower of tax rate) increasing the government deficit will be recognized as a future tax increase and have no effect. Individuals do not run out and spend their extra cash as they will need it for the future tax increase. On the other hand. if the increase in debt is created by more government spending private investment is crowded out. As the government is always viewed as inefficient relative to the private sector, this will be seen as as having a negative impact on the economy. Thus reducing the government deficit, by increasing taxes will been seen as having no effect while doing it by reducing government spending will be seen as having a positive effect.

BUT, with increasing concentrations of wealth and power, access to capital markets becomes increasingly restrictive. The theorem, neoclassical economics and the economies that are ran by them are in deep trouble and fall apart. The ownership of debt and the distribution in wealth determines the relationship of creditors to debtors. The greater inequality, the more of the population that is hit by being unable to borrow or finance. Investment and consumer uncertainty rises. In a recession liquidity constraints run riot.

Massive inequality really counts:
"These models on why deleveraging matters are all about the net wealth distribution. We shouldn’t be surprised that this recession and the Great Depression were preceded by very large increases in wealth inequality. This is well documented during the 1920s and the 2000s. This is why I get a bit annoyed at the guys who are saying it’s just a pure wealth effect, because it’s something bigger than that" An Interview on Balance Sheet Recessions with Amir Sufi (via Business Insider)
And so, trying to reduce government deficits in a recession is met by liquidity constraints and investor and consumer uncertainty. It is not offset by an increased consumer spending or investment. The greater the inequality, the worse the recession becomes. Attempts to reduce government debts are frustrated by falling taxes revenues and increased spending on unemployment benefits. Targets are missed and the governments' ability to pay back existing debt is threaten.

In a sense a better and more direct policy than fiscal stimulus (and for those who hate the state) is debt forgiveness and writing off debts.

This crisis persists as too much power lies in the hands of creditors and most governments' policies are heavily influenced by them. Forced payments, and enshrined constitutional arrangements such as those proposed in the Euro-zone, generate liquidity constraints everywhere. This perpetuates and deepens the crisis.

In Greece clearly this isn't working.  An IMF report on 13th December showed the Greek economy even worse than predicted with growth forecast for 2011 wand 2012 as revised downwards yet again.  The 2011 deficit, predicted at 7.5% of GDP, has now been revised to 9%. Public debt was 130% of GDP in 2009 and now the it predicted to peak at 187% of GDP in 2013, It might fall to 152% by 2020.  It will take 10 years, the IMF reports, for Greece to close the competitiveness gap. It is taking a much shorter period to destroy the country we know.

Investment in a such an economy is not attractive and bond yields remain high without the backing of a central authority. Private investment does not necessarily make up for the reduction in government spending.  There are no investment and growth opportunities in the periphery and capital flies from them. Don't expect investors to return back.  The real economies of the euro-zone will not converge. The Wall Street Journal reports:
"We are seeing this deglobalization, a 'de-Euroization,' of the euro zone," said Andrew Balls of Pimco, head of the big bond shop's European portfolio management. "Investors are going back to their own markets. They may still hold bonds, but they won't have them spread across the euro zone as they had before."
"The scale of the shift suggests that the euro zone isn't merely suffering from a short-term confidence crisis but that the financial lifeline of some European states is ebbing away, perhaps not to return for years, leaving some countries exposed and in danger of financial breakdown....One result could be a departure by one or more countries from the monetary union, or even its breakup. WSJ December 16, 2011
The prospect of an exit from the Euro and dramatic currency depreciation would cause a massive flight of capital. It is more than ironic that it is happening anyway.

The European Court of Injustice:
You will not find forgiveness here. Merkel and Sarkozy are succeeding in binding the institutions of the EU to the so-called 'interests' of the eurozone via the courts and the commission, over the countries in debt.  It is very Orwellian to tie this to a European court of justice, as if populations are wholesale criminals with procedures undertaken to decide what penalties are deserved.

No-one should be force to agreed to a pan-European structure that they don't believed in for the sake of some misconstrued artificial notion of 'European-ness'.  The definition of 'European-ness' is not the exclusive property of Euro zone leaders. To divide those who agree and disagree with the fiscal compact as European and un-European is akin to McCarthyism.  Nevertheless, there is now one identity that many Europeans are beginning to share:

We're all Greeks now
Austerity succeeding in establishing a common European identity

Father Ted on the difference between inflation and hyperinflation