Sovereign & Budgetary Deficit Hysteria

After the recent travails of Greece to secure its debt service ability, deficit hysteria is sweeping the EU now and is building in the U.S.

First was Ireland where draconian spending cuts led to an estimated 9% annual decline in GDP this year, thus resulting in widening the budget deficit.

Then Greece, where an EU-IMF imposed deficit reduction plan of 10 percent over two years led to a forecast decline in GDP of 20%.

Noticing a trend?

Deficit Hysteria!

Currently, Spain and Italy announced €15bn and €25bn respectively in budget cutting.

Portugal accelerated its budget reduction program to move yearly deficit spending from 9% of GDP in 2009 to below 3% by 2013, or by about 2.5% a year.[1]

In France, where the budget deficit is 8% of GDP—well below Britain’s—President Sarkozy is under pressure to follow Ms Merkel’s budget balancing maneuver in Germany.

In 2009 Merkel committed Germany to a permanently balanced annual budget after 2016, the so-called “Debt-Brake” Law, thus mandating additional budgetary cuts amounting to €10bn per year.[2]

In the United StatesPresident Obama is under increasing pressure from republicans, Tea-Bagging Libertarians, and “Blue-Dog” Democrats to match each additional expenditure with an equal cut elsewhere in the budget.

Euro Zone National Budgetary Deficits

United States National Budgetary Deficits

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An Anglo-European Lost Decade Approaching?

Pretending as if this fiscal tightening were beneficial during our current economic meltdown, ♦ the Organisation for Economic Co-operation and Development (OECD) has recommended monetary tightening as a precaution against inflation,[3] and ♦ the U.S. Federal Reserve feels undue pressure to raise rates and tighten funds along with a Congressional legislative initiative to “audit” (interfere with) the Fed.

Both the ♦ Bank of England (BoE) and the ♦ European Central Bank (ECB) are considering raising interest rates toward the end of 2010, despite the fact that the ECB forecasts:

  • the Eurozone will contract by 4.6% this year and that
  • the June inflation rate will fall 0.1% compared to a year ago, the lowest inflation rate since 1953.

Eurozone Inflation Rates

At this time, in the United States, it is getting quite difficult to argue that America is at risk of high inflation, given recent consumer price data. Despite some of the loosest monetary and fiscal policy America has ever seen, and now the pressure of a nascent economic rebound, U.S. inflation appears more than merely under control… it’s fading:

  • core inflation is at the lowest level since at least 2000
  • total inflation is also trending downwards
  • thus at its current level, the CPI data isn’t quite showing deflation yet, but it is reporting clear disinflation (falling inflation),
  • meaning that, with a few more months like January through April, we’ll see literal deflation in the U.S.

United States CPI Inflation Rates

Of course, this condition has its own problems, so I would expect to see the Fed move to prevent this condition. Actually, an inflation rate at about 2-3% is seen by many economists as beneficial. Meanwhile, Bernanke will continue to quietly withdraw liquidity, as he has been doing since the beginning of the year.

What does all this mean for the prospects of growth?

Well, looking at the Eurozone-16 countries alone, the average current deficit in 2010 is about 7% of GDP (U.S. is about 10%), and it will probably be 8% next year (see deficit charts above). The current aim is to bring this figure within the Eurozone mandated 3% limit by 2013 — or budgetary savings of 5% over two years.

Assuming a (small) government spending multiplier of 1.5 and an affect distributed evenly over the three years following 2013, a 2.5% annual reduction to Eurozone GDP growth until 2016 may be anticipated, due to austerity measures.

However, as average Eurozone growth since 2001 has been slightly above 1% per year, one should expect deficit cutting to lower future growth in Europe to near zero (or less) — with concomitant impact upon the U.S…. in addition to America’s own (reactionary) response to a deficit frenzy.

In the end… Europe’s and the United States’ pro-cyclical budget cutting will, at worst, prolong our economic malaise and turn it into a 1930s-style Depression. Hoover would be proud!

At best, the budget austerity measures will produce 1990’s Japanese-style stagnation, a “Lost Decade.”

Whichever outcome occurs, the economic and social costs will be high:

  • growth everywhere in the world will be impacted—thus the recent quick European tour by Timothy Geithner and Larry Summers from the U.S.
  • prolonged unemployment means that a whole generation will remain jobless, and
  • even when recovery takes place, these workers will enter the labor market without the skills they would otherwise have acquired,
  • therefore, further reducing European and American competitiveness.
  • many industries will decline or continue an accelerated decline, and
  • some industries may well disappear altogether, as will the wider communities which they helped support.
  • Income and wealth inequalities will form in the EU and grow even more untenable in the U.S.

Perhaps most disturbing to Europhiles such as myself — who believe in and support the new “European Dream” of an equitable capitalism based upon sustainable technology — is that Europe’s overwhelmingly successful “Social Market Model” will be so deeply damaged by lack of public financing that it may, in effect, cease to exist,… or become a patchwork of  support programs for the supposed “deserving poor” (the working poor) as in the Anglo-Saxon countries (U.S.).

The deficit cutters will bury Social Europe, and accelerate the U.S. social and economic decline.

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Why? Why would modern societies follow a socially and economically destructive course?

The answer lies partly in the ♦ outsized power of the financial sector, and partly in the ♦ near universal acceptance of neo-liberal (i.e., neo-conservative in U.S.) Austrian School/Monetarist Chicago School economic ideology.

Like Britain and America, Europe has invested in excess of a trillion euros bailing out its banking sector. Despite the european ultra-right and the Tea-Baggers in America, this action was correct at the time.

Nonetheless, as the recent sovereign debt crisis has shown very clearly, the very same financial markets that governments bailed out have raised sovereign borrowing costs (interest yields) to exorbitant levels for Greece and other nations while making fistfuls of money short-selling their Eurobonds — U.S. will be next. The casual (criminal) arrogance of Wall Street and Investment Bankers is nothing short of stunning!

Although there has been fresh impetus for greater regulation of European and U.S. financial markets, there has been no corresponding change in ideology. The orthodox ideology is not so much Monetarist or even Austrian—-it is quite simply the supposed “Common Sense” perception of bankers and small business owners alike that an economy’s budget is no different from the family budget. They assert that — “like a family sitting around the kitchen table” (gag) — a sound budget, whether private or national, must balance. This belief is simply not true; families and businesses do not issue or control their own currency, nor do they maintain central banks that may intervene in open markets.

Both Friedman/Monetarists and Keynes/Keynesians would have agreed that the financial crisis required the banks to be bailed out—which Europeans and Americans have done generously.[4] The two men differed, though, about the long term effects of a crisis on the private sector.

Friedman recommended ♦ expanding the money supply and ♦ letting capitalists do the rest.

Keynes reasoned that ♦ capitalists would be reluctant to invest (then as now, banks and lenders seem reluctant to finance business expansion), and ♦ therefore, the state must act as investor of the last resort.

Moreover, where Keynes disagreed with the prevailing orthodoxy during the Great Depression was on the question of balancing the budget. Keynes argued famously that when the private sector was rebuilding its saving, government must spend more; otherwise, aggregate demand would fall leading to falling output, employment and tax revenue.

Yes, growth is the only answer, and one might properly favor what is called the “Green New Deal”massive investment in green infrastructure and new energy sources: essential component of establishing the new “European Dream.”

Of course, a time-lag exists from government investment/expenditure to significant impact, and such a package should have been agreed long ago — still, it would be better late than never.

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How to finance growth through a “Green New Deal?”

Growth is to some degree self-financing (raising tax receipts and lowering social expenditures), but also needed will be a combination of 1) quantitative easing (of the money supply) and 2) tax reform (such that those of extreme wealth [top 1-2% of taxpayers] pay their share); 3) crucially, support must develop for some form of Tobin (or “Robin Hood”) Tax — an international charge/penalty on short-term, speculative foreign-exchange transactions, thus establishing a system for international currency stability.

Some of Merkel’s Monetarist/Austrian economics followers would argue that more state spending leads (through inflation or increased borrowing) to higher interest rates which “crowd out” private sector investment. Well, this is quite a convenient and non-sensical argument, as for this supposition to be proved true, one would need to show that “full” crowding out occurs and is something that according to their own theory can only happen at the “natural rate of unemployment.” The “natural” unemployment rate is unknowable, hence, the argument fails.

As for Keynesian economics, despite the near Depression of 2007-09, many of Merkel’s colleagues appear to remain blissfully ignorant of the concept. As Keynes explained in his “Paradox of Thrift:” Although saving may be a good thing for individuals and businesses, the more a country tries to save, the more income falls and the less it can actually save.

A good example of such economic illiteracy is the oxymoronic title of a recent piece published by the German magazine, Der Speigel: “European Austerity Is The First Step To Recovery.” [5] As the newspaper Berliner Zeitung accurately portrayed it, the end result of such nonsense is that: “Europe will save its way into the next recession.” [6]

Clearly, what we see today in Europe and America is the evolution to the exact opposite of stimulus. Much of today’s press on both sides of the Atlantic is filed with “Budget Hysteria.” Political parties on all sides call for major cuts in national and state expenditure and bicker only about the timing of such cuts, not the prudence of cuts.

Why? The answer is also clear.

For the past three decades, the financial services sector has grown exponentially more powerful—and so too, then, has the influence of “Bankers’ Economics.”

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Bankers’ Economics

Professional economists tend to forget that terms like “Keynesianism,” “Monetarism,” “Rational Expectations” and so on have little resonance with bankers. Nor do bankers have much interest for discussing the pros and cons of the Social Market or the discontents of Globalization. The main business of commercial banking is—well, should be… or at least used to be—that of making prudent loans and keeping the books balanced.

Bankers believe in a strong currency, or what’s known as “Sound Money,” especially when banks borrow from international money markets in order to lend to domestic customers. Leveraging means engaging in more borrowing; banks typically pay a risk premium to borrow more and more on the money market. The credit crunch has made borrowing more difficult. The last thing bankers want is to incur an extra risk premium for having a weak currency, though such bias is detrimental to the greater national interest.

Flexing the Banking Sector’s perceived power over governments seeking to restrict their machinations, financial players try to set an example with a “shot over the bow” of the EU.

For instance, Brussels, Belgium — home to the majority of the EU’s governance institutions — saw its credit rating outlook cut just as the European Commission prepared to increase regulation of the agencies and interests criticized for their role in facilitating the Greek crisis. On Tuesday (1 June 2010), rating agency Standard and Poor’s revised its outlook for Brussels “to negative from stable.”

Ironically, the ploy/maneuver comes just before the European Commission is due to strike back in the other direction. On 2 June, EU commissioner for internal market and financial services Michel Barnier will propose additional regulatory measures for credit rating agencies (CRAs) like Standard and Poor.

The plans confirm that one of the new European supervisory agencies — legislation for which is currently being negotiated between member states and the European Parliament — will manage the registration and oversight of CRAs in Europe. The aim is to have a more centralized supervision of the powerful credit ratings agencies, together with tougher rules on transparency.

The head of the group of Euro-Area Finance Ministers – went a step further after S&P’s ratings change for Brussels by calling for the creation of a European ratings agency overseen by the European Central Bank. The group of Finance Ministers maintain appropriately that it’s illogical for CRAs to downgrade countries due to their rising debt levels, but then also complain that government-implemented austerity measures hampered growthhighlighting the dual role “aider” and “attacker” played by the investment bank. All of this manipulation serves to show that power must be shifted from unregulated free-market bankers to Central Banks.

Central Banks’ open-market purchases of sovereign debt in the current situation would relieve the pressure of maturing debt (European and American) and tend to devalue currency, much to Bankers’ chagrin. At the same time, though, such open-market purchases would achieve making:

  • national exports less expensive internationally
  • and, hence, more attractive and
  • leading to increasing production/employment,
  • increased tax receipts,
  • reduced social spending,
  • declining yearly budget deficits and
  • eventually reducing overall sovereign debt.

Under such circumstances—and much as in the 1930s—to argue that EU countries and the U.S. must pursue “Sound Money” is bad advice. Both monetarists and Keynesians agree that extreme monetary prudence can plunge economies into deeper recession through restricted aggregate demand.

Depressed aggregate demand provides no incentive for private capitalists to invest. To raise aggregate demand, Keynes argued, the state must do what private capitalists cannot. The relevance of this argument should be obvious.

A large state-led investment program is needed to build new infrastructure and to develop alternative energy generating capacity. But no major political party in Europe dares stand up for this principle, and in the U.S. an impatient public is misled by reactionary republicans and libertarian Tea-Baggers.

Instead, what we see is a return to ol’ Bankers’ Economics: low inflation, “prudent” public finance, strong currencies, and wage compression.

The financial sector has given us the worst crisis since the Great Depression—-it now dictates the terms on which to emerge from the crisis. Balancing the budget is not the answer—rather, it is a recipe for prolonged stagnation and increased social conflict.

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[1] See http://www.ibtimes.com/articles/22922/20100509/portugal-promises-eu-to-cut-budget-deficit-more-in-2010.htm
[2] See http://www.spiegel.de/international/germany/0,1518,696760,00.html
[3] See http://www.guardian.co.uk/business/2010/may/26/oecd-backs-coalition-spending-cuts
[4] See http://blogs.euobserver.com/irvin/2010/04/13/why-sound-money-is-unsound/
[5] See http://www.spiegel.de/international/europe/0,1518,697098,00.html
[6] See http://www.spiegel.de/international/europe/0,1518,697098,00.html

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